three ways board members can think like activists...three ways board members can think like...

Three ways board members can think like activistsHow directors can get ahead of the curve as aggressive investors seek to shake up their companies.

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It’s news that corporate board members and managers dread: An activist investor firm, with billions of dollars in financial firepower, is buying up the company’s stock.

The activists might seek a controlling stake in the business and take it over, or mount a proxy challenge to get representatives on the board. Once the challenge is laid at the target company’s feet, it has any number of tactics to deal with the intruders, ranging from outright opposition to capitulation.

But there’s a better solution: Directors should get ahead of the activist onslaught, and figure out ahead of time what makes the company vulnerable. After all, the board’s job is to ensure that the company is on the right track, and activist interest often is a signal that something is amiss. Three areas to look at:

n Directors should ask the right questions: Is the weakness a lagging stock price, tepid net income growth or dropping market share? Does the company evaluate its capital structure the way an activist would? Then consider alternatives to correct the problems.

n Another consideration is for the board to be well-connected with its investors. The board is chartered to look after the shareholders’ interest. If investors, whether large institutions or individual stockholders, are unhappy, that’s fertile ground for an activist.

n Beyond that, director introspection of the boardroom is vital. Is the board too entrenched with management, doing very little and rubber-stamping every decision? Could it use some fresh thinking and new members? Activists will look at this, too.

Galvanizing a board into action may be easier said than done. Not all directors are ready to accept the responsibility of dealing with activists. According to a 2016 National Association of Corporate Directors survey, 20% of the respondents were approached by activists during the previous year, but 46% of those surveyed had no plan in place to respond to the challenges, thus leaving the door open for activists.

Introduction

| Three ways board members can think like activists |

“It’s far better to challenge yourself as a board and win, rather than being driven to the same point by an activist.”

–Bob Nardelli

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It can be tempting for directors to stay above the fray. But the argument is strong that they should get their hands dirty. Sometimes, boards will shrug and say that repelling activists is management’s job. But perhaps management is not equipped to do so, for whatever reason.

Other times, directors might say: “Well, if stockholders don’t like the company, they always can sell.” True. Yet that is no help to the share price, and avoids acknowledging the basic flaws that vex investors. Or directors might simply fire the CEO. In this case the CEO takes the fall even though the board was equally present during the period. (Some believe that Mark Fields, formerly of Ford, may be an example of this). This often avoids a proxy fight and preserves the board. While that step sometimes is merited, a more comprehensive course is to find out what is not working in the corporate structure, which goes beyond the person in the corner office.

The point is not only to fend off an activist. It is to improve the company the way a well-intentioned activist aims to do.

Glenn Tilton, former CEO of Texaco and United Airlines and director of Abbott Laboratories, AbbVie, and Phillips 66, told Harvard Business Review that the “board leader should instead be the activist.” He advised asking the board leader: “Does the talent around the board table reflect all the success determinants for the company, and the risks that can derail it?” To expand on Tilton’s view, why not expect that the entire board be activists?

If that isn’t the case, it should be. Directors must determine whether it would be better for the company to have the board, which knows the business and the employees, be the change agents—or risk the blunt-instrument approach that activists might use.

| 3 ways board members can think like activists |

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Certainly, if activists come after your company, they are not necessarily right about its vulnerabilities. Like any other human beings, they are not all-knowing seers. But in the broad scope, it pays for directors to know how they think, to better understand their motives and co-opt them by performing repairs on the company before they strike.

If directors are to be their own in-house activists, here is a useful primer about the outside activists:

Their characterThey once were called “corporate raiders,” who sought short-term payouts such as “greenmail” (a target bought them out so they would go away). Or they sought to “strip it and flip it”—that is, cut costs radically and sell the pieces. Many of today’s activists are longer-term operators, who often want to improve a company’s returns, and that means they want to stay and improve company operations. “Few activists today see themselves as short-term players,” consultant Karen Kane wrote in the Korn Ferry Institute’s Briefings Magazine.

While the most prominent activists are professional investors, namely hedge funds or private equity partnerships, a significant number are one-time players who may simply want their investment to perform better sooner.

What’s most important is they perform in-depth critiques on how companies work, from the balance sheets to the boardrooms.

Their goalsActivists seek four ultimate objectives, Ernst & Young research indicates: 1) sell the company; 2) restructure the business portfolio; 3) make operational improvements; or 4) change the capital structure.

A 2008 poll of MBA students found that they believe the primary responsibility of a company is to maximize shareholder value. As this group is moving into positions of influence in hedge funds, that orientation shows up in many of their attitudes. They may conclude that a corporation is worth more by breaking up its parts and selling them, or perhaps by taking it over and trimming its overhead. Sometimes, activists believe, a company is poorly led and needs better leadership, which entails a clean-out of the executive suite and the board as well. The Starboard fund provides a couple examples of this:

Law360, New York (March 24, 2016,)—Starboard Value is gearing up for its first major proxy fight since besting Darden in a contentious battle in 2014, as the activist hedge fund looks to hit the reset button on Yahoo’s entire board of directors after the flagging tech giant’s leadership failed to spark a turnaround.

In a letter to investors on Thursday, Starboard Value LP unveiled a slate of nine handpicked directors it plans to nominate to Yahoo Inc.’s board. Starboard blasted the company’s “atrocious performance” in recent years and slammed the board and management team for “repeatedly” failing to get the company on a better track.

And they may want to alter its capitalization by, for example, taking on more debt to make acquisitions. Another tactic along those lines: They might enhance shareholder value by putting a large cash stash to work, buying in shares, increasing the dividend or paying a special dividend, taking on more debt to make acquisitions, or driving innovation. In today’s world you either innovate or evaporate.

Who activists are and what they want


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Their powerThere was a time when shareholder proxy fights failed routinely. Not anymore. With the advent of professional activists, they regularly prevail, or at minimum get a chunk of what they seek. Activist Insight found that 58% of their demands in 2016 were at least partially successful, up from 53% in each of the two previous years.

While activists often amass no more than 10% of a target company’s stock, they can magnify their power by establishing alliances with large institutional holders or other activists. Vanguard Investments, for instance, which owns significant stakes in all U.S. public companies, has backed activists, Harvard Business Review wrote in its 2015 article “Your Board Should Think Like Activists.”

Their resultsTwo schools of thought exist on how companies targeted by activists perform once these investors get their way. This probably reflects the diversity of the activist community.

One view is that they are rapacious types who do a company no good after their takeover. A study by two professors, John Coffee of Columbia Law School and Darius Palia of Rutgers Business School, found that activists routinely cut back capital investments, particularly in research and development. This has a baleful long-term impact on both the targeted companies and the economy as a whole, they warned.

A more positive assessment discovered that stock returns and corporate financial performance improved overall. Edward Swanson, an accounting professor at Texas A&M’s Mays Business School, and doctoral student Glenn Young conducted a study that found, two years after an activist initiative, target company stocks were up 10.6%. And a measure of profitability, known as an F-score, was up markedly.

All of which suggests that activists have a significant impact on companies, so corporate boards would be wise to heed that and get there first.

The three ways directors can think like activists:

1. Ask hard questions and consider alternatives

Use activists’ key metric: return on invested capital

To many activists, this calculation best measures how well a company allocates its capital to generate returns. One way General Motors kept a group of activists at bay in 2015 was to tie executive compensation to ROIC, The Wall Street Journal reported.

One more traditional method, return on equity, does not gauge the impact of debt. Another, return on assets, does not factor in intangible assets like brand names or patents. ROIC focuses on how much capital is required to operate a business successfully. This figure is not found on many companies’ annual reports and requires more involved math than standard metrics.

Basically, the ROIC equation takes net income with interest expenses added back, and divides it by invested capital, which is equity plus debt, minus cash not used for operations.

Insist that management keep directors in the loop

Recently, news got out that a company CEO was suffering severe problems with a product that he had not briefed directors about. How can the board possibly do its job if it is ignorant of the company’s operations, specifically about things that are going wrong?

Pose the tough questions

Directors should be asking the same questions that an activist investor would. Those queries are tough ones, but necessary, by the reckoning of Raj Gupta, former CEO of Rohm and Haas, who has served on the boards of Delphi Automotive, Hewlett-Packard, Tyco, and Vanguard.

Key questions, he told Harvard Business Review, are: Is the company’s portfolio too complex? Is management top-notch? Is the cost structure too high? Has the firm missed an inflection point?


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Know the red flags

Directors should be aware when things aren’t going the way they should. Talking to management, communicating with shareholders, reading the business press—these are all ways to keep up. When an activist is known to be acquiring stock it should be a warning bell to the board and management to look at the checklist.

Here are a few warning signs to look for:

n Underperforming assets, as in laggard divisions. When consumer tastes, technologies or other factors change, sometimes a company’s legacy divisions no longer provide much value. A Harvard Business Review study divided corporate activities into four phases, with the last labeled the “struggle for survival.” At that point, entrenched management might have difficulty shrinking or eliminating an

out-of-date division. So an active board should make sure that the unit be given unsparing scrutiny.

The study recommends a “zero-based review,” where every corporate function has to prove its

worth, and internal politics plays less of a role.

n The value of the company’s parts is worth more than the whole. This was a problem spawned by the conglomerate craze of the 1960s, which cobbled

together many disparate businesses. Now, the trend is to do the opposite, spinning off valuable business units and focusing on a corporation’s core competency. Failing to take such steps invites activists climbing aboard to make it happen.

n Low stock price. Perhaps the price is down due to laggard net income, or perhaps it’s simply a matter of the stock market’s phase. A company may be in the value category, meaning it is temporarily out of fashion. Regardless, two classic methods to goose share price is to boost dividends or buy back stock—and activists will be sure to urge these options.

n The CEO and other top managers get big rewards even though the company’s revenue and earnings are suffering. To activists, this often is an unpardonable offense. Since the board sets executive pay, a good move may well be to tie the CEO and other corporate leaders’ pay to how well the company is doing meeting key objectives, such as a set revenue gain.

n There is no clear strategic vision. If a company is plodding along, doing what always worked before,

it may well be opening itself to an activist challenge. Directors need to have managers articulating a way forward.

n Dead cash. A big load of cash sitting on the balance sheet invites activists to complain that it isn’t being used productively, either for capital investments that will improve the company’s performance or returned to shareholders. A study by Credit Suisse details how ValueAct Capital, an activist firm, won a Microsoft board seat in 2013 by decrying the software maker’s enormous cash account: $77 billion, which was more than double that of its peers.

n The company trails competitors. Whether by market share or some other benchmark, a company that ranks lower than its peers, and shows no sign of improving its situation, will attract activists’ attention.

A fine example of fixing that problem is Alan Mulally’s tenure at Ford Motor, whose market share was waning when he took over in late 2006. As CNN Money recounts, Ford, then the nation’s No. 2 automaker, found itself tied in the U.S. with Japan’s Toyota. So Mulally sold off ailing brands and erased corporate fiefdoms to get it through the Great Recession and move the firm to profitability. Better, now Ford is tied for No. 1 with General Motors at 16%, with Toyota third at 14%, Statista indicates. The result, as Korn Ferry Institute’s Briefings magazine wrote, was “transforming a great-but-teetering automaker.” During Mulally’s time at the helm, activists largely stayed away.


Red flags directors should look for

Underperforming assets

Company’s parts worth more than whole

Low stock price

Management gets high pay, amid bad company performance

No clear strategic vision

Dead cash

Trails competitors

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2. Connect with shareholders

Director outreach

“The time to get to know shareholders is not when an activist approaches,” said Andy Merrill, a managing director at consultant firm Teneo Strategies, quoted in an Ernst & Young study. “A big part is inoculation. Good shareholder relations are critical. It’s more than phone calls—it’s face-to-face meetings and listening to them.”

At some companies, individual directors have a responsibility for shareholder outreach. At Coca-Cola, for instance, director Maria Elena Lagomasino uses a company website and visits institutional investors to find out what is on their minds, according to Sue Decker, Yahoo’s former CFO, in a Fortune piece. And Andy Bryant, the independent board chair at Intel, meets with four of the company’s largest shareholders every quarter.

A formal shareholder committee

That’s the recommendation of Vanguard CEO William McNabb. Aside from the standard board committees, like for finance/audit or compensation, this one is in charge of forging direct links to the company’s owners, its investors.

“We believe boards that provide such context to investors are less likely to be surprised by activists or proxy votes, and more likely to have stronger support of large long-term shareholders,” McNabb wrote in a letter to the boards that oversee the company’s mutual funds. “We also believe that engagement is a dialogue, with both parties listening to and informing each other.”

Keeping an eye out for trouble

What if an activist does show up with a list of demands? Ernst & Young advises that directors, like management, listen to what the demands are and see if they work for the company. Ripping apart a good company with a decent future might not be the wisest course, if that’s what an activist wants.


How directors can keep in touch with shareholders

Directors reach out personally

Form an investor committee

Keep alert for trouble

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3. Ensure the board is fresh and focused

Directors must be involved

When Glenn Tilton was running United Airlines, Harvard Business Review reported, he asked directors to accompany him on calls to customer CEOs to demonstrate the directors’ personal commitment to the company’s turnaround.

Board involvement is critical when it comes to governance issues. Increasingly, non-binding “say on pay” questions have cropped up on corporate ballots, allowing investors to vote for or against executive compensation packages. As Amy Borrus, deputy director of the Council of Institutional Investors, told Korn Ferry Institute’s Briefings magazine, “Over the years, companies have sharpened their pay practices, and some of the worst practices were winnowed out.”

One way to help directors do their jobs is to mandate that the chief financial officer be a member of the board, a longstanding procedure in Great Britain. As McKinsey senior adviser David Beatty put it: “Since CFOs don’t ‘own’ capital investments the way operating executives and the CEO might, they can afford to be dispassionate third-party evaluators of investment flows and alternate investment strategies.”

Boards should have fresh blood

PricewaterhouseCoopers points out in a paper that an ideal board must have new members and not the same old roster: “Activists know that other investors may be more likely to support their efforts when the board is perceived as being ‘stale’—that is, the board has had few new directors over the past three to five years, and most of the existing directors have served for very long periods.”

Yahoo ex-CFO Decker advocates giving all directors a fixed term of six to eight years. After that, they must be replaced, unless a majority of the board votes to keep them—a means of retaining expertise and institutional knowledge in exceptional cases.

Moreover, boards should be diverse. A study by the advocacy group Catalyst found that, in 2015, women had just 20% of board seats at S&P 500 companies.

Compensate directors based on performance goalsU.S. executives often are pilloried for being overpaid. But Harvard Business Review argues that directors are underpaid, with an average annual compensation of around $250,000. While some would argue that most directors don’t serve primarily for the money, appropriately compensating them using company shares as a meaningful component of their incentive package is a good idea.

Johnson & Johnson requires each director to retain the company shares issued upon election to the board and to own shares equal to five times his or her annual cash retainer. Coca-Cola grants non-option stock awards that become available only after a director has left the board. General Electric has a similar arrangement.

Beyond that, Harvard Business Review wants directors to purchase shares with their own money. These would vest only some years after directors leave the board.

After all, directors are there to make a company better, which dovetails with what activist investors say they aim to do.


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References Aspen Institute. (2008). Where will they lead? https://assets.aspeninstitute.org/content/uploads/files/content/docs/bsp/SAS_PRINT_FINAL.PDF

Beatty, David. (2017, January). How activist investors are changing the roles of public-company boards. McKinsey & Co. http://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/how-activist-investors-are-transforming-the-role-of-public-company-boards

Benoit, David. (2016, May 3). “The hottest metric in finance.” https://www.wsj.com/articles/the-hottest-metric-in-finance-roic-1462267809

Bhagat, Sanjai. (2017, May 3). “Board directors should be paid only in equity.” https://hbr.org/2017/05/board-directors-should-be-paid-only-in-equity.

Catalyst. (2016, June 14). 2015 Catalyst Census: Women and Men Board Directors. http://www.catalyst.org/knowledge/2015-catalyst-census-women-and-men-board-directors

Charan, Ran; Useem, Michael; and Carey, Dennis. (2015, February 9). “Your board should think like activists.” Harvard Business Review. https://hbr.org/2015/02/your-board-should-be-full-of-activists

Coffee, John C., and Palia, Darius. (2015, September 4). “The wolf at the door: The impact of hedge fund activism on corporate governance.” Columbia Law and Economics Working Paper No. 521. https://ssrn.com/abstract=2656325

Credit Suisse. (2016, Second Quarter). The activist agenda: What are activist investors looking for? https://www.credit-suisse.com/media/assets/microsite/docs/corporate-insights/credit-suisse-corporate-insights-q3-2016.pdf

Decker, Sue. (2015, February 3). “Keeping activist investors at bay.” Fortune. http://fortune.com/2015/02/03/keeping-activist-investors-at-bay-how-corporate-boards-can-help/

Ernst & Young. (2014, August 24). “Dealing with activist investors.” Viewpoints. http://www.ey.com/Publication/vwLUAssets/EY_activist_investor/$FILE/EY-April-2014-Dealing-with-activist-investors.pdf

Isadora, Chris. (2006, September 15). “Ford announces details of its turnaround plan.” CNN Money. http://money.cnn.com/2006/09/15/news/companies/ford/index.htm

Kane, Karen. (2015, February 9). “Activist investors take on the board.” Korn Ferry Institute. Briefings. https://www.kornferry.com/institute/activist-investors-take-board

Kunisch, Sven; Müller-Stewen, Günter; and Campbell, Andrew. (2014, December). “Why corporate functions stumble.” Harvard Business Review, https://hbr.org/2014/12/why-corporate-functions-stumble

Kurtzman, Joel and Distefano, Michael. (2014, August 11). “Alan Mulally: The man who saved Ford.” Korn Ferry Institute. Briefings. https://www.kornferry.com/institute/alan-mulally-man-who-saved-ford

McCann, David. (2016, August 5). “Hedge fund activism helps targeted companies.” CFO.com. http://ww2.cfo.com/investor-relations-banking-capital-markets/2016/08/hedge-fund-activism-helps-targeted-companies/


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References (continued) McNabb, William. (2015, February 27). Letter of Vanguard fund boards. https://about.vanguard.com/investment-stewardship/CEO_Letter_03_02_ext.pdf

National Association of Corporate Directors. (2016, April 25). NACD releases guidance to help corporate boards prepare for an activist-investor challenge. https://globenewswire.com/news-release/2016/04/25/832271/0/en/NACD-Releases-Guidance-to-Help-Corporate-Boards-Prepare-for-an-Activist-Investor-Challenge.html

PricewaterhouseCoopers. (2015, March). Shareholder activism: Who, what, when, and how? https://www.pwc.com/us/en/governance-insights-center/publications/assets/pwc-shareholder-activism-full-report.pdf

Statista. (2017, May). Selected automakers’ U.S. monthly market share. https://www.statista.com/statistics/343162/market-share-of-major-car-manufacturers-in-the-united-states/

Contributors

Robert NardelliFounder and CEOXLR-8 LLC

Alan GuarinoVice Chairman, Board and CEO Services PracticeKorn Ferry

Nels OlsonVice Chairman, Board and CEO Services PracticeKorn Ferry


© Korn Ferry 2017. All rights reserved.

About Korn FerryKorn Ferry is the preeminent global people and organizational advisory firm. We help leaders, organizations, and societies succeed by releasing the full power and potential of people. Our nearly 7,000 colleagues deliver services through our Executive Search, Hay Group, and Futurestep divisions. Visit kornferry.com for more information.

About The Korn Ferry InstituteThe Korn Ferry Institute, our research and analytics arm, was established to share intelligence and expert points of view on talent and leadership. Through studies, books, and a quarterly magazine, Briefings, we aim to increase understanding of how strategic talent decisions contribute to competitive advantage, growth, and success. Visit kornferryinstitute.com for more information.

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