Best Practices: On The Board
Wolves at the Gates
Michelle Leder
12/01/2006

The letter that Florida money manager Bruce Sherman sent to newspaper giant Knight Ridder’s board of directors in November 2005 was short and to the point. It stated that Private Capital Management, the company that Sherman runs, was now the largest owner of Knight Ridder stock. And, as the largest shareholder, it wanted the company’s directors to "aggressively pursue the competitive sale of the company."

The letter was a follow-up to a Knight Ridder board meeting that Sherman attended in July 2005 at the invitation of chairman Tony Ridder. As Sherman noted in his one-page follow-up letter, he believed that the board had not taken his suggestions seriously enough. Although the company was financially healthy and consistently profitable, Knight Ridder’s stock was declining in value.

TOP VIEW
There are about 90 activist hedge fund managers—with $100 billion in capital—prowling for underperforming or otherwise vulnerable companies on which to pounce. These firms buy a significant equity stake, hoping to force their targets to restructure their boards and management, and, often, put themselves on the auction block. While many genuinely seek to boost shareholder value (including their own) over the long term, some are in it for a quick-flip profit. Boards need to be aware of this threat, and formulate responses—the most effective of which is to outperform the market.

Six months later, Knight Ridder, a company that could trace its roots as far back as 1892, would be gone—the bulk of its assets sold to McClatchy, a smaller, 149-year-old newspaper company in Sacramento. McClatchy, in turn, resold some of Knight Ridder’s most prized assets, including the Philadelphia Inquirer and the San Jose Mercury News.

The threat of attack from activist hedge funds—a new breed of managers who believe they can spot untapped value in a company and use in-your-face, highly public tactics to unlock it—is growing. According to Taylor Cos., a hedge fund advisory firm in Greenwich, Conn., started by the late Thomas Taylor, who used to manage money for the Bass brothers in Texas, there are now about 90 activist hedge funds, more than double the number in existence three years ago. Their assets under management have climbed sharply, to around $100 billion, a four-fold increase from 2002, according to the online information portal Lipper HedgeWorld.

These funds are instigating buyouts and, in many cases, overhauling the composition of boards. In the first nine months of this year, according to research from the corporate governance consulting firm Institutional Shareholder Services, activist hedge funds were successful at gaining board seats at 70 percent of the 50 largest companies they targeted. The activist strategy has even spread to Europe, where several new funds have embraced this decidedly American model. Earlier this year, in a remark echoed by many European corporate executives, Dutch economic minister Joop Wijn described such firms as locusts.

Over the past year, the powerhouse corporate law firm Wachtell, Lipton, Rosen & Katz has issued increasingly dire warnings to its corporate clients about the dangers posed by these activist hedge funds. Founding partner Martin Lipton said earlier this year that they were the absolute top issue for directors. One memo, which the law firm sent in late June, cautioned that: "In this era of hedge fund activism, the future of hedge fund regulation may impact the balance of power between public companies and activist shareholders. At this time, public companies can only hope that some form of hedge fund regulation persists."

While their ability to demand change remains largely unchecked, the fund managers themselves argue that they are the good guys, merely trying to maximize the shareholder value of corporate laggards. They look for overpaid managers or entrenched directors with little of their own money invested in the company. A high number of related-party transactions, in which top executives and board members have multiple business relationships with the company, are another red flag for these managers. "We don’t really troll using orthodox nets," says J. Carlo Cannell, whose Cannell Capital fund has targeted about a dozen companies over the past year. "We’re basically looking for bloated companies, and that’s a nonintuitive method."

In 2005, Cannell targeted Manhattan-based BKF Capital Group with a scathing letter that used the words "comic monkeyshines" to describe the company’s long list of related-party transactions. The letter started by quoting Cicero’s words regarding corruption in ancient Rome, and went on to chide BKF over its lavish office space at Rockefeller Center. It even included a bit of self-deprecating humor: "The callous conflagration of shareholder assets by BKF galls us, as it would gall Cicero. When we visit companies, we stay at $39.95 motels, not fancy hotels with fruit at the reception desk. If the bathroom glasses are not wrapped in paper, we flee. We are not squired around in Lincoln town cars driven by perfumed manservants."

"We are not squired around in Lincoln town cars driven by perfumed manservants."

The meaning of the word "bloated" is open to interpretation. While staying in five-star hotels on business trips would not in itself be enough to draw Cannell’s ire, almost any firm can be fair game if its share price does not consistently beat the market.

The Best Defense
If an activist investor knocks at your company’s door, directors and senior managers may be able to keep a shake up at bay, at least if the company has a reasonably strong business plan and the share price is not tanking. Securities laws require all investors to alert companies when they make large investments. Anyone who accumulates more than 5 percent of a company’s outstanding shares must file a Schedule 13 with the SEC and send a copy to the company’s board. An investor can file either a 13-G, which indicates a passive investment, or a 13-D, which indicates an active investment. A 13-D could be a warning sign. Sometimes the form arrives with a letter declaring the investor’s hostile intentions (see "Poison Prose"), but most activists will try to negotiate before resorting to open warfare. At Knight Ridder, for example, Sherman asked to meet with the company’s directors months before he sent his letter calling for radical changes.

These investors want a response. Often they do not get it. A report that the investment bank Morgan Joseph released in July discussed some of the means companies possess to thwart unwanted activist attention. "While a healthy stock price is the ultimate defense," noted S. Randy Lampert, managing director in Morgan Joseph’s corporate finance department and co-head of the firm’s Shareholder Activist Group, "a proactive stance and prompt response to activist approaches can also be highly effective."

Activist investors have been known to contact board members individually. They might be trying to divide loyalties. The board’s best stance is to call an emergency meeting and designate a board member to meet with the investors. This can be a meeting without top management, although the CEO and CFO should be kept apprised and should also meet with the investors. Early discussions might lead to an agreement, especially if the representatives from the company can show that they are implementing strategic, financial and operational moves to improve the business. Everyone on the inside should be prepared, however, to disclose important initiatives that are in the works, even if the company was not prepared to release the news just yet.

Early meetings also give an opportunity for the board members and senior managers to determine the investor’s true intentions, and discover whether the activist investor is drawing a distinction between real enterprise value and the share price. Both sides ought to act constructively, with the patience to wait out changes that might cut into investment returns over the short term but produce long-term gains. It takes a bold CEO, of course, to tell any investors that they will have to live with short-term cuts, let alone a group of investors known for their bullying tactics and public denunciations.

On the other hand, activists are typically investment pros, not experts in the nuts and bolts of the industry in question. If a fund manager and a group of his handpicked advocates penetrate the board, they will, like any directors from the outside, face a learning curve. They would, in most cases, prefer to be reassured that the existing board and managers have brilliant ideas. So would other shareholders, employees and the community; it is important to have both a substantive vision and a skillful communication strategy. The board should be armed with these weapons at the first sign of predators hovering about, if not before.

Michelle Leder is the author of Financial Fine Print: Uncovering a Company’s True Value.