High risks, big rewards

No one has yet found the holy grail of governance – that is, the direct link between good governance and enhanced corporate performance. Preliminary research has been conducted, but the findings may be unreliable since these studies often are commissioned by parties with a vested interest in suggesting that such a link exists. As with grail lore, many people think it is only a fable.

However, rich rewards are available to those who invest in poorly governed companies, provided they have the endurance and the smarts to convince management that they can be a catalyst for positive change – or ride the coattails of someone who does.

There are a lot of investors in the market purporting to agitate for governance improvements, but in reality they may just be looking to put a company ‘in play.’ With institutions increasing cash holdings and assets under management – combined with sluggish long-term equity and capital market performance and lower volatility – we can expect to see more of this approach as investors look for improved returns.

In the event of an approach from an investor, how can an issuer tell the difference between a fast-money ‘adolescent,’ as one hedge fund manager puts it, and an adult investor with a genuine value-enhancing argument?

A hedge fund veteran with several successful governance plays says you can get a strong indication of investors’ intentions when they first make an approach. He also believes you should already have an idea of the situation, as most funds will have established a pattern of contact and will probably already have spoken with management.

‘It shouldn’t be a surprise,’ he says. ‘We take very concentrated positions and have done a lot of homegrown research. We’ll have filed our 13Fs, and we will have had someone talking with the company once a week since we’ve had our position. We’ll know the company well before making suggestions, and we do so only very advisedly.’

Governance – who cares?

The industry veteran explains that, despite all the talk about governance reform and increased performance, nothing has really changed. It is all just a new gloss on investors squeezing out value at underperforming companies, as they did in the 1980s. ‘Today, the politically correct buzzword for this is corporate governance,’ he notes.

Robert Friedman, senior managing director of Blackstone Group, also believes that governance is not really on the agenda of most investors and explains that ‘good management, rather than good corporate governance, is what affects share prices. Good governance is desirable and important, but I don’t think it moves the needle on share price.’

Most observers agree that hedge funds have little real interest in governance issues per se. Their singular agenda is to create value for their investors, which they do by investing in underperforming companies that have strong potential for improvement. ‘While there are some Don Quixote-type investors out there, most hedge funds are interested in corporate governance as an issue only to the extent that it provides an opening to larger returns,’ explains Charles ‘Casey’ Cogut, global head of M&A at Simpson Thacher & Bartlett.

David Drake, senior managing director at Georgeson Shareholder, agrees. ‘These campaigns are about the financial play, not a governance agenda,’ he says. ‘A stock repurchase, putting the company in play, restructuring or selling off assets are the objectives. Some form of value-enhancing activity is really the key focus. While the message to other shareholders may be Bad governance, here’s the problem, I can’t say a hedge fund would campaign to de-stagger the board or to have a more independent board. However, these may become side issues and make the company more vulnerable.’

Know your enemy

For companies that have been approached and do not wish to participate in a possible takeover, there are a number of options available. ‘The most important defensive mechanism by far is the shareholder rights plan, a poison pill,’ Cogut says. ‘Institutional investors hate them, but they’ve been very useful in creating value for shareholders. No one can hide indefinitely. Pills allow a company time to figure out who they are dealing with.’

Hedge funds have not garnered a very good reputation for themselves in recent years and, as one seasoned activist suggests, ‘we only have ourselves to blame.’ Hedge funds are, in many cases, performing better analysis and due diligence than other players in the market but still maintain the appearance of shooting from the hip. ‘This Wild West of hedge funds will go through the traditional up-and-out cycle that all financial services sectors go through. There are a lot of new players, a younger generation of cage rattlers. But we’re long-term shareholders. We prefer not to have our name out in the public domain. These hit and run for a buck types don’t help us.’

So what should a company under approach do? And, importantly, what should other investors do to monitor the situation – and possibly profit from it? Drake suggests that issuers need to respond to these kinds of situations differently than they have in the past, and believes that relying on proxy advisory firms like Institutional Shareholder Services (ISS) may not always be useful.

‘We always have clients seeing ISS involved in a fight,’ he says. ‘But they’re less relevant when the shareholder base becomes dominated by hedge funds. Hedge funds don’t normally rely on ISS for voting recommendations. They will make independent voting decisions based on their own agendas. Instead, they’re interested in the ISS recommendation to get a feel for what their chances are.’

In many cases, it may be possible to prevent a problem before it arises. Careful monitoring of and communication with shareholders may provide useful information and appease some of the more activist investors. ‘In some cases, they can accommodate hedge fund concerns short of a proxy fight,’ adds Drake. ‘What you want to do is find a way to stick with your business plan but satisfy hedge funds, rather than get mired in a battle. We advise companies in these situations to meet with activist shareholders whether they are filers or not. These meetings can be unpleasant, but they provide critical information that management needs to hear in order to know what strategic steps to take next.’

The mere presence of a hedge fund can damage a company’s reputation. Hedge funds will often level the allegation that a company is not seeking to maximize shareholder value and is refusing to communicate with investors. This tarnishes the reputation of the firm in the eyes of the market. One key question ISS will ask of an underperforming company is ‘What attempts have you made to communicate with investors and discuss their concerns.’ Often the problem is that issuers are reluctant to talk with hedge funds because the funds are very secretive, and this can make people nervous.

Drake has seen companies engage and have a hard time determining what a dissident wants. In one circumstance, a dissident ‘originally wanted a board seat for himself or his representative,’ he recalls. ‘The company hired a search firm and was trying to involve the investor in the process, but he refused to participate. Situations like this could indicate an investor who doesn’t want to foreclose the possibility of using the proxy process down the road and put the company in play.’

One hedge fund veteran suggests that while some information may not be easy to access, long-term hedge funds have established track records, and a history of activity is available to companies that look for it. ‘Ask. The first thing we’ll tell an issuer is who we are, who we manage money for, what strategies we employ and who else in the sector we’ve invested in,’ he says. ‘We’re easy to check on because we file.’

And if you are still having a hard time finding out what you want to know, you should approach the fund directly, or approach other firms with which the fund has been involved. Relying on investigative firms can be a problem. ‘I’ve seen more mistakes than accuracies in the cheat sheets from surveillance firms,’ he says. ‘And even if you think you’re dealing with children, going direct is better than hiring a [company such as] Kroll. Try getting a network of other investor sources to help you. Give them three names so they don’t know who precisely you’re asking about.’

Ultimately the hedge funds and other active investors get involved in companies because they are undervalued. Many times these firms have some form of governance issue, but the management and the business model remain sound. Indeed, there are billions of dollars being invested in companies that supposedly have bad governance, because the payoffs when things improve can be considerable.

Achieving improvement is the key for investors in badly governed and undervalued firms. Sometimes it is a simple matter of correcting some strategic thinking, but other times a change of management may be necessary.

While many of the large proxy advisory and investor rights groups will continue to trumpet the over-performance of well-governed firms, some investors will focus their efforts on buying those at the bottom of the pile and going for the bigger payoff. In this compliance-driven world, where even the smallest governance problems are portrayed as a serious assault on shareholders’ rights and the market as a whole, this approach may not win you any friends, but as one fund manager points out, ‘We are not in it to make friends. The simple fact is the badly governed companies can make great investments.’