Ways to Repel a Hedge Fund
from
September/October 2006
by Charles Burck
What would you do if your CEO called you one morning to tell you that activists had acquired 8% of the company’s stock and were demanding major changes in how the business is run? It’s a challenge that directors are increasingly being forced to face.
Most of these attacks are led by hedge funds and, to a smaller degree, by governance activists such as pension funds managed for unions or the occasional well-heeled individual like Carl Icahn. But lately other groups have joined the hordes: traditional mutual funds such as Tweedy Browne, private equity firms like the Blackstone Group, and investment banks, including UBS and Lazard.
CEOs and board members are inclined to see these folks as the new barbarians at their gate, hungry to tear apart healthy companies in pursuit of a fast buck. Others, including Institutional Shareholder Services and governance watchdogs, don’t view the attackers as barbarians at all but as the awakened voice of long-suffering shareholders. Free-marketers tend to consider them true capitalists forcing risk-averse companies to put underutilized cash to work. However you see the hordes, they seem to be winning most of their battles. The Altman Group, a leading proxy solicitation firm, tracked 34 cases of shareholder activism through June 2006 and found that in 25 of them the activists had either won control or forced the target company to accept at least some of their demands.
The resources that activists command make those of yesterday’s feared corporate raiders look like small change. Hedge funds, by most estimates, have well over $1 trillion at their disposal, and private equity firms have perhaps $300 billion in hand worldwide.
Beyond liquidity, hedge funds possess another key advantage: They don’t have to disclose share purchases and hence can wait till they’ve accumulated the chunk of shares they need before launching an attack. In the past a raider had to spend weeks or months putting together a formal tender offer, soliciting shareholder votes, and dealing with the many defenses a management could throw up when threatened. “Now all an activist has to do is publish a letter or send out a press release and let the legions of hedge funds do the work,” says Paul Schnell, a partner at the Skadden Arps Slate Meagher & Flom law firm. In other words, more hedge funds are likely to join the attack and jump into the target’s stock as well. Overnight, a company may find 20%, 30%, or more of its shares in unfriendly hands. At that point, arguments about whether the company is in play are moot. Unless the CEO and the board can persuade other shareholders to take their side, they’re apt to wind up on the losing end of a proxy fight. Many companies, rather than take that risk, give up and negotiate the best outcome they can, typically agreeing to some of the attacker’s demands and sometimes giving him one or more board seats. (See the box on page 67 for a sampling of how recent attacks on various companies played out.)
But there’s more to the activist boom than restless money; it’s part of an evolutionary process. “The first stage was in the late ’90s, when dissatisfied institutional investors began forcing out the CEOs of underperforming companies like Kodak,” says Mark Nadler, a partner in the Mercer Delta consulting firm. The excesses and fraud that spawned Sarbanes-Oxley marked another step, into what Nadler calls “a coming together of activists, academics, lawyers, and government. That’s when shareholder activists began to realize they could have influence in ways we hadn’t perceived before.”
Laden with new fiduciary responsibilities and standards of accountability, directors cannot automatically step up to the plate for management, as they mostly used to do, but must be more certain than ever that their actions serve the best interests of shareholders. It’s one more illustration, says Nadler, of “a historic shift in the power relationship between the CEO and the board in all kinds of places the CEO operates. Succession, for example, may become almost entirely a board responsibility. It’s the same with responding to outside pressure from activists. Boards have to figure whether shareholder and management interests diverge at some point.”
Preparation for an activist assault breaks down into two broad categories. One is tactical: the specifics of what to do should an activist knock on your door. Putting this plan together is mainly the job of your CEO and his team, but the board should be familiar with it—and satisfied that it will work. If not, push the CEO on the details until you are confident.
The board’s larger job—call it defense strategy—begins even before the planning. You need to know how well your company is meeting the interests of the shareholders as a whole, and where it might be vulnerable to activists claiming to act on behalf of those shareholders. Start with a reality check—a thorough review that includes everything from governance to strategy and operations. The list of potential vulnerabilities that surface while a company is under attack may be longer than you think. “Most directors are familiar with performance and strategy issues,” says attorney Martin Lipton of Wachtell Lipton Rosen & Katz, who won his spurs defending managements during the takeover battles of the 1980s. “But every company should run through a total check each year to look for the kind of things activists might raise.” For example, that strategy you think so highly of: Does the investment community agree that it’s on the mark, or is it unable to see the same virtues you do? How do your stock’s valuation multiples—price to earnings, price to cash flow, and so on—compare with those of your peers? If they’re lower, consider that a red flag and figure out why, as well as what you need to do about it. If you’ve got a lot of cash, which makes you an attractive target, can you explain persuasively why management can create more value with it than shareholders would get if it were returned to them, say through stock buybacks?
Step back and make a clear-eyed assessment of your governance practices. “There are some things you should have a position on ahead of time,” says Robert E. Mittelstaedt Jr., dean of the Arizona State University business school and a consultant and author. “Should you embrace majority voting [for directors]? You need to have the debate on that. How much should you disclose about executive compensation? Do you have a CEO succession plan? These are the kinds of things governance activists can campaign on.”
In putting your defense together, get as much outside help as you need. A board that hires its own outside advisers is not undermining the CEO; it’s protecting him from making mistakes. You can’t necessarily rely on your CEO to have all the right answers, because there’s always the possibility that he’s part of a problem. As Martin Lipton says, an activist attack is “in large measure an attempt to drive a wedge between the board and management by raising doubts about strategy and management performance.” But these are questions that a competent board should have been asking all along. Says Nadler: “Increasingly, boards are bringing in their own outside advisers, primarily financial and legal experts, to help them understand what’s really going on. I don’t want to impugn management motives, but everyone’s susceptible to the natural instinct to be self-serving.”
Consider whether you want to play dirty if your back is to the wall. This includes installing poison pills, which shareholders have been resisting, and using the “head fake,” in which a company promises to acquiesce to an activist’s demands and later changes its mind. While these kinds of maneuvers might buy time in the event of an attack, they cost you credibility and give governance critics, not to mention future attackers, additional ammunition.
Activist investors have their best shot at winning when they can make a clear argument that management has been allowed to underperform for too long. Typical is the case of Wendy’s International Inc. In 2005 the investment community was generally convinced that the company was badly managed and had lost focus on its core business by acquiring other restaurant chains, such as Canada’s Tim Hortons. Several hedge funds pushed Wendy’s for change, but not much was forthcoming until Nelson Peltz, who describes himself as “an operational activist,” acquired more than 5% of the company’s stock through Trian Fund Management LP, his investment vehicle. Peltz had previously bought and turned around Arby’s (which he still controls) and Snapple (which he sold). He unveiled detailed plans for a turnaround at Wendy’s, including unloading the other restaurant chains. When Wendy’s CEO John T. Schuessler refused to meet with him, Peltz launched and won a proxy fight, and added three of his own nominees to the board. Schuessler resigned shortly after. CFO Kerrii Anderson took over as interim CEO, and since then Wendy’s has pretty much followed the Peltz agenda. Three months later, in mid-July, it remained to be seen whether the cure was working.
Peltz got some of his own medicine in June in his role as chairman and CEO of Triarc, the company that operates Arby’s and other food concerns. The proxy-voting advisory firm Proxy Governance accused the company of overpaying Peltz, saying his average three-year $16.4 million compensation was 396% above the median paid to CEOs at peer companies, while Triarc had performed poorly compared with its peers. The shareholders didn’t seem to care: Peltz was reelected to the board at the June annual meeting.
Many companies hope to keep the lid on the news of an attack by activists. Dream on. Even though the law doesn’t usually require a company to disclose overtures, the attacker will typically go very public once he makes his move, and the consequences of ignoring him can be severe. The company needs to get its story—the one you’ve prepared—out to its other shareholders immediately. And if the activist has pinpointed flaws you’ve failed to spot, you should make it clear that you will correct them.
The reality is that your company is being thrust into a sort of political campaign. If you’re going to fight back, you’ll need the votes—actual or implicit—of other shareholders. The victor will be the side that can make the most persuasive case, and activists are growing increasingly creative about promoting theirs. In his drive to get McDonald’s to restructure, for example, William A. Ackman, whose Pershing Square Capital Management hedge fund had acquired nearly 5% of the company, took over a ballroom at the Millennium Broadway Hotel in New York City in January and invited shareholders and media representatives to come hear him pitch what he wanted to do with the company. The room was packed, and Ackman reached out to a much bigger audience via an Internet video broadcast and a free call-in number. Though McDonald’s initially rebuffed his ideas, within weeks it had agreed to sell 1,500 or more underperforming company-owned restaurants and to share a larger amount of its operating company’s financial information with investors.
In a more confrontational mode, as
Corporate Board Member
reported in this year’s March/April issue, Relational Investors, a fund run by shareholder activists Ralph Whitworth and David Batchelder, went public in its fight with Pennsylvania’s Sovereign Bancorp Inc. Eye-grabbing full-page newspaper ads featured photographs of Sovereign’s directors under the headline “Long-Term Liabilities.” Sovereign fought back by getting the state senate to pass an anti-takeover bill, but eventually gave Relational a seat on its board and also promised to appoint an additional director from candidate lists provided by the fund. In May, Sovereign CEO Jay Sidhu told a financial conference in London that relations with Relational were now “wonderful.”
To impress shareholders, your board needs to make sure that management plays dual roles, being well-informed and cool yet at the same time open-minded and responsive. Time Warner CEO Richard D. Parsons got kudos for how he handled Icahn’s assault on the company last year. Icahn had reason to expect success. Shareholders were unhappy with a stock that has languished in the $17-to-$18 range for years. With some 3% of Time Warner stock (his and his allies’) in his pocket and with investment banker Lazard in his corner, Icahn demanded that the media giant spin off its cable division and possibly some other businesses and also buy back $20 billion of its stock. He threatened a proxy fight to install a new slate of directors, and complained to anybody who’d listen that Parsons was mismanaging the company. “It’s hard to imagine a case that could have been handled better,” says Nadler. “Though some of Icahn’s tactics may have grated, Time Warner couldn’t completely dismiss what he was saying. So they said, ‘Let’s figure out what this guy thinks, and if some of the things he advocates are credible, let’s do them.’” Bolstered by the full support of his board, Parsons spoke frequently with Icahn—and, wisely, spent a lot of time talking to the media and the financial community, carefully and repeatedly laying out flaws in Icahn’s position.
“When Time Warner pressed Icahn on how he’d run the company differently, that’s when his case collapsed—there was no there there,” Nadler says. Parsons had to make a few concessions, including a bigger stock buyback than the board had already agreed to and a promise to “consult” with Icahn about new board nominations. The CEO triumphed and Icahn bowed out—or so it seemed at first. But Time Warner’s stock continued to languish, and who was to say whether Icahn or some other activist might not soon be calling Parsons, or going around him to board members, with more ideas on how to fix the becalmed company?
One of the most difficult decisions a board can face in such confrontations is whether an activist’s proposal makes sense in the long run. No matter how carefully you’ve reviewed a strategy, a lot depends on assumptions that can’t be readily proved or disproved. And just what is the long term these days? Companies used to swear by their detailed five- and even 10-year plans. Today adapting to change, real-time, seems the most important key to survival.
It’s been argued that the long run, like patriotism, is the last refuge of scoundrels, namely CEOs who can’t justify a poor showing in the here and now. Some avuncular advice comes from former raider Irwin L. Jacobs—“Irv the Liquidator,” as he was known in the 1980s—who now runs privately held Genmar Holdings, a manufacturer of pleasure boats. “Some companies will ask their investment bankers to help make a case that they’re undervalued because they just don’t want to sell a business,” Jacobs says. “That’s irresponsible.” Yet it’s equally true that hedge funds in particular peer at much closer return horizons than the ones you’re likely to have—or the ones your other investors will look toward, if you can reassure them that hanging on will be rewarding. “You have to know the value of your business,” says Jacobs. “If you’ve got a stock that’s selling for $10 and someone says, ‘It’s undervalued, and I will pay you $13 or $15 a share for it,’ well, the actual value has a lot to do with what value the shareholders think you can create for them. People want 30%, 40%, 50% gains; that’s why they bought the stock.” Still, he acknowledges, “the string is shorter than it ever has been, and there’ll be more and more situations where the deals get done, because you’ve got so much hot money in the market today.”
In the broadest sense, the best defense is the fortress a company builds when it knows where it’s going strategically, is executing well, has a strong succession plan, and meets all the contemporary requirements for good governance. Such near-perfection won’t necessarily deter all activists. If you’re sitting on a big pile of cash, for example, or if your share price for one reason or another doesn’t reflect all your good work, a hedge fund or other activist may try to force you into making a stock buyback. But if your company can explain itself thoroughly and persuasively, you’ve raised the hurdle—and the likelihood that the activist will start looking for an easier target.
