The Director's Dilemma- Bondholders

Institutional shareholders usually welcome activist investors into a stock they hold. The mere presence of activists often causes the share price to spike upward. Yet a  study by Moody’s Investors Service indicates that bondholders have fewer reasons to welcome such advances.

The study concludes that companies targeted by shareholder activists almost always experience a decline in creditworthiness and a downgrade to their debt rating or rating outlook. “Demands by short-term activists are generally negative for credit quality, especially when they result in the break up of the company,  or the sale of significant assets with the proceeds passing to shareholders or in the assumption of significant new debt,” says Mark Watson, managing director of Moody’s Corporate Governance Group.

For boards, the study results could make the decision to yield to activist shareholders a trickier one. Directors will have to consider that such a move could result in a credit downgrade and a higher cost of capital. Timothy Burns, an attorney at Heller Ehrman in Madison, Wisc., says that while boards need to be respectful of creditor rights when weighing a decision, they don’t have the same legal fiduciary duty to bondholders that they have to shareholders, unless the company is insolvent.

It should come as no surprise to board directors that a cash-draining event, like a large dividend or stock buyback, would erode credit quality. But the study may be an indication that Moody’s—which set up its Corporate Governance Group in 2003 to work alongside credit analysts and more systematically incorporate governance into the credit-rating process—is looking to be more proactive in putting up a red flag before a credit-damaging event takes place. Moody’s and other ratings firms have shown an increased willingness to consider changes to a company’s rating outlook even if it is merely contemplating an event that could affect credit-worthiness.

In fact, late last year, Fitch Ratings told companies that the  announcement of a debt-financed acquisition or buyback could bring a ratings downgrade even before the event had been completed. While it is not apparent that ratings agencies are considering changing a company’s outlook or rating just because an activist shows up, it is clear they are watching the activists—and the boards’ reaction to them—with great concern.

Characteristics of companies most likely to be targeted by shareholder activists who seek to unlock greater shareholder value, according to Moody’s, include strong balance sheets, entrenched management, low leverage (allowing for larger stock purchases or dividend pay outs), low valuation compared to peers, and varied business lines that would unlock value if unbundled and sold off.

“The balance of power at U.S. companies appears to be undergoing a substantial shift in which shareholders are demanding and winning new rights that give them more direct and active influence over decisions that are the traditional purview of management and boards of directors,” says Watson. “The most common demands by short-term shareholder activists are to push for strategic changes, including acquisitions, asset sales, or the sale of the company,” he adds.  Other demands might include share buy-backs, increased dividends, operational changes, or governance changes like board or management shakeups.

“These are potentially significant demands, and any one of them has the potential to change the company’s credit profile over the short-to-medium term,” says Watson.  “The activists also distract management from running the business to deal with their demands, eating up corporate resources and wealth.”

Moody’s did find a small number of cases in which some actions advocated by activists were not misaligned with the company’s creditworthiness and debt-rating quality. These involved mostly cases where a company refocused its strategy, moved away from expansion into non-core businesses, or made more disciplined capital-allocation decisions.