Activist investor Glenn Welling recently launched a director-election battle at organic food company Hain Celestial Group Inc. (HAIN) , with the goal of taking over the company's board and agitating for a sale and other changes.
Welling's fund Engaged Capital LLC accumulated a 9.9% stake over a short period of time. In addition, long-term holders Vanguard Ltd., Fidelity Investments, and BlackRock Inc. each own about 8% of the company, according to FactSet Research Systems Inc. As a result, Hain's top four holders control well over 30% of the company—and its top 12 investors control about 50%.
Therefore, instead of convincing hundreds of shareholders to support his director candidates, Welling only has to convince a handful to back his efforts.
The battleground for the Hain tete-a-tete is not unusual in today's world of activist insurgencies. And expect a growing number of proxy contests to reflect its realities in the years to come. Consider this emerging trend: There are billions of dollars in funds flowing from actively managed strategies into an increasingly concentrated number of passive funds. In particular, the top index funds, including Vanguard, BlackRock and State Street Corp., are becoming larger, a transformation that some argue will be a positive development for activist hedge funds. Already BlackRock, Vanguard and State Street have $5.4 trillion, $4.4 trillion and $2.6 trillion under management, respectively.
Many experts in the institutional investor world expect that over the next five years the big three index funds will significantly increase their ownership positions at U.S. companies. Jim Rossman, managing director and head of Lazard's shareholder advisory team, argues that this will be a positive development for activist funds.
"If you are an activist your job is harder if you have to convince 25 to 30 big shareholders," said Rossman. "Your job is made easier if you only have to convince four or five managers, especially if it is the same four or five individuals you know well and talk to on a regular basis."
Rossman said it is extremely likely that when a well-known activist strikes they will have conversations with people they know at BlackRock, Vanguard, State Street and other major funds because they have communicated with them in prior activist campaigns. On the other side of the spectrum, targeted corporate executives and their boards are likely to have few or no relationships with the top index fund managers and may have trouble getting their perspective across.
"The relationship between activists and big index funds is strong," Rossman said. "And each year as more money flows into passive strategies, passive managers become more assertive, willing to use their large stake and influence to have companies make changes."
Indeed, the amount of capital shifting from active managers to passively managed funds is growing, suggesting that activist hedge funds will have to convince fewer and fewer investors to back their campaigns in the years to come.
According to Morningstar Inc., passive fund inflows reached more than $225 billion in the first quarter of 2017, while about $11 billion exited actively managed funds. The shift in funds was an extension of what Morningstar found in all of 2016, when $506 billion flowed into passively managed funds at the same time that active funds received outflows of $343 billion. Morningstar includes index funds from firms such as Vanguard and BlackRock, as well as Exchange-Traded-Funds in its definition of passive funds.
Lazard's Rossman argues that already at many companies in the S&P 1500 three index funds and one fundamental owner control 25% to 30% of the equity. In addition, he contends that recommendations made by influential proxy advisory firms Glass, Lewis & Co. LLC and Institutional Shareholder Services Inc. will essentially automatically influence the votes of an additional 30% to 35% of the votes, though others argue that fewer investors systematically follow their advice.
"At many companies [facing activists] it's not 400 to 500 investors deciding the day. It is coming down to four or five votes," he said.
However, don't expect it to be all share-price spikes and acquisition premiums for activist investors any time soon. Insurgents still have to face the fact that for a variety of reasons there is a better than not chance that index funds won't back their campaigns. And legislators on Capitol Hill are trying to impose tougher regulations on proxy advisory firms, which could make life more difficult for activist funds and their director battles.