An increase in nontraditional activists waging proxy contests – particularly in energy and mining stocks – is bringing the issue of conflicts of interest into greater relief. For first-time activists, the issue may be even more crucial.
Several of the year’s biggest contests, including at EQT, PDC Energy, and Hudbay Minerals, are or have been run by investors that straddle the divide between public and private equity. At EQT, this means the Rice family, which built an oil and gas exploration company, took it public, and then sold it to EQT for $6.7 billion in 2017.
Kimmeridge Energy, a private equity firm and direct operator of energy assets with about $1.3 billion under management, sold Colorado-based PDC Energy Inc (NASDAQ:PDCE) 57,000 net acres in Texas’ Permian basin in 2016, giving the company its start in what is now America’s hottest energy market. Familiarity with those assets makes its founder, Ben Dell, "uniquely qualified" for a seat on the board, Kimmeridge says.
PDC, by contrast, argues Dell has "clear conflicts of interest" that should concern its shareholders. Kimmeridge plays in some of the same markets and even leases PDC mineral rights, which could lead to misalignments of interests or Kimmeridge putting itself ahead of other investors, it argues.
Kimmeridge flatly contests any conflicts, which – to the extent any exist – are not so much clear as amorphous and by necessity speculative (PDC says Kimmeridge’s disclosures have been inadequate, Dell says Kimmeridge has disclosed what it owns, and that PDC accounts for only 10% of the acreage in its mineral fund). The company argues Kimmeridge could compete with PDC for assets, but also that the activist wants to participate in M&A in partnership with PDC. Indeed, the activist volunteered that it offered to drop the proxy contest in return for a standstill agreement that would allow it to discuss ideas.
"We would support them if they wanted to be a consolidator in the industry, which they've attempted to misconstrue," Dell said in an interview, before turning the issue on its head. "We're a great believer in mergers of equals but they are threatening to management teams because two become one."
Exposure to PDC’s stock – 5.1% of it, or around $109 million at yesterday’s close – is some deterrent against rent-seeking or stealing assets from under the nose of PDC. It is, as Dell told me yesterday, "a material stake as a percentage of the company and as a percentage of our investments."
Boards are supposed to find ways of dealing with conflicts, including through recusals, codes of conduct, and special committees to review transactions. PDC has signaled that it does not believe this will be easy with Kimmeridge. The two sides are at loggerheads over whether Dell and another of his nominees who benefitted from the 2016 transaction, James Adelson, should be considered independent under Nasdaq guidelines; a designation would have to be made by the board after the annual meeting. The board could attempt to freeze the pair out of major decisions if they are elected, but such a drastic step would probably invite another proxy contest with potentially more serious consequences.
Such choices present shareholders with a difficult task, so it should be no surprise if Kimmeridge’s interests, and PDC’s importance relative to them, end up as a matter of trust. Kimmeridge’s decision to seek a minority slate won it the recommendation of Institutional Services (ISS) for two of its nominees, including Dell.
Dell, for his part, believes investors will see past the dispute. "This might be a narrative that's being told but most investors are focused on the poor alignment of management and misallocation of capital," he predicted.
Ian Robertson, a communications strategist at proxy solicitor Kingsdale Advisors, says the issue of conflicts is "a huge contributor" to voting decisions but is unlikely to be the sole factor or even come before profit motives. "There is a difference between an actual conflict of interest and what sides at war in a proxy fight try to do which is create the perception of a conflict of interest," he told me this week. "It is often hard – if not impossible – to actually prove a conflict of interest would actually influence a decision that would disadvantage one group of shareholders before it actually happens."
PDC is still a live fight, but at Hudbay Minerals another first-time activist, Waterton Global Resources, ended up with three seats in a late settlement despite the company sharing investor decks featuring snakes wearing business suits, in a not so subtle allusion to the risks involved in voting a private equity operator onto the board.
Proxy advisers have shown little aversion on principle to such nontraditional activists. ISS recommended for two of Waterton’s four nominees. Glass Lewis backed the management slate at Kimmeridge but supported three Waterton nominees. ISS even recommended for one nominee from MNG Enterprises' slate at Gannett earlier this year, which started off as a traditional hostile bid. Similarly, definitions of independence that form part of company proxy statements and stock exchange listing requirements typically emphasize independence from management, rather than independence from all conflicts.
The issue is likely to be of continuing importance this year – and as long as hybrid private equity and activist funds exist.
While the PDC annual meeting on Wednesday will be one data point on investor sentiment, the proxy fight between the Rice brothers and EQT will be a much bigger affair. EQT has accused Toby Rice of previously soliciting business on behalf of Rice Investment Group from current EQT employees. Rice is seeking a majority slate and to become CEO, which would weaken some of the board’s softer protections.
Today is the day of Argo Group International’s annual meeting but it won’t be the deciding day in Voce Capital Management’s proxy contest. The activist withdrew its nominees earlier this week, although it is voting against the directors up for re-election, because two of five state insurance regulators withdrew their approvals. Unlike at HomeStreet last year, when approval wasn’t sought from the state banking regulator until it was too late, Voce felt it had done enough to overcome the very obvious pitfalls of activism in the regulated financials space. It has accused Argo of lobbying to turn the regulators and said the development should "send a chill down the spine" of any owner of an insurance company. At HomeStreet, and several other campaigns from past years where regulators intervened, the activists came back for second bites at the cherry. Voce’s ship might not have sailed just yet.
Quote of the week comes from a rare public letter by ValueAct Capital Partners, recommending that U.K.-based theme park-operator Merlin Entertainments go private. The thoughtful letter is complimentary to Merlin and considerate of employees, but is unlikely to have met with Merlin’s complete agreement for ValueAct to go public. Indeed, Merlin intends to continue its current growth agenda putting the ball in private equity’s court.
"Merlin's ultimate success depends on alignment between management, the board of directors and shareholders that value and reward the company's growth capital deployment," Chief Investment Officer Mason Morfit and Partner Jake Welch wrote. "As the company deploys an increasing amount of capital that takes time to generate earnings, we fear it will take several years for Merlin to be appropriately valued by public shareholders."