Confessions Of A Hedge Fund Activist

In the latest of our weekly Q&As with governance and compliance executives, we talk to Jeffrey Ubben, managing partner at the $3.5 billion hedge fund ValueAct Capital. An index of previous conversations is available here.

Let’s cut to the chase: Are activist hedge funds just short-term speculators, that often threaten long-term corporate plans?

Although that’s true for some activists, ValueAct Capital looks long term—three to five years out—to maximize value. We believe a long-term investment strategy has to start with an analysis of the underlying quality of the business, and then consider what one has to pay for that business. Activism can then enhance and protect returns by bringing a change to the boardroom and management. We believe that certain activists will demonstrate the patience and the diligence to really understand the business, will work with the company to close the value gap, and in certain cases, when the gap is wide and persistent, will take action to force change.

What do activists bring to the boardroom, anyway, that can make a difference in shareholder value and better corporate governance?

We are not control investors. As a result of the significant capital we’ve invested, we are motivated to ask tough questions. My experience is that a lot of the time boards are guessing at what shareholders want. We know what shareholders want, and oftentimes it’s the opposite of what the investment banker in the boardroom is recommending.

Example?

One of the toughest challenges for boards is founder-management succession. In the cases of Martha Stewart Omnimedia and Mentor Corp., our participation enabled that transition to occur and legacy issues to be addressed. This issue is the basis for our pursuit of board seats at Acxiom Corp.; the board refuses to deal with a founder culture that is stifling business performance.

You’ve said that Corporate America “doesn’t understand the cost of capital,” and hence companies are over-capitalized. How does a board member address that situation?

Clearly, it’s not understood that capital structure is an important arrow in the quiver of a sophisticated board charged with the responsibility to drive shareholder value. This is becoming more important as companies mature, especially in previously high-growth segments like technology. By replacing high-cost equity with low-cost debt, the cost of capital is reduced, and that enables more economic value to be created. It is critical to get this right, when you consider that there are fewer high-return projects out there.

At Per Se Technology, financial engineering skills we brought to the board room contributed to driving the stock up fourfold on modest income growth in the core business. Loss-making businesses were sold, shares were repurchased, and high-cost debt refinanced.

Ralph Whitworth at Relational Investors once said he wanted to put a large shareholder on the board of every company. Do you agree?

I find my job is to get the CEO and the rest of the board off the 90-day clock. As agents of shareholders, option-incented management and boards take the low-risk approach: quarterly earnings that meet or beat expectations. A lot of the energy on the part of management and the board is spent on satisfying the short-term demands of investors.

That’s a poor allocation of resources. As large shareholders, we have a huge impact on decision-making when we tell management not to worry about the quarterly impact of a business decision, but instead look to maximize long-term value of the firm. If the stock is going to go down because we make the decision to take short-term pain for long-term gain, so be it. We can marry a share repurchase with that action and take advantage of the short-term stock price action—taking out, by definition, our short-term investors—and lowering our cost of capital.

“Independence” has become a watchword for better governance, and indeed, is a big part of new governance rules. What’s your view of independence?

I believe there is some good in Sarbanes-Oxley. But it comes at a very high cost that isn’t well-recognized. I am seeing firsthand corporate CEOs robbed of the authority to run companies and shareholders powerless in the face of protracted and ridiculously costly investigations. By defining significant shareholders as non-independent, boards and certainly audit committees are left without anyone whose interests are fully aligned with the shareholder. Instead, we have audit committees consisting of non-executives and non-shareholders, serving to the best of their ability, but only on a part-time basis. They are not being paid to take risk, and they will act to minimize their personal risk of getting sued. The rise of the “professional independent director,” who is economically divorced from ownership, is letting the tail, which is a misplaced fear of widespread fraud, wag the dog, which is the fiduciary duty to shareholders to create value.

What is your take on executive compensation reform?

I see executive compensation problems as an outgrowth of entrenched management and boards. When it becomes difficult to remove executives or directors for poor performance, then there’s no “pay for performance” and compensation in its many forms skyrockets. Efforts to shield management from unwanted advances and demands have a long history. Pennsylvania’s new law making it harder to remove directors of any incorporated company is the latest example. Yet, by making it harder to effect change at the board level, this sets the stage for bad corporate behavior that goes beyond egregious compensation.

At Acxiom, the board put in place a policy last year that no shareholder will serve on their board due to conflict of interest. This is indicative of a board that has lost its way. A staggered board, poison pill, fair price provisions, the lack of written consent—it’s all here. We had no recourse to effect change except to pay a premium for all the shares to get control of the company. With all the entrenchment mechanisms in place, the board exercised their prerogative to “just say no”, choosing also to ignore their “duty to inform” under Delaware law. The system has a broken feel to it when as a shareholder you are powerless.

And what about majority voting for directors, the other hot topic this spring?

Majority voting is simply a way to express displeasure. The SEC, under [former Chairman] William Donaldson, was on the right path. The 2003 shareholder access proposal provided for nomination of an additional director at the annual meeting the following year if 35 percent of the votes had been withheld for a director. Consistent with my view that long-term shareholders have a moral authority—as compared to the short-term, quicker buck funds that are looking for pop—the proposal specified that 5 percent shareholders who have held for two years would identify an independent director to serve on behalf of the shareholders.

The friction in the system has to be reduced because the alternative recourse, a proxy fight, is very expensive and time-consuming.

What’s your prognosis on hedge fund activism? Will it continue to grow, and be successful at forcing change?

Activism is a backlash to the extreme passivity on the part of shareholders and growing schism between management and boards, and shareholders. The value gap that has ensued got too wide, cost structures too fat, and capital structures too lazy.

We are finding more support from the institutional investor community. For example, as a minority shareholder of Chiron Corp., which is working to improve the terms to the tender offer made by Novartis, we were delighted to see CAM North America stand behind us publicly, which mutual funds have historically been hesitant to do. CAM advises clients that are shareholders to Chiron including Smith Barney Aggressive Growth Fund. That’s all a way of saying this thing has legs.

Thanks, Jeff.