In September 2020, the German anti-money laundering authority launched an investigation into the German financial services provider Grenke. Fuelled by fears of a new scandal in the style of Wirecard, the authorities were looking into suspicions of money laundering, alleged investment fraud, insider trading and market manipulation.
The story quickly spiralled out of control for the company, leading to the sudden resignation of the COO and CEO, external audits by KPMG and further investigations by the German financial regulatory authority, BaFin.
While most or the allegations could not be substantiated, the damage was already done. The reason for this escalation was activist investor Fraser Perring, head of the British hedge fund Viceroy Research. The investor and his team uploaded a 60-page document on its website accusing Grenke of money laundering, questioning the existence of reported assets, classifying several acquisitions as worthless and the balance sheet inflated.
The share price of Grenke immediately plummeted to a record low, sending the company into the abyss—over €1bn in value vanished overnight.
Over the past decade, attacks like this have become more popular and common in many European countries. They not only pose big economic risks, but also reputational risks for firms of any size and industry, making it important for the management to have a solid communication strategy in place.
Big profits from falling stocks
Short selling is a common but controversial way of trading in financial markets. While going short, an investor borrows shares of the company in question to sell, with the bet that the shares can be rebought at a lower price when the stock falls – the difference is the profit. This scenario allows great profits but also entails great risks: If the share price of the targeted company rises, the short seller will be forced to buy back the shares at a higher price (to repay the original loan), therefore incurring a loss.
In theory, these losses can be infinite as the share price can rise indefinitely but can only fall to zero.
Short sellers’ activists take this practice to the next level by analysing companies’ balance sheets, doing extensive research, and gathering insider information on companies they suspect of being involved in shady business tactics, non-transparent account procedures or even illegal activities.
Their targets are capital structure, corporate governance issues, incorrect accounting, and financial reporting, as well as suspected insider trading. By publishing their findings and allegations, the attackers bet on strong market reactions and consequent falling share prices of the targeted company.
Short selling as a corrective for the markets?
On one hand, critics argue that short sellers deliberately try to depress share prices to maximise profits. On the other hand, supporters claim that short selling can contribute to the “self-cleaning” of the markets and raising awareness for corporate governance issues at an early stage.
A healthy company cannot be shorted, as the bet would simply turn out to be wrong and huge losses would occur. Short stocks provide a partial corrective to the rosy picture of companies’ prospects, including PR companies and media influence.
However, even if the accusations are not proven, the damage is done, and it can take years for the firm to fully recover. Researchers from the French universities HEC Paris and the Université Laval found that over the course of three days after an attack, the stock price of firms targeted by prominent activist short sellers dropped by 11.2% on average. Targeted companies were also more likely to be delisted, suspended from stock exchanges, or go bankrupt in the future.
Communications as a weapon of choice
Short sellers use communications, PR, and social media in the investing sphere to attack targets in various ways and spread a convincing narrative. This way of communications is a powerful “nimble and agile” tool, as opposed to the “slow” or delayed reaction of many companies that are attacked. The middlemen, such as newspapers and other media institutions, are completely cut out and communications plays out almost like “guerilla warfare”.
Short sellers try to evoke negative sentiments against the targeted firms and their executives to impress readers, convincing them that the means of investigation are serious and thorough. The reports get published on their websites, in popular financial forums, and on social media platforms, such as Twitter.
Frequently, the results of their reports get picked up by other media outlets, which in turn magnifies the impact of the results published and, importantly, the convincing narratives used. Many online activists have also developed significant followings on their social media channels and generated credible track records.
Walk the talk
Considering these attacks, company leaders and management boards need to develop a detailed strategy that initiates the necessary steps during an attack to mitigate damages and avoid common pitfalls. A random attack and some false allegations can ruin a well-positioned and reputable company overnight.
But what is the best way for companies to respond to the influence of activist investors? We recommend some basic guidelines on how to react after a company becomes the target of an activist investor:
• Accept the rules of the capital markets: Kekst CNC recommends that management boards accept the rules of the capital market as a precaution against activist advances. This includes transparent communicating with shareholders, for example, about dividend policy.
• Create transparency by seeking exchange with activists, other shareholders, and analysts and intensify the investor relations activities. Initiate an active exchange with the media in the form of background discussions with all relevant outlets, including trade and financial press as well as blogs.
• Proactive analysis: Effective prevention should start with an analysis of whether and for what reasons the company could be affected by a short attack. This involves structural issues to be prepared, preparing the team and processes based on a comprehensive risk analysis.
• Active and transparent communication: Transparent, prompt, and clear communications and a careful, fact-based presentation of the actual circumstances are pivotal. Allegations made should be clarified and grievances rectified. The company’s response should express confidence in the stock and business model. This requires a comprehensive approach and will often take time.
Alexander Fink and Roland Leithäuser are partners, and Zeno Bach is an associate, at Kekst CNC.