An activist may be trying to shake up one of the biggest banks in the world — here's what it takes to do it

jeff ubben valueact
ValueAct CEO Jeff Ubben motions during a speech at Northwestern University's Kellogg School of Management in January 2015 Kellogg School of Management/Youtube

Jeff Ubben and his activist hedge fund ValueAct have taken a $1.1 billion stake in investment bank Morgan Stanley, according to filings with the Securities and Exchange Commission released Monday.

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While it is still unclear if the stake is going to lead to an aggressive push for changes at the bank, Ubben is best known for shaking up giants such as Microsoft and Adobe. So it's not out of the question.

To get those changes, even if Ubben and ValueAct play nice, is a massive undertaking.

From preparation to building a stake to meeting with company management, an investment by an activist fund takes huge amount of time, money, and even showmanship.

So as we learn more about the ValueAct-Morgan Stanley investment in the coming days, here's a look inside everything it takes for such a huge gamble to pay off — or fall totally off the rails.

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Before you get started, here are a few terms you need to know.

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The world of activism is one of the most colorful in investing. It’s full of not only big names and even bigger money, but also some of the most colorful language in the market lexicon.

Here are a few of the essential terms you need to know, and some of the most out-of-the-box:

Proxy fight: The ultimate endgame of an activist campaign. This is the fight for shareholder votes at the company's annual meeting, and a chance to make a big change in one fell swoop.

Bear hug: An offer to acquire a company, meant to force the company to either put itself on the auction block or respond to your private approaches. These are usually leaked with the effect of adding pressure on a company's board.

Poison pill: A way for a company to make it impossible for an activist to acquire enough of a stake to get anything done. The poison pill lets the company issue new stock to shareholders to keep the activist's stake small.

Bedbug letter: Basically the equivalent of taking a schoolyard fight to the teacher. A letter to the Securities and Exchange Commission during a proxy fight that complains the other side is using misleading information — which breaks the rules and can lead to disqualification of the proposal.

Wolf-pack: Piling into another activist's campaign on the investor's side but without coordinating with the other fund.

Greenmail: Basically paying the activist to go away, usually by buying up the fund's stake at a nice premium. It was once more common, but isn't considered very kosher these days.

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Start by toughening up.

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In theory: Activist investing is a very public exercise. If you're going to pressure a board of directors into making big changes, you need to be able to get its attention. Of course, with that publicity comes the public's scorn.

Get something wrong or lose some money, and you'll hear about it in the press for years.

In practice: One great way to know what you'll face is to learn the ropes from another activist. Almost every notable activist has come off the tree of a former great. Keith Meister of Corvex Management learned from Carl Icahn; Scott Ferguson of Sachem Head learned from Bill Ackman; Rehan Jaffer of H Partners learned from Dan Loeb.

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Find an idea ...

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In theory: Activist investors are actually just very noisy value investors. They start by finding a company that they think is worth more than the stock market is giving it credit for — and then they take matters into their own hands by pressuring a company to shake things up with a breakup or sale or change of leadership.

Activists usually look for a few things — efficient and productive use of capital, proper management incentives, and a strong focus on the business, measures such as return on invested capital, and use of capital for shareholder-friendly practices such as buybacks — to determine where there's room for improvement.

In practice: Ideas can even come from other activists. After Ackman announced a short of Herbalife, calling it a pyramid scheme, Icahn decided to go long on the company, leading to one of the most intense exchanges in investing history.

As investors have poured into the activist game, it is getting harder for fund managers to find unique targets. Often, fund managers wind up in the same investment as other funds, and sometimes they don't agree on a prescription.

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... and then research (and Google) everything.

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In theory: This goes way beyond the old "take a stroll through the parking lot to see if a company's executives are overpaid."

Activist investors research every detail about a company, looking for opportunities and weaknesses. They comb financial records and even sturdy things like topography around factories, the type of people the company employs, and the types of cars used in deliveries.

In practice: In an activist campaign on Darden Restaurants, Jeff Smith at Starboard Value highlighted the fact the the firm's Olive Garden restaurants didn't add salt to the water of the pasta.

"If you Google 'how to cook pasta,' the first step of Pasta 101 is to salt the water," Smith said in a presentation on the campaign.

While the effort to add salt didn't work out, the campaign did; Darden's entire board of directors was replaced.

In 2012, Loeb said that a "rudimentary Google search" revealed that Yahoo's then new CEO Scott Thompson was falsely claiming he had a degree in computer science; Thompson was gone within two weeks.

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Pick a lane ...

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In theory: There are many ways to go about shaking up a company.

For instance, activists have to consider: Do I want to be friendly or antagonizing? How public should I be about the investment? What are the specific goals for the investment? How long should I stay in the investment? Am I looking for board seats, or is this a quick strike?

Answering all of these and more is key to a successful investment.

So is knowing your target: Some companies won't budge until the activist gets mean and loud, and others are willing to talk quietly behind the scenes — and knowing which you're dealing with is critical.

In practice: Even Loeb — whose letters are so humiliating to the CEOs they target that they've been profiled over and over again — knows to change his approach. But when he targeted Japan's Sony in 2013, urging an initial public offering of its entertainment unit, Loeb's tone was remarkably demure: "In a spirit of partnership, we offer our timely plan to strengthen Sony," he wrote.

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... and get your ducks in a row.

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In theory: An activist needs to have everything ready before they bring the idea to the world. A legal team has to be in place, capital needs to be accumulated, and a media plan has to be developed. Even tiny things, like the date and time to file the investment, have to be ready to go in order to make sure the effect is as big as possible.

In practice: The average activist campaign ending in a proxy fight costs $10.71 million. This includes costs for lawyers, researchers, and stamps for letters to shareholders.

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Silently build the stake.

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In theory: Once you've got everything lined up, it's time to start the execution. Activists have a short time to amass a substantial stake in a company. Once an activist buys more than 5% of a firm, it must be disclosed to the SEC.

In practice: Secrecy is key. If word leaks too soon, companies can begin to build their defenses, and other investors can go after the same trade, diluting the upside.

The stake doesn't even have to be that big. Barry Rosenstein at Jana Partners built a small holding, 1.2%, in Walgreens, but still managed to get a board seat and instigate changes in the company.

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Make it public ...

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In theory: Once the stake has been built over 5%, the activist has 10 days to file a form 13D with the SEC. Plenty of investors never build positions that large, so they just kick it off with a well-placed leak or a press release. Or, in Icahn's case, a tweet:

The point is simply this: Alert other investors.

In practice: The 10-day window to file a 13D has come under fire recently, with Democratic senators proposing to shorten the time frame to improve transparency.

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... and start the campaign to win friends and influence others.

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In theory: Activists can't go it alone. Eventually other shareholders and major players have to support the bid to shake up the company — and getting some big guys in your camp can make this much easier.

According to The Wall Street Journal, 50% of mutual fund managers said they had been contacted by an activist investor, and 45% of those contacted had decided to support the activist.

In practice: ValueAct Capital Management got a board seat at Microsoft after making friends with mutual funds that had large shares of the company, The Journal reported last year. Though ValueAct held less than 1% of the company, fund managers with much more of the stock contacted Microsoft, too.

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Get in front of a camera ...

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In theory: One of the easiest ways to get the word out is through the media.

Let's be honest, the media love a good boardroom battle, and at Business Insider, we cover activist fights extensively. TV interviews, sending your presentations to outlets, even going on podcasts can all be good ways to get people to pay attention to your message.

This is also where the tactics can get dirty. Activists will sometimes leak the position and the strategy to outlets before the official filing comes out, putting targets on the back foot in terms of their response.

In practice: Maybe the best example of a sustained media campaign by an activist is Ackman's relentless effort against Herbalife. He has a website, he hosts huge presentations for analysts and investors, and he even let a filmmaker follow him around and make a documentary about it.

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... then take some time to meet the management.

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In theory: Often, the first meeting with a company's management happens before an activist goes public with their position. But if you're hearing about it, that's probably because it didn't work out the way an investor wanted.

But going up against a difficult management is costly, time consuming, and a pain for activists, so finding an easier road can be key, and sometimes the investor and the board can still reach an agreement before the fight really heats up.

In practice: "We always tell the company's exactly what we're going to do. We told the Microsoft board we were going to run a proxy contest just on [former CEO Steve] Ballmer's record, and we gave them five months to figure it out. We didn't ambush them, and over the course of the summer, the shareholders welcomed us, and they took care of Ballmer on their own." — Jeff Ubben, ValueAct Capital

Increasingly, these interactions are taking place over email. During his fight with Canadian Pacific, Ackman released a few of his communications with the railroad's management to the Canadian newspaper The Globe and Mail. In them, he details not only initial meetings with management, but also the back-and-forth that goes on between activists and companies.

"Based on yesterday and my not receiving a return call from you, the probability of war occurring has gone up meaningfully," he wrote.

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Prepare for the pushback, and remember the media works both ways.

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In theory: Things can get nasty, especially when the jobs of management are on the line, and words can fly back and forth. In fact, companies have their own toolkits — and specialized PR firms — to help fend off activists.

In practice: Herbalife swung back at Ackman with its own website about him called "The Real Bill Ackman" in which it trumpets all his flops — like stakes in JC Penney and Borders — with highly polished videos. Its tagline: "William Ackman's self-serving activism is shameful."

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The worst nightmare: A poison pill.

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In theory: One of the biggest defensive moves a company can make is to issue mounds of new stock to dilute the activist's stake to the point that it is no longer substantial. This is known as a poison pill.

In practice: After Icahn took a stake in Netflix, the company responded in 2012 by adopting a poison pill.

Icahn complained, but Netflix only terminated the plan after he cut down his stake.

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Proxy fight!

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In theory: The ultimate showdown in an activist battle is the proxy fight. Basically, that's a fight for the support of shareholders — either in the activist's favor or in the company's.

In practice: Nearly every major activist has been involved in a proxy fight. Ackman took on Canadian Pacific and won — just hours before the shareholder vote, the railroad's chairman, president, and four board members resigned.

And, yeah, it's expensive for everyone involved: A proxy fight between DuPont and activist Nelson Peltz in 2015 cost a combined $23 million, the News Journal reported. DuPont won that one.

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Beating them to the punch.

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In theory: As activism has increased, so too has the number of companies employing tactics to fend them off — not just with poison pills, but by looking at the metrics that activists use to determine whether they will go after a firm.

In practice: Hewlett Packard hired Goldman Sachs to defend against activists looking to break up the company. Then it gave Ralph Whitworth, an activist investor, a seat on the board to help it through a restructuring and avoid a more hostile move by other potential investors.

"We believe that Ralph will bring a constructive voice and a track record of value creation into the boardroom," Ray Lane, HP’s executive chairman, said in a statement. "We look forward to benefitting from his perspective and experience."

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Profit (?)

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In theory: Eventually, all good things must come to and end, which means exiting the trade and selling off the stock stake.

Depending on the outcome goals, this can happen in a short amount of time — get the big buyback program, see a pop in the stock, and get out.

It can also be after years and years of involvement in the company — after sitting on the board and appointing new management.

In practice: After Fortune Brands announced a split into three companies, Ackman made about $302 million based on his large ownership in the company. According to The Wall Street Journal, this created a 270% return for investors in the company — the largest it has listed.

But generating those returns is getting harder and harder as more funds go after the same targets. The Activist Insight Index, which tracks at least 20 funds, rose just 1.2% last year — underperforming the S&P 500 Index. That's a far cry from the days of double-digit, market-beating returns in 2009 and 2010.

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The million (and one) things that could go wrong.

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In theory: The outcome for activists isn't always pretty. In fact, myriad things could go wrong.

A poison pill could dilute the holdings of the activist to the point they no longer have enough sway to complete their goals. A proxy fight can go wayward — an activist fails to get enough votes, and management can stay entrenched.

Even when an activist "wins" and gets the changes they are pushing for, the campaign can still be a loser. The company can turn out to have even more issues than it appears, and the shake-up only exposes more negatives.

The media can also turn on an activist if they are seen as too aggressive or unreasonable. Or the changes can be made and the stock simply doesn't go up, making the trade unprofitable.

In practice: Even when an activist wins, they can lose.

For instance, Ackman successfully replaced JC Penney's CEO with one Ackman chose. Sales under the CEO's replacement, Ron Johnson, plummeted until Johnson was removed from his job. Ackman eventually resigned from the company's board of directors, lost millions on the trade, and included the company among his "failures."

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