Three Ways Board Members Can Think Like Activists

Three ways board members can think like activists

How directors can get ahead of the curve as aggressive investors seek to shake up their companies. | Three ways board members can think like activists |

Introduction

It’s news that corporate board members and managers dread: An activist investor firm, with billions of dollars in “It’s far better to financial firepower, is buying up the company’s stock. challenge yourself The activists might seek a controlling stake in the as a board and win, business and take it over, or mount a proxy challenge to get representatives on the board. Once the challenge is rather than being laid at the target company’s feet, it has any number of tactics to deal with the intruders, ranging from outright driven to the same opposition to capitulation. point by an activist.”

But there’s a better solution: Directors should get –Bob Nardelli ahead of the activist onslaught, and figure out ahead of time what makes the company vulnerable. After all, the board’s job is to ensure that the company is on the right track, and activist interest often is a signal that something is amiss. Three areas to look at: Galvanizing a board into action may be easier said than done. Not all directors are ready to accept the n Directors should ask the right questions: Is the weakness a lagging stock price, tepid net income responsibility of dealing with activists. According to growth or dropping market share? Does the a 2016 National Association of Corporate Directors company evaluate its capital structure the way survey, 20% of the respondents were approached by an activist would? Then consider alternatives to activists during the previous year, but 46% of those correct the problems. surveyed had no plan in place to respond to the challenges, thus leaving the door open for activists. n Another consideration is for the board to be well-connected with its investors. The board is chartered to look after the shareholders’ interest. If investors, whether large institutions or individual stockholders, are unhappy, that’s fertile ground for an activist.

n Beyond that, director introspection of the boardroom is vital. Is the board too entrenched with management, doing very little and rubber-stamping every decision? Could it use some fresh thinking and new members? Activists will look at this, too.

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It can be tempting for directors to stay above the fray. But the argument is strong that they should get their hands dirty. Sometimes, boards will shrug and say that repelling activists is management’s job. But perhaps management is not equipped to do so, for whatever reason.

Other times, directors might say: “Well, if stockholders don’t like the company, they always can sell.” True. Yet that is no help to the share price, and avoids acknowledging the basic flaws that vex investors. Or directors might simply fire the CEO. In this case the CEO takes the fall even though the board was equally present during the period. (Some believe that Mark Fields, formerly of Ford, may be an example of this). This often avoids a proxy fight and preserves the board. While that step sometimes is merited, a more comprehensive course is to find out what is not working in the corporate structure, which goes beyond the person in the corner office.

The point is not only to fend off an activist. It is to improve the company the way a well-intentioned activist aims to do.

Glenn Tilton, former CEO of Texaco and United Airlines and director of Abbott Laboratories, AbbVie, and Phillips 66, told Harvard Business Review that the “board leader should instead be the activist.” He advised asking the board leader: “Does the talent around the board table reflect all the success determinants for the company, and the risks that can derail it?” To expand on Tilton’s view, why not expect that the entire board be activists?

If that isn’t the case, it should be. Directors must determine whether it would be better for the company to have the board, which knows the business and the employees, be the change agents—or risk the blunt-instrument approach that activists might use.

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Who activists are and what they want

Certainly, if activists come after your company, they Their goals are not necessarily right about its vulnerabilities. Activists seek four ultimate objectives, Ernst & Young Like any other human beings, they are not all-knowing research indicates: 1) sell the company; 2) restructure the seers. But in the broad scope, it pays for directors business portfolio; 3) make operational improvements; to know how they think, to better understand their or 4) change the capital structure. motives and co-opt them by performing repairs on the company before they strike. A 2008 poll of MBA students found that they believe If directors are to be their own in-house activists, the primary responsibility of a company is to maximize here is a useful primer about the outside activists: shareholder value. As this group is moving into positions of influence in hedge funds, that orientation shows up in many of their attitudes. They may conclude that a Their character corporation is worth more by breaking up its parts and selling them, or perhaps by taking it over and trimming They once were called “corporate raiders,” who sought its overhead. Sometimes, activists believe, a company is short-term payouts such as “greenmail” (a target poorly led and needs better leadership, which entails a bought them out so they would go away). Or they clean-out of the executive suite and the board as well. sought to “strip it and flip it”—that is, cut costs radically The Starboard fund provides a couple examples of this: and sell the pieces. Many of today’s activists are longer-term operators, who often want to improve a Law360, New York (March 24, 2016,)—Starboard company’s returns, and that means they want to stay Value is gearing up for its first major proxy fight since and improve company operations. “Few activists today besting Darden in a contentious battle in 2014, as the see themselves as short-term players,” consultant activist hedge fund looks to hit the reset button on Karen Kane wrote in the Korn Ferry Institute’s Briefings Yahoo’s entire board of directors after the flagging tech giant’s leadership failed to spark a turnaround. Magazine. In a letter to investors on Thursday, Starboard Value While the most prominent activists are professional LP unveiled a slate of nine handpicked directors it investors, namely hedge funds or private equity plans to nominate to Yahoo Inc.’s board. Starboard partnerships, a significant number are one-time blasted the company’s “atrocious performance” players who may simply want their investment to in recent years and slammed the board and perform better sooner. management team for “repeatedly” failing to get the company on a better track. What’s most important is they perform in-depth critiques on how companies work, from the balance And they may want to alter its capitalization by, for sheets to the boardrooms. example, taking on more debt to make acquisitions. Another tactic along those lines: They might enhance shareholder value by putting a large cash stash to work, buying in shares, increasing the dividend or paying a special dividend, taking on more debt to make acquisitions, or driving innovation. In today’s world you either innovate or evaporate.

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Their power 1. Ask hard questions and There was a time when shareholder proxy fights failed consider alternatives routinely. Not anymore. With the advent of professional Use activists’ key metric: return on activists, they regularly prevail, or at minimum get a chunk invested capital of what they seek. Activist Insight found that 58% of their demands in 2016 were at least partially successful, up from To many activists, this calculation best measures how 53% in each of the two previous years. well a company allocates its capital to generate returns. One way General Motors kept a group of activists at bay While activists often amass no more than 10% of a target in 2015 was to tie executive compensation to ROIC, The company’s stock, they can magnify their power by Wall Street Journal reported. establishing alliances with large institutional holders or other activists. Vanguard Investments, for instance, which One more traditional method, return on equity, does not owns significant stakes in all U.S. public companies, has gauge the impact of debt. Another, return on assets, backed activists, Harvard Business Review wrote in its does not factor in intangible assets like brand names or 2015 article “Your Board Should Think Like Activists.” patents. ROIC focuses on how much capital is required to operate a business successfully. This figure is not found on many companies’ annual reports and requires Their results more involved math than standard metrics.

Two schools of thought exist on how companies targeted Basically, the ROIC equation takes net income with by activists perform once these investors get their way. This interest expenses added back, and divides it by invested probably reflects the diversity of the activist community. capital, which is equity plus debt, minus cash not used for operations. One view is that they are rapacious types who do a company no good after their takeover. A study by two professors, John Coffee of Columbia Law School and Insist that management keep directors Darius Palia of Rutgers Business School, found that in the loop activists routinely cut back capital investments, particularly Recently, news got out that a company CEO was in research and development. This has a baleful long-term suffering severe problems with a product that he had impact on both the targeted companies and the economy not briefed directors about. How can the board possibly as a whole, they warned. do its job if it is ignorant of the company’s operations, specifically about things that are going wrong? A more positive assessment discovered that stock returns and corporate financial performance improved overall. Edward Swanson, an accounting professor at Texas Pose the tough questions A&M’s Mays Business School, and doctoral student Glenn Young conducted a study that found, two years after an Directors should be asking the same questions that an activist initiative, target company stocks were up 10.6%. activist investor would. Those queries are tough ones, And a measure of profitability, known as an F-score, was but necessary, by the reckoning of Raj Gupta, former up markedly. CEO of Rohm and Haas, who has served on the boards of Delphi Automotive, Hewlett-Packard, Tyco, and All of which suggests that activists have a significant Vanguard. impact on companies, so corporate boards would be wise to heed that and get there first. Key questions, he told Harvard Business Review, are: Is the company’s portfolio too complex? Is management The three ways directors can think like activists: top-notch? Is the cost structure too high? Has the firm missed an inflection point?

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Know the red flags n Low stock price. Perhaps the price is down due to laggard net income, or perhaps it’s simply a matter of the stock market’s phase. A company may be in Red flags directors should look for the value category, meaning it is temporarily out of fashion. Regardless, two classic methods to goose Underperforming assets share price is to boost dividends or buy back stock— and activists will be sure to urge these options. Company’s parts worth more than whole

n Low stock price The CEO and other top managers get big rewards even though the company’s revenue and earnings are Management gets high pay, amid suffering.To activists, this often is an unpardonable bad company performance offense. Since the board sets executive pay, a good No clear strategic vision move may well be to tie the CEO and other corporate leaders’ pay to how well the company is doing Dead cash meeting key objectives, such as a set revenue gain.

Trails competitors n There is no clear strategic vision. If a company is plodding along, doing what always worked before, it may well be opening itself to an activist challenge. Directors need to have managers articulating a way Directors should be aware when things aren’t going the forward. way they should. Talking to management, communicating with shareholders, reading the business press—these n Dead cash. A big load of cash sitting on the balance are all ways to keep up. When an activist is known to be sheet invites activists to complain that it isn’t being acquiring stock it should be a warning bell to the board used productively, either for capital investments that and management to look at the checklist. will improve the company’s performance or returned to shareholders. A study by Credit Suisse details how Here are a few warning signs to look for: ValueAct Capital, an activist firm, won a Microsoft board seat in 2013 by decrying the software maker’s n Underperforming assets, as in laggard divisions. enormous cash account: $77 billion, which was more When consumer tastes, technologies or other factors than double that of its peers. change, sometimes a company’s legacy divisions no longer provide much value. A Harvard Business n The company trails competitors. Whether by market Review study divided corporate activities into share or some other benchmark, a company that four phases, with the last labeled the “struggle for ranks lower than its peers, and shows no sign of survival.” At that point, entrenched management improving its situation, will attract activists’ attention. might have difficulty shrinking or eliminating an out-of-date division. So an active board should A fine example of fixing that problem is Alan Mulally’s make sure that the unit be given unsparing scrutiny. tenure at Ford Motor, whose market share was waning The study recommends a “zero-based review,” when he took over in late 2006. As CNN Money recounts, where every corporate function has to prove its Ford, then the nation’s No. 2 automaker, found itself tied worth, and internal politics plays less of a role. in the U.S. with Japan’s Toyota. So Mulally sold off ailing brands and erased corporate fiefdoms to get it through n The value of the company’s parts is worth more than the whole. This was a problem spawned by the Great Recession and move the firm to profitability. the conglomerate craze of the 1960s, which cobbled Better, now Ford is tied for No. 1 with General Motors together many disparate businesses. Now, the at 16%, with Toyota third at 14%, Statista indicates. trend is to do the opposite, spinning off valuable The result, as Korn Ferry Institute’s Briefings magazine business units and focusing on a corporation’s wrote, was “transforming a great-but-teetering core competency. Failing to take such steps invites automaker.” During Mulally’s time at the helm, activists activists climbing aboard to make it happen. largely stayed away.

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2. Connect with shareholders Keeping an eye out for trouble What if an activist does show up with a list of demands? How directors can keep in touch with Ernst & Young advises that directors, like management, shareholders listen to what the demands are and see if they work for the company. Ripping apart a good company with a Directors reach out personally decent future might not be the wisest course, if that’s what an activist wants. Form an investor committee

Keep alert for trouble

Director outreach

“The time to get to know shareholders is not when an activist approaches,” said Andy Merrill, a managing director at consultant firm Teneo Strategies, quoted in an Ernst & Young study. “A big part is inoculation. Good shareholder relations are critical. It’s more than phone calls—it’s face-to-face meetings and listening to them.”

At some companies, individual directors have a responsibility for shareholder outreach. At Coca-Cola, for instance, director Maria Elena Lagomasino uses a company website and visits institutional investors to find out what is on their minds, according to Sue Decker, Yahoo’s former CFO, in a Fortune piece. And Andy Bryant, the independent board chair at Intel, meets with four of the company’s largest shareholders every quarter.

A formal shareholder committee

That’s the recommendation of Vanguard CEO William McNabb. Aside from the standard board committees, like for finance/audit or compensation, this one is in charge of forging direct links to the company’s owners, its investors.

“We believe boards that provide such context to investors are less likely to be surprised by activists or proxy votes, and more likely to have stronger support of large long-term shareholders,” McNabb wrote in a letter to the boards that oversee the company’s mutual funds. “We also believe that engagement is a dialogue, with both parties listening to and informing each other.”

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3. Ensure the board is fresh Moreover, boards should be diverse. A study by the advocacy group Catalyst found that, in 2015, women and focused had just 20% of board seats at S&P 500 companies. Directors must be involved

When Glenn Tilton was running United Airlines, Compensate directors based on Harvard Business Review reported, he asked directors performance goals to accompany him on calls to customer CEOs to U.S. executives often are pilloried for being overpaid. demonstrate the directors’ personal commitment But Harvard Business Review argues that directors to the company’s turnaround. are underpaid, with an average annual compensation of around $250,000. While some would argue that Board involvement is critical when it comes to most directors don’t serve primarily for the money, governance issues. Increasingly, non-binding “say on appropriately compensating them using company pay” questions have cropped up on corporate ballots, shares as a meaningful component of their incentive allowing investors to vote for or against executive package is a good idea. compensation packages. As Amy Borrus, deputy director of the Council of Institutional Investors, told Johnson & Johnson requires each director to retain the Korn Ferry Institute’s Briefings magazine, “Over the company shares issued upon election to the board and years, companies have sharpened their pay practices, to own shares equal to five times his or her annual cash and some of the worst practices were winnowed out.” retainer. Coca-Cola grants non-option stock awards that become available only after a director has left the board. One way to help directors do their jobs is to mandate General Electric has a similar arrangement. that the chief financial officer be a member of the board, a longstanding procedure in Great Britain. As McKinsey Beyond that, Harvard Business Review wants directors senior adviser David Beatty put it: “Since CFOs don’t to purchase shares with their own money. These would ‘own’ capital investments the way operating executives vest only some years after directors leave the board. and the CEO might, they can afford to be dispassionate third-party evaluators of investment flows and alternate After all, directors are there to make a company better, investment strategies.” which dovetails with what activist investors say they aim to do. Boards should have fresh blood

PricewaterhouseCoopers points out in a paper that an ideal board must have new members and not the same old roster: “Activists know that other investors may be more likely to support their efforts when the board is perceived as being ‘stale’—that is, the board has had few new directors over the past three to five years, and most of the existing directors have served for very long periods.”

Yahoo ex-CFO Decker advocates giving all directors a fixed term of six to eight years. After that, they must be replaced, unless a majority of the board votes to keep them—a means of retaining expertise and institutional knowledge in exceptional cases.

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References

Aspen Institute. (2008). Where will they lead? https://assets.aspeninstitute.org/content/uploads/files/content/ docs/bsp/SAS_PRINT_FINAL.PDF

Beatty, David. (2017, January). How activist investors are changing the roles of public-company boards. McKinsey & Co. http://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/ how-activist-investors-are-transforming-the-role-of-public-company-boards

Benoit, David. (2016, May 3). “The hottest metric in finance.” https://www.wsj.com/articles/the-hottest-metric-in- finance-roic-1462267809

Bhagat, Sanjai. (2017, May 3). “Board directors should be paid only in equity.” https://hbr.org/2017/05/board- directors-should-be-paid-only-in-equity.

Catalyst. (2016, June 14). 2015 Catalyst Census: Women and Men Board Directors. http://www.catalyst.org/ knowledge/2015-catalyst-census-women-and-men-board-directors

Charan, Ran; Useem, Michael; and Carey, Dennis. (2015, February 9). “Your board should think like activists.” Harvard Business Review. https://hbr.org/2015/02/your-board-should-be-full-of-activists

Coffee, John C., and Palia, Darius. (2015, September 4). “The wolf at the door: The impact of hedge fund activism on corporate governance.” Columbia Law and Economics Working Paper No. 521. https://ssrn.com/ abstract=2656325

Credit Suisse. (2016, Second Quarter). The activist agenda: What are activist investors looking for? https://www. credit-suisse.com/media/assets/microsite/docs/corporate-insights/credit-suisse-corporate-insights-q3-2016.pdf

Decker, Sue. (2015, February 3). “Keeping activist investors at bay.” Fortune. http://fortune.com/2015/02/03/ keeping-activist-investors-at-bay-how-corporate-boards-can-help/

Ernst & Young. (2014, August 24). “Dealing with activist investors.” Viewpoints. http://www.ey.com/Publication/ vwLUAssets/EY_activist_investor/$FILE/EY-April-2014-Dealing-with-activist-investors.pdf

Isadora, Chris. (2006, September 15). “Ford announces details of its turnaround plan.” CNN Money. http://money. cnn.com/2006/09/15/news/companies/ford/index.htm

Kane, Karen. (2015, February 9). “Activist investors take on the board.” Korn Ferry Institute. Briefings. https://www. kornferry.com/institute/activist-investors-take-board

Kunisch, Sven; Müller-Stewen, Günter; and Campbell, Andrew. (2014, December). “Why corporate functions stumble.” Harvard Business Review, https://hbr.org/2014/12/why-corporate-functions-stumble

Kurtzman, Joel and Distefano, Michael. (2014, August 11). “Alan Mulally: The man who saved Ford.” Korn Ferry Institute. Briefings. https://www.kornferry.com/institute/alan-mulally-man-who-saved-ford

McCann, David. (2016, August 5). “Hedge fund activism helps targeted companies.” CFO.com. http://ww2.cfo.com/ investor-relations-banking-capital-markets/2016/08/hedge-fund-activism-helps-targeted-companies/

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References (continued)

McNabb, William. (2015, February 27). Letter of Vanguard fund boards. https://about.vanguard.com/investment- stewardship/CEO_Letter_03_02_ext.pdf

National Association of Corporate Directors. (2016, April 25). NACD releases guidance to help corporate boards prepare for an activist-investor challenge. https://globenewswire.com/news-release/2016/04/25/832271/0/en/ NACD-Releases-Guidance-to-Help-Corporate-Boards-Prepare-for-an-Activist-Investor-Challenge.html

PricewaterhouseCoopers. (2015, March). Shareholder activism: Who, what, when, and how? https://www.pwc.com/ us/en/governance-insights-center/publications/assets/pwc-shareholder-activism-full-report.pdf

Statista. (2017, May). Selected automakers’ U.S. monthly market share. https://www.statista.com/statistics/343162/ market-share-of-major-car-manufacturers-in-the-united-states/

Contributors

Robert Nardelli Founder and CEO XLR-8 LLC

Alan Guarino Vice Chairman, Board and CEO Services Practice Korn Ferry

Nels Olson Vice Chairman, Board and CEO Services Practice Korn Ferry

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