June 01, 2007

Targeting Underperformers

THE FORMER CHAIRMAN of the Securities and Exchange Commission, Richard Breeden, has served as the high-profile outside monitor for the scandal-plagued WorldCom and was brought in by the board to address corporate governance misdeeds at Conrad Black's former company, Hollinger International. Last year, he launched his own hedge fund, Breeden Partners in Greenwich, Conn., raising $500 million in commitments, $400 million of it from the California Public Employees' Retirement System. The fund's philosophy is to invest in underperforming companies that can be redirected by focusing on basic value creation and removing the underlying causes of underperformance.

It's been a year since you launched your fund, how is it doing?
We have nine stocks in our portfolio. By midsummer, we will be at about $1.5 billion in assets under management. (Directorship checked with several investors who said the returns are averaging 15 to 20 percent annually.) We are a deep-value investment fund, and we are focused on companies that are underperforming, typically in the bottom quartile of their peer group. We consider the variety of causes and if it's our type of problem, meaning one we know how to fix, we advocate change. Not infrequently, governance is part of the discussion because when there's a lack of accountability for performance, that is the greatest governance misdeed.

Overall, we look only at long-term investments, which is part of our fund charter, and we also have not borrowed a dime, so there's no leverage. Our typical time horizon going in is a two- to five-year holding period. You can't have a dialogue about change sooner than that.

How would you describe your fund management style?
This is a team effort. We have two analysts who follow every company we're involved in, and they work closely with the other senior partners. My name is on the door, so it is important that I have a comfort level with the investment. We vote on every investment; a majority of the team has to be in favor, and I need to be in the majority.

Does your strategy differ materially if you participate directly as a board member versus only as an activist investor?
There are times we go on boards. For example, we were elected to Applebee's [board] recently... but there is a limit to how many one can serve on and still get management attention. If on the other hand we're on the outside, then we're writing letters to the board directors, as we first did at Applebee's. We wrote the head of the compensation committee, "Here are some counterproductive things, places where the incentives are not aligned." Activating boards is part of my approach, as it is also Ralph Whitworth's [see related story] . We're willing to walk the talk and engage as peers with other directors.

Do you think board directors should differentiate between short-term and long-term investors?
Boards should be indifferent. Every day you have shareholders—whoever they are—who care about your return. You're the steward of their capital while they are invested. People look for an excuse as to why they should ignore the imperative to generate shareholder value. Although I should mention that for our purposes, I never buy into a company unless I'm prepared to stay with it at least two years. The macro economy may change and events may force you to sell sooner, but our mind-set is to be prepared to work with a company over a period of years.

Do managements spend too much time focused on short-term tactics to drive profits and P/E's? Should management take the short-term lumps from the market?
I think companies should quit giving short-term guidance. Just stop. Just say no. All sell-side analysts want company management to guide them so they can predict accurate numbers, make the all-star rankings, and get a big raise. Management shouldn't give guidance more than yearly. We get far too hooked on the drill of predictions, but I think morning, noon and night corporate managers should be worried about the performance of their business. Publicly traded companies have an infinite supply of their own stock that they can use to raise capital forever as long as they do a good job of protecting the value of those shares by maintaining competitive levels of return. This is the most important asset a company can have. You can use it to improve ratings, acquire other assets, and distribute to shareholders. It is the board's most precious asset—the right to increase the pool of stock, so long as the market places a correspondingly high value on it.

What about acquisitions?
The core strategic asset every company has is the ability to raise capital through public markets, and that asset is lost if you lose sight of value, whether short-termism or dilutive acquisitions. An overlooked issue is of core competence. After all, there is a limited amount of bandwidth—how many businesses can one CEO run? We worry about companies expanding into shoulder or marginal businesses. If boards and management would consider the risk factors in acquisitions, we suspect there would be fewer—and by definition they would be discounted. Consider how much time management and the board spend absorbing and integrating and developing strategy. The farther a company goes out from its core, the more likely it is to lose focus.

Is peer-group comparison a good tool for measuring CEO pay?
The focus on peer groups starts with the theory that if we are not competitive, the CEO may leave us and go work for our rival. That happens sometimes, but it's an overrated threat. There's nothing wrong with benchmarking, which gives you one data point on what is ultimately a judgment call. But it should only be one data point. Peer groups are frequently constructed to drive up pay, and they routinely have been damaging to the interest of shareholders and have [contributed] to bad board decisions.

What's more important is not the dollar amount you pay a CEO but how you got there. How rigorously do you measure performance? Do your standards have a high correlation to actual shareholder value? Warren Buffett figures out what to pay his top management in ten minutes.

How can boards improve?
One way is for them to turn to major shareholders when they are looking for a new board member. The Scandinavian system is fascinating. At Volvo, only one out of five nominating committee members is a director, while the other places are reserved for shareholders. They then propose the nominees to the board at the annual meeting.

Certainly, you should use some discretion in choosing which investors to nominate for the board. But why wait for Ralph Whitworth or Richard Breeden to bang on the door? Shareholders should regularly be thought about because they have a complete alignment of interest with the company and often have very relevant perspectives on issues such as pay and expenses. You have to use some discretion in which ones to choose, but too many lawyers and outside advisers fan the flames of paranoia with warnings about how disruptive it will be to have an investor sitting on the board.

The traditional wisdom for many shareholders is they don't want inside information, which restricts their ability to trade. But if I'm going to hold the stock for three to four years anyway, then going on the board adds a level of value and brings perspective and independence.