The largest asset managers, led by BlackRock, are elbowing activists out of the spotlight on the topic of corporate governance. This blog has tracked tracked how mutual funds are putting distance between their priorities and the activist agenda (see here, here, here, here and here). The rift widened earlier this month when BlackRock, Fidelity, Vanguard and T. Rowe Price met with Warren Buffet and JPMorgan to create guidelines for best practice on corporate governance. Discussions have focused on issues such as the role of board directors, executive compensation, board tenure and shareholder rights, all of which have been flashpoints at US annual meetings.
This effort appears to be in direct response to the prominence of activist hedge funds (now managing in excess of $100 billion) and the success they have had in forcing share buybacks and other financial moves by corporations to increase returns to shareholders.
On the heels of the meeting, BlackRock CEO Larry Fink sent another letter to chief executives of S&P 500 companies urging “resistance to the powerful forces of short-termism afflicting corporate behavior” and advocating they invest in long-term growth. Make no mistake, “short-termism” is code for activist hedge funds and paragraph two of the letter takes aim at common goals of activists:
Dividends paid out by S&P 500 companies in 2015 amounted to the highest proportion of their earnings since 2009. As of the end of the third quarter of 2015, buybacks were up 27% over 12 months. We certainly support returning excess cash to shareholders, but not at the expense of value-creating investment. We continue to urge companies to adopt balanced capital plans, appropriate for their respective industries, that support strategies for long-term growth.
The letter asks CEOs to develop and articulate long term growth plans and move away from quarterly earnings guidance. “Today’s culture of quarterly earnings hysteria is totally contrary to the long-term approach we need,” writes Fink. Without a long term plan and engagement with investors about the plan, “companies also expose themselves to the pressures of investors focused on maximizing near-term profit at the expense of long-term value. Indeed, some short-term investors (and analysts) offer more compelling visions for companies than the companies themselves, allowing these perspectives to fill the void and build support for potentially destabilizing actions.”
With respect to “potentially destabilizing actions,” Fink acknowledged that BlackRock voted with activists in 39% of the 18 largest U.S. proxy contests last year, but says “companies are usually better served when ideas for value creation are part of an overall framework developed and driven by the company, rather than forced upon them in a proxy fight.”
With this letter and the group of large investors that is in formation, traditional fund managers are giving corporate America a buffer against activists. If a company were to explain to the largest asset managers “how the company is navigating the competitive landscape, how it is innovating, how it is adapting to technological disruption or geopolitical events, where it is investing and how it is developing its talent,” and had their support, it would be more straightforward to resist an activist campaign, particularly one based on a financial strategy like buybacks. “Companies with their own clearly articulated plans for the future might take away the opportunity for activists to define it for them,” writes Matt Levine in Bloomberg View.
If the pendulum is to shift from activists to traditional fund managers, are they ready to be proactive on governance matters? The AFL-CIO’s key vote survey which tracks institutional voting on proposals to split the roles of chairman and CEO, curb executive compensation, give shareholders more say in board appointments and improve disclosures about lobbying, found many of the largest mutual/index fund companies to be in the bottom tier of firms in their support for these governance-related votes.
The FT suggests that the size of these institutions may limit their involvement, “any governance principles that emerge from a consensus of the large managers are likely to fall short of those typically supported by the powerful proxy advisory services ISS and Glass Lewis, which offer voting recommendations to pension funds and other investors.”
However, a research paper entitled Passive Investors, Not Passive Owners finds that ownership by passively managed mutual funds is associated with significant governance changes such as more independent directors on corporate boards, removal of takeover defenses and more equal voting rights.
Investing for the long term is an issue in the Presidential campaign and is becoming more relevant in corporate America as the US adjusts to globalization, technology that is disrupting many sectors and the continuing shift from manufacturing to service and knowledge-based industries. The practice of quarterly reporting limits disclosure and discourse about long term objectives. As Matt Levine notes, “If you are an investor, you might want to know your company’s plans, no? It is odd that corporate disclosure is so backward-looking; like so much in corporate life, it is probably due mostly to the fear of litigation…Also, notice that Fink’s list of “what investors and all stakeholders truly need” is exactly what isn’t (for the most part) in companies’ public disclosures.”
In the UK, quarterly earnings reports are optional and more companies are giving them up. “I am surprised that more people haven’t stopped,” Mr Lis [of Aviva Investors] says. “For long-term investors it really wouldn’t matter whether there are quarterly reports or not in any sector.”
The investor group and the BlackRock letter are more examples of fund managers pursuing a governance agenda independent of activists. It remains to be seen how wide the rift between index/mutual fund managers and activist hedge funds will become, but it is clear that some major asset managers have seen limitations in today’s forms of activist investing, been put off by regular overreach by activists and maybe concluded that activists have jumped the shark.
Passively managed funds are under attack again. Last summer Carl Icahn famously blasted fixed income ETFs and this month, Bill Ackman devotes one third of Pershing Square’s annual letter to investors to criticizing index funds.
To start, the letter suggests that as asset flow to index funds accelerates it creates momentum in the indexes they seek to represent which raises the bar for hedge funds benchmarking to those indexes. Violins. Returns are down among activist managers and when looking at individual stocks, excess gain from activist campaigns dropped significantly from 2012 to 2015. S&P’s US Activist Interest Index is down 31% in the last year.
His primary claim is that index funds have no incentive to pursue good governance at companies within their portfolio and cannot have the bandwidth to make intelligent proxy decisions. “Index funds managers are not compensated for investment performance, but rather for growing assets under management. They are principally judged on the basis of how closely they track index performance and how low their fees are. While index fund managers are, of course, fiduciaries for their investors, the job of overseeing the governance of the tens of thousands of companies for which they are major shareholders is an incredibly burdensome and almost impossible job. Imagine having to read 20,000 proxy statements which arrive in February and March and having to vote them by May when you have not likely read the annual report, spent little time, if any, with the management or board members, and haven’t been schooled in the industries which comprise the index.”
He cites the example of Dupont when last year index managers who owned 18% of the stock voted against board members proposed by Trian Capital Management. He also says that the lack of index fund support for Pershing Square’s teaming with Valeant to buy Allergan shows how those firms “did not take this issue [corporate governance] seriously.”
This is an extremely thin argument, especially the case involving Valeant in which the legality of Pershing Square’s actions were broadly questioned. In reality, index fund companies are getting much more involved in governance and are engaged with corporations and their boards. Evidence is everywhere. BlackRock, State Street and Vanguard are members of the Shareholder-Director Exchange, a group formed to enhance shareholder-director engagement.
Recently, Doug Braunstein of Hudson Executive Capital called Michelle Edkins, BlackRock’s head of corporate governance, the most powerful person in corporate America because of BlackRock’s ability to influence corporate boardrooms.
The assertion that index managers are not motivated by performance is wrong. If indexes keep going up, assets will keep flowing in. The index manager is constrained in terms of allocation of the portfolio and cannot sell an underperformer. This creates a powerful incentive to ensure that index constituents perform. Governance is the steering wheel whereby passive investors can influence performance. This makes them natural allies of activists, not disinterested bystanders as Ackman might have us believe.
Larry Fink CEO of BlackRock which manages $2.7 trillion in index funds wrote an open letter to 500 CEOs encouraging a new focus on clear long-term vision, strategic direction and credible metrics against which to assess performance. “At BlackRock we want companies to be more transparent about their long-term strategies so that we can measure them over a long cycle. If a company gives us a five-year or a 10-year business plan, we can measure throughout the period to see if it’s living up to the plan. Is it investing the way it said it would? Is it repaying capital to shareholders?” he asks.
To me this is about getting leverage on corporations and holding them accountable.
As index fund managers ramp up their focus on governance, there is broad opportunity for activists to tap into that growing sector for support because to a large extent, their interests are aligned. What activists have to worry about is the possibility that index funds diverge from hedge funds and forge their own path in advancing the governance principles they perceive as enhancing long term corporate performance. Braunstein predicts that in five years every public company will have an investor member on its board.
The SDX is one example of how index fund managers are pursuing a governance agenda independent of activists. Last month another step in going it alone was taken when it was announced that BlackRock is among the founders of Focusing Capital on the Long Term, a group of large global investors which also founded the S&P Long-Term Value Creation Global Index.
So much went so wrong at Theranos that it’s hard to know where to begin. At its core, it is another case of deeply flawed, if not failed, governance at a company that too quickly achieved global recognition and a $9 billion valuation.
Some might say that as a private company, there is no harm or foul. That would be a mistake.
The Food and Drug Administration is investigating whether Theranos administered diagnostic blood tests despite knowing its system was inaccurate and whether the company modified its equipment during the FDA approval process, a violation of research practices. Recently Walgreens announced that it has postponed deployment of blood testing centers in partnership with Theranos and Safeway has delayed the launch of a similar program.
Thirteen years in, Theranos’ technology has never been independently tested.
Despite longstanding questions about the efficacy of its technology, the firm has surrounded itself with an all star cast of investors and advisors, including:
- Riley Bechtel, chairman, Bechtel Group (director)
- David Boies, attorney (director)
- Timothy Draper, Draper Fisher Jurvetson (investor)
- Larry Ellison, CEO, Oracle (investor)
- William Foege, former director of the U.S. Center for Disease Control and Prevention (medical board member, former director)
- Bill Frist, former Senate majority leader (medical board member, former director)
- Henry Kissinger, former secretary of state (advisor, former director)
- Richard Kovacevich, former CEO and chairman, Wells Fargo (advisor, former director)
- Don Lucas, earl investor in Oracle (investor)
- Sam Nunn, former senator (advisor, former director)
- William Perry, former U.S. Secretary of Defense (advisor, former director)
- George Schultz, former secretary of state (advisor, former director)
Among a recent flurry of highly skeptical media coverage, The New York Times credits Theranos founder Elizabeth Holmes with executing the Silicon Valley playbook perfectly from dropping out of college to embracing quirks worthy of Steve Jobs to championing a humanitarian mission. “But that so many eminent authorities — from Henry Kissinger, who had served on the company’s board; to prominent investors like the Oracle founder Larry Ellison; to the Cleveland Clinic — appear to have embraced Theranos with minimal scrutiny is a testament to the ageless power of a great story.”
Last year, $633 million in new investment flowed into Theranos. This demonstrates the degree to which many investors will suspend disbelief for a hot commodity.
While Silicon Valley and the VCs who typically speak for innovative technology companies are known for their skewed views on governance, the executives and board at this company appear guilty of large scale malpractice. Reports that in October the company had filed to issue more shares suggest that the board could have been complicit in Ponzi-like plans to cash out early investors, even as the company’s troubles continued to mount.
Despite the setbacks experienced at Theranos, the board hardly appears chagrined. A press release from the firm attributes this quote to the board and other advisors: “Theranos’s technology is both transformative and transparent: Our blood tests are faster, less expensive and require less blood than traditionally required. As a group, we embrace this promise and stand with Theranos.”
This saga demonstrates how boards of directors, despite their pedigrees, can be far, far out of touch with the companies they are supposed to oversee. Many directors are simply spread too thin to be effective. In the case of Theranos, Bill Frist is on 3 public company boards, seven private company boards and six non profit boards.
Theranos is just the latest proof of the need for continuous vigilance in our markets. It shows how the system continues to benefit from, even encourage activist hedge funds, whistle blowers and regulatory watchdogs to ensure that investors get reasonable protection and, when it comes to health and public safety, rigorous standards based on peer reviewed science.
Breaking Views says that they Theranos case could reflect badly on unicorns, privately held startups valued at more than $1 billion. Good, it should be hard to achieve a high valuation and it should be harder still for companies which hide behind walls of secrecy like Theranos, regardless of who is on their board.
With the increase in hedge fund activism, a growing array of corporations and corporate activity are coming under pressure. No aspect of corporate decision making, not even M&A and corporate strategy appear insulated from activists’ reach. However, amid the growing activist voice, little attention has been directed on broader corporate governance issues such as the upward spiral of CEO compensation.
In 1965, the ratio of CEO pay to that of the typical worker was 20:1. Now it’s 300:1. Between 1979 and 2011, productivity rose by 75 percent, but median pay rose by just 5 percent, yet from 1978 to 2013, CEO pay rose by a mind-boggling 937 percent.
Nancy Koehn, a Harvard researcher writing in the Washington Post said,“they [CEOs in the post war era] drew their public legitimacy by orchestrating national prosperity.” But then something changed. In the 1980s and ’90s CEOS became celebrities. Steve Jobs and Lou Gerstner were revered as saviors. In 1992 Ted Turner was Time’s Man of the Year, first CEO to win that accolade since 1955. In 1999 Jeff Bezos was Time’s Person of the Year. Koehn cites the “Great Man” theory as partial explanation for the current state of executive compensation. She notes that examining the top decile of the top one percent of income distribution between 2000 and 2010 shows that between 60 and 70 percent of those earners were top corporate managers — not celebrities or athletes.
Dodd-Frank and other regulations have attempted to create more transparency on compensation practices in order to discourage lavish compensation through, in effect, public shaming.
“I don’t think those folks are particularly ashamed,” observes Regina Olshan, head of the executive compensation practice at Skadden Arps. “If they are getting paid, they feel they deserve those amounts. And if they are on the board, they feel like they are paying competitively to attract talent.”
Ironically, CEO pay is criticized using much of the same logic that is levied against activist hedge funds: “CEO capitalism creates incentives for executives to favor policies — reducing jobs or research and development — that boost stock prices for a few years at the expense of long-term growth. How much of this is a real problem as opposed to a rhetorical debating point is unclear. But the contrast between executives’ rich rewards and the economy’s plodding performance suggests why CEOs have become political punching bags.”
For whatever reason, hedge funds have not been punching that bag.
Perhaps CEO compensation should be studied more closely by the capital markets. In a purely unscientific exercise, I compared the 50 names on Goldman Sachs’ “Very Important Short Positions” list to Equilar’s list of the 200 highest paid CEOs. The correlation is remarkable.
From the GS list of most shorted companies by hedge funds, here’s how many are also on the list of highest paid CEOs:
- 8 of the top 10
- 17 of the top 20
- 25 of the top 30
- 29 of the top 40
- 35 of the top 50
That appears to be more than coincidence. Hedge funds need to look more holistically at issues of corporate governance and spark a national discussion in the press and in the boardroom about the relationship between corporations and shareholders. For every lightning rod topic like share buybacks and every proxy battle over board membership there are important governance issues such overpaying for performance and unfair dual share structures that are not getting enough attention.
Financial engineering. Sounds bad, doesn’t it. Not as bad as “financial weapons of mass destruction,” but bad. Financial engineering is the term now used to describe a set of activist strategies, including share buybacks, dividends, spinoffs and mergers. According to Activist Insight, more than 600 activist investments since 2010 (more than a quarter of all activism) qualify as financial engineering.
The effect seems profound. S&P Capital IQ calculates that companies in the S&P 500 now spend 36% of operating cash flow on dividends – significantly more than the 29% of operating cash flow committed to capital expenditures.
Some economists fear that reducing capital spending results in lower growth and fewer jobs. A recent paper from Harvard advocates banning share buybacks. The Economist notes that US corporations spent $500 billion on buybacks in the 12 months ending in September 2014 and calls buybacks “corporate cocaine.”
Much of the criticism levied against financial engineering and buybacks, in particular, treads familiar ground: activists are forcing corporations to make decisions that sacrifice long term growth for the sake of near term reward.
A new paper from Proxy Mosaic examines activist campaigns that could be termed financial engineering and suggests critiques based on short termism are probably misplaced. According to Proxy Mosaic, total returns to shareholders increase over time and on average activist campaigns that result in buybacks, spinoffs, etc. generate more than 25% returns. Looking at individual strategies, spinoffs generate the highest returns (about 50%) followed by buybacks at nearly 30%. The caveat is that activists’ financially-driven strategies do not typically beat the market. Buybacks, for example, trail the S&P 500 performance by 3%.
Proxy Mosaic concludes that:
- The type of financial engineering matters (spinoff strategies typically generate strong returns, while acquisitions are dilutive)
- Financial engineering transactions “may actually have moderate longer-term benefits to shareholders.”
- “Shareholders have legitimate reasons to be wary of activist that advocate for financial engineering transactions…[while] financial engineering has been a valid and productive strategy on an absolute basis, it is not clear that shareholders are actually better off after the activist intervention.”
We should expect that financial engineering, particularly stock buybacks and special dividends, will be the focus of growing analysis, attention and debate. Corporate governance experts will have their say. Boards might become more hesitant to approve share buybacks. Ultimately, it might become easier for corporations to resist activists pursuing financial engineering strategies.
For activists, even in the near term, the bar is rising when it comes to pressuring companies for share buybacks. Activists are going to have to be even more persuasive among investors and the media to get support for campaigns in the financial engineering category. Activists will have to become more selective, more data driven (when making their case) and, perhaps, more prepared for long campaigns, assuming that companies have stronger ground to resist calls for share buybacks.
Those activists who are best at picking their spots, communicating effectively and bucking the financial engineering stigma, will separate themselves from other funds and enjoy the benefits that come with being perceived as leaders within the activist sector.
The more media coverage an activist hedge fund gets, the more negative it becomes. That’s the key finding in my study of activists in the press.
Value Act, Jana Partners and Blue Harbour Group are the funds which score highest in terms of positive media sentiment. Their high scores for reputation are tempered, however, by the low volume of media coverage they receive. That said, these funds are well regarded in the press for their success in using constructive and typically non-confrontational approaches to engaging with management and boards.
The biggest names in the business (Pershing Square, Third Point, Elliott Management, Icahn and Trian) are on the other end of the spectrum. They receive enormous media attention but the sentiment in that coverage is much more negative. With greater attention comes greater scrutiny and the media are compelled to come up with new story lines about these funds. Tactics are questioned, managers’ personalities become news, wealth becomes a focus. Even when they score a victory the media coverage will often include reference to a past failure. The bigger the target or the bigger the campaign the greater the risk for negative publicity. Elliott’s fight with the Argentine government, Pershing Square’s campaigns on Allergan and Herbalife and Trian’s fight with Dupont have each been damaging to the managers’ reputation.
In studying the media coverage activist managers’ preference for letting their campaign records do the talking become clear. Most managers do not directly engage with the press, but use letters to shareholders and CEOs/boards as proxies for media relations. Of course some managers do make the rounds on TV, do live events with reporters in attendance and even sit with journalists for in depth interviews. But for the most part, the activist industry wants their record to define them. This is a mistake and the activist scorecard is insufficient to build a consistent, positive reputation. Look at Starboard Value, a fund that has become more active in recent years and received more press, as a result. Their record in terms of wins and losses has been highly positive, yet, the sentiment in the media is more or less neutral.
That is because reputation has to be about more than wins and losses. The previous post in this blog focused on whether activism is good for our financial system. That is the big question and the fact that activists have been winning a lot more than they have been losing doesn’t provide the answer.
The research shows that certain funds would probably benefit from greater media exposure and that the name brand funds would benefit from picking their public battles more carefully and calibrating campaigns based on the associated reputational risk.
From the research one can also conclude that if the activists which get the largest share of voice in the media are viewed negatively, it creates a risk for the entire sector. The case still has to be made for activism: how activists improve corporate governance, accelerate corporate performance and advance the interests of other investors. Until that happens, the activist sector itself faces the risk that the media, the market and even regulators will decide that they are part of the problem rather than part of the solution.
Activist hedge funds have never had more influence and success. While it may be the golden age of activism, these funds are still underdogs, in the grand scheme of things. Staggered boards, poison pills, the resources available to large corporations and many more factors make it difficult, even risky for activists to go after big companies.
Here’s another: it is hard for activists to recruit qualified board candidates for proxy contests. Institutional Investor’s Alpha interviews Steven Seiden of executive search firm Seiden Krieger Associates about the challenge of finding dissident director candidates.
“I have to call at least four times as many people when it’s a proxy battle as I do for a non-contested election,” says Seiden, who has been recruiting directors since 1984. “ISS and Glass Lewis prefer directors with industry knowledge, impeccable reputations, committee eligibility and total independence.”
A director with the best chance of getting elected must “have the courage of their convictions and aren’t going to act like sheep when they’re on the board. The activist can’t bind them to vote his way once they’re elected,” says Seiden.
Clearly, having a strong slate of directors is an enormous advantage for the activist, but how does the fund position itself to recruit the best candidates? Negative perception can be a factor that complicates the process. “People often bridled when they were asked to be on a contested slate. They knew their names would be in the news. They thought it might sully their reputation and figured they’d never be invited to serve on another board,” explains Seiden.
The answer is to invest in reputation. The funds known for the best strategy and most effective techniques for engaging with corporations, not the ones that generate the most headlines, will be the most palatable to would-be directors. The funds that have that important back story about what makes them tick instead of just a scorecard of wins and losses will be the ones most likely to rally coalitions of qualified board candidates, institutional investors, proxy advisory firms and media around their causes.