Stop Demonizing Activist Investors. The Real Problem is the Public Company Governance Model
A recent Financial Times article, Why Corporate Boards Should Not Indulge Activists’ Sugar Highs, zeros in on and criticizes activist investors who push companies to sell divisions, subsidiaries or otherwise breakup certain companies. “Be in no doubt, [activist investing] is an asset class in its own right, and to raise funds and justify hefty management fees, it must demonstrate returns,” it states.
In many cases, pushing companies to sell divisions or subsidiaries is exactly the right thing to do. But there’s another fundamentally flawed assumption in the piece: that public company boards have the capability to demonstrate, as the article suggests, “their readiness to manage business portfolios in the long-term interest of all shareholders, to set clear performance targets for every division and, where a unit is struggling, put a plan in place.”
There are two problems with this statement. First, there are many public companies that are in more than one business resulting in less value than could be generated under a different structure. Whitbread, cited in the FT article is a good example. Its hotel and coffee operations were completely different businesses with Whitbread underperforming the wider market for several years. Activist investor Elliott believed that 3 Billion (pounds) in value could be created by spinning off the coffee business. And, in fact that proved to be a low estimate as the coffee business was sold to Coca Cola for 3.9 Billion (pounds) in January of 2019. So, to assume that the right strategy to which boards should adhere is to always fight off the activist and retain/manage all business units is simply not correct.
Second and more importantly, however, is that the assumption that public company boards are designed to make the right decisions in regard to capital and asset allocation falls short of reality. The public company governance model does not result in boards that can excel in this regard. As I delineate in my book Governance Arbitrage: Blowing Up the Public Company Governance Model to Maximize Long-Term Shareholder Value, this model leads to the following, among other, shortfalls:
Low Capital Allocation Skill
If public company boards had a more robust governance model, there would be a clear governing objective to optimize capital allocation and maximize company performance and shareholder value. There is no such objective as public company boards are mired in process, compliance, obsession with director independence and quarterly earnings. This current state of public company boards was, rightly so, described in a recent white paper by Steffen Meister, chairman of Partners Group, as “Governance Correctness.” (2) Because this governing objective is lacking, there is no context for recruiting the types of directors who would excel with capital allocation which is the arena that acquisitions and divestitures belong. Rather than excelling at capital allocation, research has determined that:
- Majority of 1500 companies surveyed, over a 20 year period, doled out the same amount of capital to business units they did the previous year. (Most aggressive re-allocators – those that shifted more than 56% across business units – delivered 30% higher returns to shareholders) (*)
- More than one third of the $8 Trillion in invested capital in the S&P 1500 does not earn the cost of capital (*)
If capital allocation is not a core competency of public company boards, how can shareholders be assured that the board is making the right decision to retain all business units and “manage” them for the long term?
Lack of Director Knowledge
The top private equity firms execute a very deep-dive due diligence effort during the process of evaluating a company for acquisition. And, this process is in one form or another ongoing after the acquisition is complete. As such, the members of the board of each portfolio company have in-depth knowledge of the company, its industry and the levers that can be pulled to maximize the company’s performance and value over the holding period.
Unfortunately, the public company governance model is not designed in the same manner as the private equity governance model. As noted above, because the public company model lacks a governing objective of maximizing value for shareholders (whereas the private equity model does have this objective) it is not conducive to directors developing in-depth knowledge of the company being governed as a survey by McKinsey found: (*)
- Only 34% of directors surveyed agreed that the boards on which they served fully comprehended their companies’ strategies
- Only 22% said their boards were completely aware of how their firms created value
- Only 16% claimed their boards had a strong understanding of the dynamics of their firms’ industries
While only privy to public information, the really great activist investors are similar to the best private equity investors when it comes to detailed knowledge of a target or investee company. Activists typically know far more about the company, its shortfalls and opportunities than the incumbent boards does.
For public companies there is an obsessive focus on populating the board with directors who fit the independence criteria. And that criteria certainly matches with the current governance model which functions more like a police body with limited engagement. However, the heavy focus on independence has resulted in boards that lack the right competencies to maximize the performance of the company and shareholder value and is also lacking in those with capital allocation skills.
Public company boards (with a few exceptions) are missing experience and track record in the following three categories at minimum: The industry in which the company operates; specialized expertise related directly to key value drivers of the company and general value creation (the kind of skill the private equity professionals have).
The best activist investors come to the table with clear objectives, in-depth knowledge of the company and high degrees of competency in capital allocation understanding at a much greater degree than most boards of directors. This should not result in demonization of activist investors but instead should be a clarion call that something is suboptimal in regard to public company boards.
At the top private equity firms, the boards of their portfolio companies are distinctly viewed as assets. At public companies boards are an undervalued, and thus, underperforming asset. The only way to maximize this asset is to blow up the public company governance model and replace it with a model that approximates the governance model found at the best private equity firms’ portfolio companies. Only then can there be better odds that boards will optimize capital allocation and maximize company performance and shareholder value. Only then can there be higher comfort that a board will pursue value accretive acquisitions and know when to divest business units that reduce value and scatter focus and resources away from the core business.
- Hernan Christerna, “Why Corporate Boards Should Not Indulge Activists’ Sugar Highs,” Financial Times, April 9, 2019.
- Steffan Meister and Richard Palkhiwala, Governance Correctness. How Public Markets Have Lost Entrepreneurial Ground to Private Equity, Partners Group 2018
- Dominic Barton and Mark Wiseman, “Where Boards Fall Short,” Harvard Business Review, January – February 2015
- Gerry Hansell and Dieter Hueskel, The CEO as Investor, Boston Consulting Group, April 14, 2012
- McKinsey & Company, Improving Board Governance: McKinsey Global Survey Results, August 2013.