Boardroom Battlegrounds: Banks and Activist Investors

It happened with breathtaking speed. In early August, the activist hedge fund Basswood Capital Management announced that it had turned a relatively small, passive stake in Astoria Financial, the holding company for a $15.1 billion-asset savings bank, into a 9.2% ownership position.

With the bigger share came demands: give Basswood a seat on Astoria's board and strongly consider selling the Lake Success, N.Y.-based company. Astoria "has substantial opportunities in the current environment to take steps to enhance shareholder value," whether by staying independent or selling itself, Basswood principal Matthew Lindenbaum wrote in his filing with the Securities and Exchange Commission.

Astoria Chief Executive Monte Redman and his board weighed their alternatives, and quickly decided against engaging in a fight they couldn't win. Like many lenders, Astoria has been grappling with rising compliance and technology costs and low margins. Its return on tangible equity for 2015 was 5.1% and falling, according to Bob Ramsey, an analyst with FBR.

In October, less than three months after Basswood began its public assault, Astoria's board agreed to sell to rival New York Community Bancorp for $2 billion, a 15% premium over recent trading.

"I think Basswood's patience ran out. Here we are, years after the Great Recession and with credit costs at all-time lows, and Astoria still wasn't earning its cost of capital," Ramsey says. Astoria's board "could either wait for things to get ugly and see shareholders turn against it, or it could acknowledge the activists had a good case and sell."

As the largest activist-driven M&A deal in years, the Astoria deal could mark a key turning point in banking's relationship with shareholder activism.

Recent years have seen an explosion of aggressive activist pressure across corporate America. Eager to make up for investment losses suffered during the financial crisis, pension funds and other institutional investors had more than $130 billion invested in activist hedge funds at the end of June, according to Hedge Fund Research. That was up from less than $50 billion five years earlier.

The activists use that money to take significant stakes in underperforming companies — in banks, 4.9% and 9.9% are popular positions, due to regulatory limits — and then negotiate, cajole and otherwise agitate for dividend hikes, cost cuts and even company sales. The goal, more often than not, is to boost the share price and exit the stock at a profit.

According to the investment bank Lazard Freres & Co., 160 companies with market caps above $500 million faced public activist challenges in 2015. The list included such big-name companies as DuPont, General Electric and Yahoo!

Many more held private talks with investors agitating for change: a 2015 survey of corporate directors by the consultant PwC found 32% had interacted directly with activists.

Banking has been a relative no-show at this party. While the industry has a long history of activism, asset-quality issues, regulatory uncertainty and low valuations — combined with rules meant to tamp down the ability of random shareholders to control banks — have conspired to make it a less-than-attractive alternative for most activists.

Between 2012 and 2014, only 8% of SEC filings showing at least 5% ownership and "activist intent" came at financial institutions, according to figures supplied by 13D Monitor, a tracking firm.

"The goal of an activist is to create transformational change at a company, which leads to a significant increase in the stock price," says Gerard Cassidy, head of U.S. bank equity strategy for RBC Capital Markets. "Banking, with its cumbersome regulatory process and recent troubles, hasn't been very fertile ground for achieving those objectives."

But that is starting to change. Hedge-fund tactics toward banks are getting more aggressive and nasty, and the targets are getting larger. In 2015, more than 17% of all activist filings came in the financial space, and most everyone expects the numbers to grow.

"Many banks were given a pass during the downturn, when survival alone was sufficient," says Robert Klingler, a partner at Bryan Cave, who is starting to see more of his bank clients draw activist attention. "We're in a new normal now. Things have stabilized. If you're underperforming, publicly traded and you haven't felt any heat yet, you will soon."

Consider it a compliment: a sign the industry is strong enough for investors to resume their normal worries about earnings and growth. Balance sheets are healthier than they've been in nearly a decade, yet earnings remain challenged.

Most significantly, consolidation has re-emerged as a primary industry theme. Analysts expect the number of banks to be halved over the next decade, and the activists want to expedite things and make a profit. Data from the Federal Deposit Insurance Corp. shows that the average bank's return on equity is 9.3%, about equal to the average cost of capital. Many banks aren't hitting the mark, leaving them vulnerable to an attack, particularly as valuations rise.

Regulators generally appear to be more open to deals, after a long period when getting one approved was tough enough to make even skilled acquirers leery, observers say.

"What's changed is that there's now more confidence that deals can get done," says David Ingles, a partner and co-head of the financial institutions group at the law firm Skadden, Arps, Slate, Meagher & Flom. "Activists see the ultimate exit opportunity — a sale — as being more likely than a year or two ago.

"The net effect is that we're going to see more activists in the space than we've had before — more money coming into bank stocks to make a play," Ingles adds.

Richard Lashley, a principal at the activist fund manager PL Capital LLC, is so upbeat about the prospects that his firm is raising money for a new fund that will target banks with up to $75 billion in assets. The industry, he argues, is plagued by overcapacity. Rising technology and compliance costs are spread across too many institutions, leading to sluggish returns. "Our thesis is that everyone, regardless of size, is headed back to the old days of 'acquire or be acquired,' " says Lashley, whose $300 million fund family owns stakes in 40 banks, most of them microcaps below $3 billion in assets.

Some midsize institutions already are drawing attention, including Columbus, Ga.-based Synovus Financial Corp., a $27 billion-asset holding company that at the end of September was Basswood's second-largest holding, behind Astoria.

Analysts speculate that soon a "too big to fail" institution could fall into an activist's crosshairs. That would certainly make for entertaining theater, and could potentially lead to investors accomplishing what lawmakers and regulators cannot: the breakup of a complicated megabank.

"You could argue that Washington has made the requirements on large banks so onerous that the only way to drive shareholder value is to split them apart," says Cassidy, one of many observers who expect to see an activist make a run at a systematically important financial institution in the next couple of years.

If activism is to break into banking's major leagues, however, the players, methods and objectives likely will need to change.

None of the activists that are regulars in the industry — Basswood, PL, Stilwell Value Partners, Seidman & Associates, among them — have anywhere near the capital and influence with large investors that would be needed to get the attention of the biggest banks.

Instead, the task would likely fall to one of seven or eight big-name activists that have been taking on large companies in other sectors. And unlike in the community banking space, large-bank activism is more likely to focus on spinoffs, sales of business lines and even property, not M&A. Think of a bank with a profitable investment banking or payments unit inside — one that an activist believes would be worth more as a stand-alone entity.

In a telling illustration of what could come, the billionaire hedge fund activists Carl Icahn and John Paulson have recently partnered to pressure AIG, the underperforming insurance giant, to split into three parts.

With such campaigns, "the central theme is, 'You're better off as a handful of smaller companies than one big company, because the regulatory oversight and pain is so much less,' " says Gary Howe, head of the financial institutions group at Lazard. "If you're no longer systemically important, it frees up capital which can be given back to shareholders."

Closer to home, the billionaire activist Nelson Peltz's Trian Investment Management last year successfully turned a 2.6% stake in Bank of New York Mellon into a board seat, and has been pressing the custody bank to cut costs. BNY Mellon has since sold its landmark headquarters building at 1 Wall Street and launched an expense reduction program.

"A transformational change at BONY would be them splitting up the company between the asset management and custody businesses," Cassidy says. "That hasn't been proposed — at least, not yet."

One attorney confides some of his activist clients have taken so-called "stakeout positions" of less than 5% in some larger banks, preparing for potential approaches. One rumored potential target: Bank of America, which has an ROE around 7% and last proxy season faced a shareholder resolution demanding management sell off non-core banking units. (B of A declined to comment for this story.)

"There used to be a view that the largest financial institutions had moats around them" that insulated them from an activist attack, says James Rossman, managing director and head of corporate preparedness for Lazard.

"Now, we're slowly seeing that activists are willing and able to swim through those moats," he says. "They're acknowledging the importance of large shareholders and regulators, but no longer view them as insurmountable factors and are willing to present their ideas to the markets."

Activism has a rich history in the banking business. It was a driving force behind the consolidation waves of the last couple decades, and sparked such landmark deals as the 1996 marriage of Chase Manhattan Bank and Chemical Bank and the 2008 sale of Wyomissing, Pa.-based Sovereign Bancorp to Spain's Grupo Santander.

A 2015 study by Raluca Roman, an economist at the Federal Reserve Bank of Kansas City, found that one-third of publicly traded banks experienced some sort of activist pressure between 1994 and 2010, with an average of about 8.5% of such banks subject to an activist approach in any given year.

The modern-day version of activism got its start in the wake of the financial crisis, and is louder and more intrusive than those campaigns of the past. That could pose a problem for the big generalist hedge funds.

Activists thrive by taking large enough positions in a company's stock to exert control and pressure management and the board for changes. They're adept at using recently expanded good-governance tools, such as proxy access and annual elections, to press their cases, and often demand board seats and even enter proxy contests to get their way.

Though these tactics are used in banking, it isn't as vulnerable as other sectors because of strict government oversight. A whole set of rules surrounds the industry to prevent investors from pushing strategies that could imperil an institution's liquidity or stability. Dividend hikes and organizational changes require the approval of regulators who care more about safety and soundness than profitability.

Any outside investor that attempts to exert "control," either by acquiring a large block of shares or working in concert with others, might be faced with regulatory demands to register as a bank holding company or sign a "passivity commitment" that prevents it from making noise to get its way. Neither of those things is something an activist wants.

"In other industries, shareholder value is nearly sacrosanct. It's legitimate for investors to demand actions that will boost value," says Joseph Vitale, a partner with Schulte Roth & Zabel LLP.

"In banking, the standards are different. It's considered a privilege to own a bank, not a right. An activist can't just come in like they would in another industry, try to raid the cookie jar and then leave," Vitale says. "The analysis in banking is more complicated."

Despite the challenges, there are activist strategies commonly used in other sectors but so far absent from banking that some say could pop up.

One example is real estate investment trusts. Activists have been pushing retailers, restaurateurs and other companies with lots of real estate to monetize those holdings by splitting them off into a separately managed REIT, and then leasing back the properties.

Big banks, with their expansive branch networks, could be ideal for such a strategy — provided it doesn't affect the institution's stability.

Several lawyers say they know of investors who have been contemplating the REIT strategy, but Howe says he is skeptical about whether it might happen.

One issue might be the uncertainty of the role of the branch in an increasingly mobile world. "The challenge is how to value the real estate," Howe says. "Everyone has a smartphone in their pocket, so no one knows what that real estate might be worth."

For now, most of the activity remains centered on the small-bank space, where the only real lever to enhance shareholder value is a sale. Scuffles have become increasingly frequent of late, and several of the recent ones illustrate the varying types of pressure and occasional nastiness that can come into play.

At the $2.8 billion-asset Metro Bancorp, three activists — Basswood, PL Capital and Clover Partners — with more than 20% ownership between them, demanded a sale and ultimately got it. In August, the Harrisburg, Pa., company announced a deal to sell to Pittsburgh-based F.N.B. Corp. for $474 million.

Metro CEO Gary Nalbandian did not respond to interview requests, but having three sizable investors pushing in the same direction put intense pressure on the board, according to sources who declined to be quoted because the transaction had yet to close.

"In the past, it was usually just one activist and maybe a second" taking positions in a bank, says Steve Nelson, a managing director at Davidson & Co. "Today, we're seeing one activist, followed by another and another. They'll pile in because they smell blood."

Oftentimes, things can get testy. Last May, the board of the $160 million-asset Harvard Illinois Bancorp agreed to sell under pressure from Joseph Stilwell, considered a tenacious activist. The deal came a year after Stilwell, in the heat of a proxy contest, sent a letter to shareholders purportedly showing Chairman William Schack asleep under a bank banner.

"Below is a picture taken at last year's annual shareholder meeting of our bank's chairman," the letter reads. "None of the other board members bothered to wake him up."

The best defense against such approaches is preparation and performance. Lashley, who has a reputation for developing long-term relationships with some of the banks PL buys stock in, says activists looks at factors like ROE, market valuations and board ownership when evaluating an investment. "The only way to avoid us showing up is by addressing those issues before we arrive," he says.

A growing number of boards are now inviting investment banks, law firms or consultants to help identify potential flash points ahead of time. "You're airing all the dirty laundry, exposing all the vulnerabilities and making sure you know how to respond," Howe explains.

Communication with large shareholders has never been more important. "You need to spend time with your shareholders talking about long-term strategy, so that if an activist hits, you can go back and say, 'As we told you, this is our strategy and we agreed it was good,' " says H. Rodgin Cohen, senior chairman of the law firm Sullivan & Cromwell. "You want to take the initiative, not be on the defensive."

Critics of activism say it is damaging the competitiveness of corporate America by placing too much emphasis on short-term gains, at the expense of long-term strategy and investment. Advocates say activists play a crucial role in improving management's performance on behalf of all shareholders.

"Most of the time, what an activist does is reprioritize your strategic initiatives," Howe says. "None of the ideas is particularly new. The company has thought about it, but came up with a different pecking order."

At the $1.5 billion-asset MutualFirst in Muncie, Ind., CEO David Heeter has been balancing the competing demands of activists for the last two years. When Ancora Partners took a 5% stake in the company and began demanding dividend hikes and a sale, Heeter invited Lashley to join his board.

PL Capital, owner of 9.4% of MutualFirst shares, has been patient as the former thrift converts its mortgage-heavy balance sheet into something more commercial-bank-like.

The compromise with Ancora bought Heeter some time, though he's not sure how much.

"We all want the performance to improve. What's most frustrating is that the activist timelines are so much shorter than what most banks can realistically do," Heeter says. "But the ship sails when you become a public company. Anybody can own your stock. That's the way it is."