Article originally appeared in The Financial Times.
Publicly traded companies are increasingly hearing privately from investors that the era of the “liquidity premium” is coming to an end. This fading of the valuation boost for companies with good access to liquid sources of funding has significance for investor relations, executive teams and boards of directors.
At the onset of the pandemic, publicly traded companies almost universally cut share buybacks and bulked up on liquidity. Incredibly, lenders were calling corporate treasurers to ask them if they wanted to draw down fully on credit lines even though there was no immediate need for the cash.
Other companies went even further and took on large cash infusions in the form of PIPEs (private investments in public equity, in which discounted stock is sold to private equity groups). One of our clients issued almost twice its market capitalization in the form of a PIPE. Markets in turn rewarded these corporations with “liquidity premia” or, in other words, inflated valuations in recognition of their fortified condition.
As we shift to the recovery era, corporations will start to see their liquidity premia erode. The last time this happened on a large scale was a decade ago as we emerged from the financial crisis. The consequence was a rise in aggressive calls by activist shareholders for excess capital to be either returned to shareholders through buybacks and dividends, or put to use through near-term capital projects to boost earnings along with mergers and acquisitions.
The hallmark of this shift will be activism by hedge fund shareholders. The campaign that Elliott Management commenced against Crown Castle in the second half of last year, which entailed a critique of capital allocation and sought an increase in allocation to dividends, is representative of what is to come. As is typical for investor activism campaigns these days, Elliott created a flashy webpage—Reclaiming the Crown—flush with colorful open letters along with ancillary attacks on the compensation of executives and the composition of the board.
Not surprisingly, companies that already have activists in their profile—such as Comcast and Sallie Mae where Trian and ValueAct, respectively, have been agitating—have now been among the first to announce a return to buybacks. At the end of January, Comcast announced that it would recommence share buybacks in the second half of 2021 with the goal of ramping up to pre-pandemic levels and Sallie Mae announced a program to buy back about 20% of its then-market capitalization.
Activist funds will be scanning publicly traded companies for issuers with liquidity cushions that are too large. As a result, executive teams must without delay do their homework on their “recovery era” business plan.
As part of this effort, they need to map out plans for capital allocation. This exercise requires balancing the management of economic uncertainties and debt covenants, pre-empting demands for buybacks and special dividends, and the pursuit of returns from new capital expenditures and M&A strategies.
In the boardroom, public company directors have to be sure that capital allocation is at the top of the agenda for upcoming meetings. Otherwise, there is a reasonable chance that an activist investor will put it there for them.
They should ensure they are comfortable with the internal forecasts that support management’s recommendations on capital allocation, understand the effects of these recommendations on valuation, and press their investor relations teams to be candid with the board about whether these plans chime or conflict with shareholders’ expectations.
It is critical for investor relations teams to make sure that their company’s narrative on capital allocation for the recovery era is proactively sold to their shareholder base.
If a company needs to be more conservative because of business plan risks or debt covenant requirements, its messaging needs to make this clear and provide visibility about timing for a move towards allocating less capital to preserving liquidity.
If a company is taking steps away from preserving liquidity, but is allocating capital in directions other than returns of capital to shareholders, then it needs to be clear to investors about what alternatives are being pursued and what benefits are expected.
As we have seen over the past 12 months, excess liquidity can be a nice problem to have. However, in order to fend off the forthcoming activist campaigns, companies must act proactively to maintain control of their market narrative as we move away from the era of the liquidity premium.