The Shifting Sands of Activist Investing

For about the past 6 – 7 years there has been a quiet revolution occurring in corporate governance. It has been an interesting process to watch as shareholders, usually led by union pension funds, have pushed for reforms in anti-takeover provisions, executive pay and director elections.  

The fact that it is the unions pushing for reform strikes me as ironic.  Regardless of how you feel about the need for collective bargaining, unions are not known as reforming forces.  Many union pension plans, in particular, have been grossly mismanaged, so for them to lead the charge for reform in corporate governance seems to be rich indeed.  When I gave this some thought, my conclusion was that a governance system has to be pretty broken for a group of union people to see an opportunity for reform.  So I took a hard look at the issues they chose to contest. 

Start with anti-takeover measures.  Companies usually experience a takeover bid in the form of an offer to purchase the company’s stock that is higher than the current stock price.  So anti-takeover measures, when all is said and done, are designed to allow management to turn down an offer that is higher than the current market price, but less than the managers think the company might be worth sometime in the future.  Presumably this is because the company managers know more about the company than the market and are in a better position to assess the true value of the company.  But wait, aren’t markets supposed to be efficient and incorporate all available information about a company into the stock price?  And aren’t managements supposed to disclose all material information about the firm to investors?  So anti-takeover measures really boil down to company management saying we want the ability to say no, because we believe that our two birds in the bush (the future value of the company) are worth more than the bird you have in hand (the takeover bid), because of information which we haven’t bothered to disclose, but which could make us real valuable in the future.  Sounds like a losing issue to me. 

Executive pay is an issue where corporations ceded the moral high ground a long time ago.  The pay packages you see for most CEOs of major corporations today are obscene.  The irony here is that the unions have persuaded Wall Street money managers, who often make almost as much as CEOs, to vote for reforms aimed at lower pay.  Maybe there’s a touch of envy involved. 

Finally, think about director elections.  I lived in Chicago for many years, so I’m not shocked by elections that are lopsided in favor of incumbents.  But under the current system for electing directors, you only need a single vote in favor of the director to get him elected.  You can’t vote against him, you can only withhold your vote.  This bears a strong resemblance to the old Soviet era politburo elections. 

If this were just about the obscure ways in which companies conduct their internal workings you could file this piece under important, but boring.  However, it seems that by allowing activists to learn how to win votes on easy issues, corporations are now starting to encounter a more sinister foe. 

According to a speech given by John Siemann of Laurel Hill Advisory Group at the NIRI 2008 Southwest Conference, hedge funds have become much more involved in the proxy activist arena.  ISS, the proxy advisory firm, now counts almost as many hedge funds as clients as it does union pension funds. For the hedge funds, the preferred method of attack is the “Short Slate” proxy fight, where an activist hedge fund nominates one or two directors for the board.  Once on the board, the new directors use their positions to agitate for items that may boost the near term stock price, such as special dividends, share repurchases and the sale or spin-off of non-core assets, at the expense of longer range initiatives.  According to Laurel Hill statistics, in 2006 – 2007, there were almost 200 short slate fights and in more than 66% of these situations, hedge funds won at least one seat on the board. Moreover, in almost 80% of the contests, ISS recommended in favor of at least one member of the dissident slate.  

So it would appear that having allowed the camel’s nose under the tent on issues that were hard to defend, corporations now find that they have provided a road map to investors to actively challenge the manner in which a corporation is being run.  I guess you really do reap what you sow.