Activist Hedge Funds, ‘Golden Leash’ Special Compensation Arrangements, And Advance Notice Bylaws

Jason D. Schloetzer

Georgetown University – McDonough School of Business

December 20, 2015

The Conference Board Director Notes DNV7N5, December 2015

Abstract:

The tactics used by activist hedge funds to target companies continue to command the attention of corporate executives and board members. This report discusses recent cases highlighting activist efforts to replace directors at target companies. It also examines the use of controversial special compensation arrangements sometimes referred to as “golden leashes,” the arguments for and against such payments, their prevalence, and the parallel evolution of advance notification bylaws (ANBs) to require disclosure of third party payments to directors.

Activist Hedge Funds, ‘Golden Leash’ Special Compensation Arrangements, And Advance Notice Bylaws – Introduction

The allocation of new capital to hedge funds with activist strategies continues to grow. According to Hedge Fund Research, hedge funds that use activism as part of their investment strategy managed $127.5 billion in the first quarter of 2015 compared with only $23 billion in 2002. While activist funds represent a small fraction of the $2.94 trillion under management by hedge funds in general, activist strategies generate the highest returns of hedge funds deploying any event driven strategy, posting gains of 8.5 percent in 2014, 19.2 percent in 2013, and 9.3 percent in 2012.2 In the words of Carl Icahn, “There has never been a better time for activist investing.

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Along with this increase in assets under management, the amount of media attention given to activist hedge funds has exploded. Chart 1 demonstrates this trend. Since 1990, there have been nearly a quarter of a million national and international news articles covering hedge fund activism. This is a relatively recent phenomenon; since 2007 nearly 21,000 news articles on average are written each year about activist hedge fund interventions. To provide perspective on the intensity of media coverage, there were 22,974 news articles about hedge fund activism in 2013, while the law firm Wachtell Lipton identified only 200 instances of activist-investor initiatives in the same year.

Activist Tactics: Target the Board

It is difficult to fully observe the methods activist fund managers use to engage underperforming boards. Activist interventions typically have both private and public components that span multiple years. For instance, a review of 12 large-scale interventions by Carl Icahn’s Icahn Enterprises and Bill Ackman’s Pershing Square Capital Management showed that, on average, an activist intervention by these funds lasts nearly three years.

One of the principal tactics available to an activist fund manager against a company that fails to take the actions suggested by the hedge fund is to replace one or more members of the board. An analysis conducted by The Conference Board in collaboration with FactSet shows that activist hedge funds led the majority of the proxy contests seeking board representation at Russell 3000 companies during the first half of 2014. The 15 proxy contests mounted by hedge funds for that stated purpose represented 58 percent of the 26 activist solicitations motivated by the election of a dissident’s nominee to the board of directors, and 61 percent of the 25 contests launched by hedge funds during that period. In six cases, the reason for the solicitation was even more hostile, with the investor attempting to gain full control of the board.8 In 2014, activists gained board seats at 107 companies, an all-time record that appears on pace to be broken in 2015, based on FactSet data through June 30, 2015.

Icahn has said, “[T]here are lots of good CEOs in this country, but the management in many companies leaves a lot to be desired. What we do is bring accountability to these underperforming CEOs when we get elected to the boards.” His statement highlights one key premise of activist hedge fund managers—that targeted companies have managerial deficiencies and fund managers can take steps to discipline boards who fail to maximize shareholder value. To provide perspective on the extent to which activist hedge fund managers will aggressively engage underperforming boards by pushing to nominate dissident directors, it is useful to review recent high-profile actions by JANA Partners, Harry Wilson (on behalf of four funds), Third Point, and Elliott Management.

Harry Wilson/General Motors, Inc. In February 2015, General Motors announced that it received notice from Harry Wilson regarding his intent to nominate himself as candidate to stand for election to the GM Board of Directors.11 Wilson was acting on behalf of himself and four investment funds that supported his election: the Taconic Parties, Appaloosa Parties, HG Vora Parties and the Hayman Parties, which together owned approximately 1.9 percent of the company’s shares. The parties sought GM to repurchase $8 billion of shares by the 2016 annual meeting.

By March, General Motors had agreed to repurchase $5 billion in stock in exchange for an agreement with Wilson and the four investment funds to drop the request for a seat on the board. A buyback was already under consideration and investor talks sped it up. GM officials determined that its $25 billion in cash was enough to fulfill spending plans and handle uncertainties, including a federal investigation into an ignition-switch recall. GM finance chief Chuck Stevens said during a conference call, “We believe an initial $5 billion share buyback is good for our owners because we cannot earn better returns by investing that cash in the business at this time.” Moody’s called the buyback a negative credit development, stating, “This program weakens GM’s positioning at the current rating level and will likely delay any potential consideration for an upgrade.” The ratings firm said the key credit risk was GM’s decision to fund the repurchase by reducing the liquidity position of its automotive operations by about $5 billion in the face of a number of operational and financial challenges.

GM acted quickly in repurchasing shares—in the nine months ended September 30, 2015 the company repurchased 85 million shares of outstanding common stock for $2.9 billion as part of the common stock repurchase program announced in March 2015.

Third Point/Dow Chemical Co. In January 2014, Third Point announced that the fund’s largest investment was in Dow Chemical. Activist investor Dan Loeb, principal of Third Point, indicated in his quarterly investors letter that, “Dow shares have woefully underperformed over the last decade, generating a return of 46 percent (including dividends) compared to a 199 percent return for the S&P 500 Chemicals Index and a 101 percent return for the S&P 500. Indeed, in April 1999, nearly 15 years ago, an investor could have purchased Dow shares for the same price that they trade at today!”

Third Point proposed that Dow separate its petrochemical business into a standalone company to improve Dow’s strategic focus. In response, Dow stated it would “continue an open dialogue to further enhance value for all of our shareholders.” By May, Loeb again called on Dow’s management to “focus on what is driving this underperformance and how to cure it,” and boldly stated, “Dow’s integrated strategy does not maximize profits.”

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