THE FORMER CHAIRMAN of the Securities andExchange Commission, Richard Breeden, has served as the high-profileoutside monitor for the scandal-plagued WorldCom and was brought in bythe board to address corporate governance misdeeds at Conrad Black’sformer company, Hollinger International. Last year, he launched his ownhedge fund, Breeden Partners in Greenwich, Conn., raising $500 millionin commitments, $400 million of it from the California PublicEmployees’ Retirement System. The fund’s philosophy is to invest inunderperforming companies that can be redirected by focusing on basicvalue 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. (Directorshipchecked with several investors who said the returns are averaging 15 to20 percent annually.) We are a deep-value investment fund, and we arefocused on companies that are underperforming, typically in the bottomquartile of their peer group. We consider the variety of causes and ifit’s our type of problem, meaning one we know how to fix, we advocatechange. Not infrequently, governance is part of the discussion becausewhen there’s a lack of accountability for performance, that is thegreatest governance misdeed.
Overall, we look only at long-term investments, which ispart of our fund charter, and we also have not borrowed a dime, sothere’s no leverage. Our typical time horizon going in is a two- tofive-year holding period. You can’t have a dialogue about change soonerthan that.
How would you describe your fund management style?
This is a team effort. We have two analysts who follow everycompany we’re involved in, and they work closely with the other seniorpartners. My name is on the door, so it is important that I have acomfort level with the investment. We vote on every investment; amajority of the team has to be in favor, and I need to be in themajority.
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 toApplebee’s [board] recently… but there is a limit to how many one canserve on and still get management attention. If on the other hand we’reon the outside, then we’re writing letters to the board directors, aswe first did at Applebee’s. We wrote the head of the compensationcommittee, “Here are some counterproductive things, places where theincentives 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—whoeverthey are—who care about your return. You’re the steward of theircapital while they are invested. People look for an excuse as to whythey should ignore the imperative to generate shareholder value.Although I should mention that for our purposes, I never buy into acompany unless I’m prepared to stay with it at least two years. Themacro economy may change and events may force you to sell sooner, butour mind-set is to be prepared to work with a company over a period ofyears.
Do managements spend too much time focused on short-term tacticsto drive profits and P/E’s? Should management take the short-term lumpsfrom the market?
I think companies should quit giving short-term guidance. Just stop.Just say no. All sell-side analysts want company management to guidethem so they can predict accurate numbers, make the all-star rankings,and get a big raise. Management shouldn’t give guidance more thanyearly. We get far too hooked on the drill of predictions, but I thinkmorning, noon and night corporate managers should be worried about theperformance of their business. Publicly traded companies have aninfinite supply of their own stock that they can use to raise capitalforever as long as they do a good job of protecting the value of thoseshares by maintaining competitive levels of return. This is the mostimportant asset a company can have. You can use it to improve ratings,acquire other assets, and distribute to shareholders. It is the board’smost precious asset—the right to increase the pool of stock, so long asthe market places a correspondingly high value on it.
What about acquisitions?
The core strategic asset every company has is the ability to raisecapital through public markets, and that asset is lost if you losesight of value, whether short-termism or dilutive acquisitions. Anoverlooked issue is of core competence. After all, there is a limitedamount of bandwidth—how many businesses can one CEO run? We worry aboutcompanies expanding into shoulder or marginal businesses. If boards andmanagement would consider the risk factors in acquisitions, we suspectthere would be fewer—and by definition they would be discounted.Consider how much time management and the board spend absorbing andintegrating and developing strategy. The farther a company goes outfrom 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 notcompetitive, the CEO may leave us and go work for our rival. Thathappens sometimes, but it’s an overrated threat. There’s nothing wrongwith benchmarking, which gives you one data point on what is ultimatelya judgment call. But it should only be one data point. Peer groups arefrequently constructed to drive up pay, and they routinely have beendamaging to the interest of shareholders and have [contributed] to badboard decisions.
What’s more important is not the dollar amount you pay a CEO buthow you got there. How rigorously do you measure performance? Do yourstandards have a high correlation to actual shareholder value? WarrenBuffett 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 arelooking for a new board member. The Scandinavian system is fascinating.At Volvo, only one out of five nominating committee members is adirector, while the other places are reserved for shareholders. Theythen propose the nominees to the board at the annual meeting.
Certainly, you should use some discretion in choosing whichinvestors to nominate for the board. But why wait for Ralph Whitworthor Richard Breeden to bang on the door? Shareholders should regularlybe thought about because they have a complete alignment of interestwith the company and often have very relevant perspectives on issuessuch as pay and expenses. You have to use some discretion in which onesto choose, but too many lawyers and outside advisers fan the flames ofparanoia with warnings about how disruptive it will be to have aninvestor sitting on the board.
The traditional wisdom for many shareholders is they don’t wantinside information, which restricts their ability to trade. But if I’mgoing to hold the stock for three to four years anyway, then going onthe board adds a level of value and brings perspective and independence.