Law360 (October 2, 2020, 4:37 PM EDT) --
Below are some key trends that we believe will begin to play out as hesitation gives way to opportunism. Companies should thoughtfully assess how they intend to navigate the coming resurgence.
Demonstrating Real Estate Bona Fides
In light of recent market dislocation, the broader institutional investor base will expect REIT activists to demonstrate a deeper understanding of a target company's business. This is especially true in REIT sectors that may be facing existential questions about the nature of their business in light of shifting market behavior or ongoing business disruption. It will not be adequate for an activist simply to point out stress in a company's business model.
Instead, institutional investors will expect activists to demonstrate viable ideas — on an operational, financial, capital allocation or strategic level — that merit giving an activist a seat at the table in decision-making. Companies should be prepared for activists who lack this depth of industry knowledge to seek to establish their bona fides by teaming up with real estate industry professionals to form an investor group, or by adding real estate veterans to their director slates.
On the flipside, more traditional real estate investors may begin to take activist positions themselves, a trend observed more broadly across industries in recent years as activism has become a strategy as well as an asset class.
Focus on Pure Play and Pruning Strategies
REIT investors are increasingly interested in so-called pure play stocks centered on a specific asset class, with a particular focus on specialty assets. As with the trend away from conglomerates in other industries, REITs facing off against activists have been challenged to increase their portfolio pruning by divesting noncore or lower quality assets including through multi-property portfolio sales or spin-offs.
This is particularly true where REITs trade below net asset value. And even if these divestitures are pursued, debate may persist about the terms of the transaction or the best use of the resulting sale proceeds, with dividends and share buybacks historically favored by activists over reinvestment in the business.
While the divisibility of REITs makes a pruning strategy more actionable than in many other industries, the ability of REITs to sell properties at justifiable valuations depends on market conditions as well as the availability of acquisition financing on favorable terms, both of which cannot be taken for granted in the current environment.
Where asset level pruning and resulting balance sheet management are not available, companies should expect activists to focus on critiques of management's and the board's ability to execute with their current property portfolio. To successfully defuse such arguments, companies will need a well-articulated strategy to support why their particular asset base makes sense.
Attacks on Management
It is a well-worn path for activists to criticize senior management's performance or to seek a CEO's removal as part of a settlement or after gaining board representation. According to FTI Consulting Inc., average CEO turnover more than doubles when an activist wins board representation, and even where an activist is unsuccessful in gaining board seats, CEO turnover increases by 71% following an activist campaign.
Expect the market turbulence brought about by the pandemic, and the apparent need for many sectors to pursue a reinvention strategy, to create additional opportunity for activists to argue that current management is not up to the task. And as recovery drags on, also expect activists to focus on whether a thoughtful succession plan for senior management is in place to ensure that strategy over the long term can be implemented in a capable set of hands.
Attacks on Founding Families
Many REITs that began as private family-owned businesses have founding families with significant economic, voting and other rights in the company. These rights can include board appointment rights, high-vote stock, consent rights over specified transactions, and/or tax protection provisions. Activists often target such REITs, criticizing the founding family's control rights and agitating for governance changes.
While such companies can present structural challenges for activists who must pursue a campaign all the way to a proxy contest, the existence of built-in defensive provisions has not kept activists on the sidelines, and naming and shaming legacy families can lead to a settlement well before that point is ever reached.
More broadly, in light of the pervasive focus on environmental, social and governance — including board diversity — that has catalyzed institutional investors, expect governance arguments to become a renewed flashpoint in the REIT space.
While corporate governance issues in and of themselves may not drive an activist to target a company, these governance issues often become a theme in any activist approach and a rallying cry for attracting support from other influential shareholders.
This is particularly true for REITs, many of which have been criticized in the past for governance provisions or reliance on state statutory protections such as the Maryland Unsolicited Takeover Act, which are perceived by some as shareholder unfriendly. REITs can preempt these types of campaigns by proactively evaluating their governance and clearly articulating the board's alignment with shareholders.
M&A Still a Key Driver, But Under the Right Circumstances
A push for M&A has been a tried and true argument for activists across all sectors, including the REIT space, but when valuations are down it becomes increasingly difficult for buyers and sellers to align on an appropriate valuation, and for the target board to answer the critical question of why now is the right time to sell the company.
Where these factors do not align in the complicated alchemy that is required for M&A deals to happen successfully, expect activists to pressure the board's standalone strategy and to facilitate unsolicited approaches from interested acquirers. Recent toehold acquisitions by a number of private equity firms in public REIT equities present an interesting additional dynamic in this multidimensional chess game.
While the playbook for REIT activism shares many similarities with other industries, there are important distinctions that can be outcome determinative in preparing for and responding to an activist approach. Well-advised companies will thoughtfully formulate and articulate their strategic plans to address the current market dislocation and double down on off-season shareholder engagement.
Michael Brueck, Shaun Mathew and David Perechocky are partners at Kirkland & Ellis LLP.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
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