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Assessing a Company's Potential for Activism

10/21/2013

There are known knowns; there are things we know that we know.
There are known unknowns; that is to say, there are things that we now know we don't know.
But there are also unknown unknowns – there are things we do not know we don't know.
— United States Secretary of Defense, Donald Rumsfeld

The famous observation above misses an important category. There are also unknown knowns; there are things you don't know you know. Until recently, I had a pocket of knowledge in the last category: what leads an activist to a particular company.

Two Minute Version:

There are three pieces to a successful activist campaign. First is some perceived hidden value. Second, the ability to buy in and own it. And finally there is the activist's ability to uncover that value, either by convincing management to take some action or forcing them to through the shareholder voting process. A company must have all three to be interesting to a (sane) activist.

Below I've unpacked it and given some common factors that lead to activism, but the beauty is that once you've grasped it, you can apply it to your own situation and find the relevant factors yourself. Its a framework that will allow you to access a company's chances of being attacked. It is also quite useful for a company, which wishes to reduce their chances of such an encounter, as well as, for an activist seeking to maximize returns.

Deja Vu For Starboard Value in Office Depot!

1/8/2013

As we wrote last month, Starboard Value's chances of winning a proxy battle at Office Depot are less than half of what they were at AOL, which didn’t turn out well even with support from ISS. The common problem for Jeff Smith and the Starboard Value team is that in both AOL and now Office Depot, they are at the mercy of a larger shareholder with MUCH more control over the outcome of a proxy battle.

Then: Starboard Value's Proxy Battle Fate at AOL was Decided by One Large Shareholder.
First lets look at what really happened at AOL. As the graph below shows, Starboard had much less control (in blue) in AOL, than top shareholders (see caption for explanation).

The Distribution of Control and Ownership Among Shareholders at AOL: This graph shows the percentage Ownership (in grey) and the %Control (in Blue) of the largest shareholder's at AOL prior to the recent Proxy Battle. Notice that in both AOL and ODP (see figure below) Starboard’s Control (circled in red) is very small compared to the larger shareholders. This means that Starboard's proxy future comes down to their ability to convince those few large holders to side with them. In the case of AOL that did not happen.

Starboard Value's control, circled above in red, was only about 17%. That means there was less than a one in five chance that starboard's vote would matter in the proxy battle. Now compare this to the control of the larger shareholders, especially Dodge and Cox who had control in nearly 60% of possible outcomes to the shareholder vote!

Now, Starboard’s chances of winning, on the face of things, didn't look terrible at AOL. After all, There was a 58% chance that they would come out victorious. However, that number changed drastically depending on the vote of a single shareholder, Dodge and Cox. In fact, to a large extent the outcome was determined by which side got Dodge and Cox's vote. When Dodge and Cox eventually decided to vote with management, Starboards chances of winning plummeted to just 29%.

Aside for proxy battle experts and aspirants: People are generally friendly and will often tell you what you want to hear. It is common for both sides to be sure they have a proxy battle in the bag, because of large shareholders being nice to both sides. It would be unsurprising to learn that both AOL's Management and Starboard Value went into the vote thinking Dodge and Cox was on their side. That is why it is so crucial to use methods of analysis that are able to handle reality: massive uncertainty in how people will vote, even if they have told you they are with you.

Now: Starboard Value's Fate at Office Depot is Also Likely to be Decided by One Large Shareholder
The graph below is the same as above, only now showing the current shareholders in Office Depot. Notice how eerily similar Starboard's strategic position at Office Depot is to AOL:

Again Starboard Value is far from the largest shareholder, though much closer here
Again we have a large shareholder - BC Partners -who basically controls the outcome of a potential proxy battle.

BC Partners with just over 20% of the vote has a whopping 86% control! (BC partners is a preferred shareholder who gets to vote their shares on an as-converted basis. We'll cover this more in the next post.) Since BC Partners is currently contractually required to vote with the recommendation of Office Depot's board(a condition of their preferred investment), we know they will vote against Starboard in any potential proxy battle. That only leaves Starboard Value a 14% chance of winning a proxy battle at Office Depot. That is a rough position for someone who is by far the largest common stock holder!

The Distribution of Ownership and Control Among Shareholders at Office Depot: This graph shows the percent ownership (in grey) and the %Control (in Blue) of the largest shareholders at Office Depot today. Notice that in both AOL (above) and ODP, Starboard’s Control (circled in red) is very small compared to the larger shareholders, especially in the case of BC Partners at Office Depot. Note: Here %Ownership is actually percent of the vote, because BC Partners has a large chunk of the vote through preferred shares that do not show up as common-stock ownership.

What does this mean for Starboard Value (and coattailers)?
It's not all bad news for Starboard: Office Depot is deja vu in more ways than one. Though they lost the proxy battle at AOL, some of their proposals were instituted and AOL's stock appreciated by ~70% while they held it. In that sense too, Office Depot looks very similar to AOL. Namely the share price is up 100% since Starboard started buying in. Starboard Value may be losing battles, but so far they are winning the war! And despite the long odds, Starboard appears to be gearing up for a fight, with their recent retainer of Bob Nardelli, the former chief of companies such as Home Depot and Chrysler, and Joseph Vassalluzzo, a former vice chairman of Staples Inc. Both are powerful choices for an opposition slate of directors!

Next time we'll cover the Office Depot innovation that Starboard was attempting to counter with their recent letter to independent directors. Depending on your view, it is either the greatest or the worst thing to hit the field of corporate governance in years. I call it the Permanent White-Knight Defense. Starboard might call it the Chained White Knight Defense. Whatever your take, it makes the poison pill, the subject of much gnashing of teeth, look like a kitten in a pretty pink bow, so tune in next week!

Rotary Gallop's Analysis Featured In 'The Deal': Office Depot vs Starboard Value

12/6/2012

We had a great talk with Paula Schaap at The Deal recently about the Starboard Value/Office Depot Activist Situation which we've been following closely It is a fascinating case study in corporate defense. Starboard's chances of winning a proxy battle at Office Depot are about half as much as they were at AOL, where they recently lost. We'll be covering some of our in-depth analysis here over the next couple of weeks so stay tuned. Until then Paula covers our thoughts on Starboard best chance of turning things around, so check out the article!

The Tragedy of Projections: Part 1

3/15/2012

At Rotary Gallop, we believe that measuring the right thing, with the right tool is REALLY important!

One of the biggest tragedies in the field of Investor Relations and Defense/Contested-Situation Advisory is one brought on by a terrible tool: Projections. Proxy solicitors popularized the name projections, but really all the experts we’ve talked to in the area of winning shareholder votes, (from successful activists, to Corporate Secretaries, heads of IR, IR consultants) are doing essentially the same thing. In fact, the problem described below is endemic to all analysis that involves starting at the top and working your way down a shareholder list (for convenience we’ll refer to all of this broader class as “projections”). Projections not only destroy useful information, but force people into measuring the wrong thing. These methods are wrong and destructive. So why is this terrible tool so wide spread? Because projections are intuitive and, in the absence of a better technology, were the only available choice.

What is wrong with Projections?

Your expert has LOTS of valuable information, which they generally use to predict a result (e.g. Projection - 63% of the vote For Managment). Unfortunately, the expert feeds this valuable information into their traditional method of analysis - projections. The problem is projections are inherently incapable of handling the vast number of outcomes (defined as combinations in which your shareholders might vote) possible in a shareholder vote! Projections are essentially a pencil and paper method that, with the help of an excel sheet and a really ambitions practitioner, might be able to consider, say, 100 different outcomes.

To drive home how inadequate this really is, below on the left is the number of atoms in the known universe. On the right are the number of unique outcomes possible in an election of just 1000 shareholders! A mind-boggling number!

Atoms in the Known Universe: 100,000,000,000,000,000,000,000,000,000,
000,000,000,000,000,000,000,000,000,000,
000,000,000,000,000,000,000

Possible Outcomes in a 1000 Shareholder Election: 1,000,000,000,000,000,000,000,000,000,000,
000,000,000,000,000,000,000,000,000,000,
000,000,000,000,000,000,000,000,000,000,
000,000,000,000,000,000,000,000,000,000,
000,000,000,000,000,000,000,000,000,000,
000,000,000,000,000,000,000,000,000,000,
000,000,000,000,000,000,000,000,000,000,
000,000,000,000,000,000,000,000,000,000,
000,000,000,000,000,000,000,000,000,000,
000,000,000,000,000,000,000,000,000,000

So, in order to reduce the number of outcomes to something manageable your expert is forced to start adding in shaky information, and eventually even making outright assumptions. If you mix good information with even a tiny amount of bad information, especially in a flawed methodology, the bad information wins every time. Thus the output of projections is garbage. “Garbage in – Garbage out” isn’t just a saying. It is an inarguable fact about our world, like the area of a triangle, resulting from the way errors propagate.

Garbage in - Garbage out: Projections force the use of shaky information, poisoning what solid intelligence is available and inevitably producing inaccurate results.

Your expert has spent a career building the expertise and connections that make up their incredibly valuable knowledge. It is precious. We should be protecting it from harm. Don’t let Projections ruin your experts most valuable assets!

At Rotary Gallop, because we can handle the vast number of outcomes possible in your next shareholder vote, we can pool only the most certain information from all your experts and calculate useful, relevant, actionable intelligence - such as your control, your chances of victory, the control of each shareholder, and how much a given shareholder could change your chances of victory by siding for you or against you.

Next time I’ll explain how in addition to destroying your experts precious information, projections measure the wrong thing! It will be obvious once you see our latest innovation: The Map! If you have any questions email me at T@RotaryGallop.com.

Understanding The Power Of Board Seats

3/5/2012

I have a confession to make: unlike both of my business partners, I am not a natural-born negotiator. Like a lot of Americans, I have been conditioned by shopping in stores where the price displayed is the price paid. We agree at the outset or we don’t do business. Anything else is a rude and uncouth argument. I’ve witnessed my partners in action enough to know that that’s not the way the real world works. (On the lighter side I once witnessed, open-mouthed, one of my partners negotiate an $8 piece of cake for free in return for assurances that if they liked it they might buy it next time and even tell their friends about it!)

I knew this was an area I could really improve on, so I started read a lot of books about how to negotiate. For me, Roger Dawson’s “Secrets of Power Negotiating” stands head and shoulders above the rest. That book taught me to stop viewing negotiation as an argument, and to start seeing it as a fun and fascinating game of strategy.

So when the e-mails between John Cleghorn of Canadian Pacific Railway and Bill Ackman of Pershing Square Capital were released, I was extremely excited to see such high-stakes negotiation play out right before our eyes. I turned to Roger Dawson to help analyze the negotiating tactics between Cleghorn and Ackman.

I suggested to Roger, “between your negotiating expertise and my ability to measure the control of each side under each proposed scenario, we could really dissect and analyze this thing play-by-play and tell the whole story!”

He agreed but added, “the only thing that really stands out as interesting is that Bill Ackman seems extremely aggressive and confrontational. Do you know if this style of negotiation generally works for him, because it’s never worked for me, and I’ve never really seen it work well? Generally, this sort of tone shuts negotiations down.”

That got me thinking … I have never met Bill Ackman, but given his line of business and his success, I imagine he’s not a bad negotiator. Why would he make such a rookie mistake? What if he didn’t make a mistake?

This is the difference between an enthusiastic practitioner and a real master of his craft. I was lost in the trees, simply spotting glorious negotiating tactics flying this way and that, until Roger gently pulled me back – “Did you notice this forest?” The forest was quite fascinating! What I saw was that Ackman was walking a tight wire out of a subtle trap – the negotiations themselves.

Measuring (and gaining) control of a board of directors is difficult. Two seats are definitely better than one, but not exactly twice as good. It is better to replace a sitting member, than to pull up a new chair at the table, and better still to replace one of the opposition. It can all get very muddled. But when you can measure control directly, you can see the forest plain as day. Let me show you:

Exhibit 1 shows Managements’ (Blue) and Pershing’s (Red) control of the board of directors under various hypothetical scenarios. The first scenario is the current 15-member board of directors. Management has 77% control, meaning they hold the deciding vote in 77% of all possible voting outcomes on the board of directors [1].

As we move to the right on the horizontal axis we see the power structure if Ackman is given 1, 2, 3, 4, 5, or 6 seats added to the board.

The brick wall divides the scenarios likely to result from negotiation, from those that would almost certainly require a proxy battle to achieve. Under the possible negotiated outcomes, management retains significant control of the board. If Pershing were to accept 1 or even 2 board seats, they would have very little chance of causing change at Canadian Pacific.

Exhibit 1: Canadian Pacific Railway and Pershing’s control of the Board of Directors

Exhibit 1: Bill Ackman and Pershing square have very little chance of causing change on the board of directors with a negotiated settlement of two or less seats. Such a settlement would likely result in another year for current strategies to play out, while Ackman must wait for the chance to gain additional seats next year. To have an effect on Canadian Pacific now Pershing needs to engage in and win a proxy battle.

Now we see that Ackman cannot win negotiating. The best he can hope for from negotiations is to be stuck on a board he cannot influence for a year while he waits to try again next year.

It’s a tricky situation. Ackman is trying to combat the seemingly cooperative and congenial offer of a seat for himself on the board of directors that both sides know comes with essentially zero power to accomplish anything. If this wasn’t clear at the start, Canadian Pacific’s decision to add two new handpicked members to the board made it loud and clear, before they even made the offer. Now we can understand Ackman’s strategy. He has to negotiate, without appearing unreasonable, and without coming off as too much of a bad guy. To do otherwise would alienate other shareholders. At the same time, he cannot be trapped in a negotiated settlement. Hence the aggressive email followed by the befuddled apology, on the advice of his team.

The pairing of personalities at Pershing Square allows them to naturally implement one of the most powerful and well-known negotiating techniques: good-guy/bad-guy. A more useful, if less pithy, description of good-guy/bad-guy might be sympathetic-and-flexible/emotionally-charged-and-firm (Here is Roger on good guy/bad guy).

The email exchange is a fine example of this technique’s opening rounds, with Ackman’s team nicely set up in the good-guy role. Good-guy/bad-guy is a powerful negotiating gambit, and not easily countered when genuine, as is the case at Pershing Square. Ackman was smart enough to surround himself with cooler heads, and to know that he needs to keep them there. I suspect the cooler heads at Pershing see the value in Ackman’s passion as well. We’ve all seen enough cop-drama to know that when the team gets broken up, they’re useless without each other.

Control measurement reveals several more fascinating insights to the Canadian Pacific vs. Pershing Square case, which we doubt even the players involved fully understand. Check out this article on how significant representation for Pershing Square will double the power of existing independent board members!

[1]: For these calculations we have assumed that management controls 4 of the 15 votes on the board of directors. We have no inside knowledge and have never spoken to anyone on the board. However, we do believe this is a conservative assumption, given that 5 board members have been on the board for 10 years, one board member is the CEO, two board members joined the board in the same month as the CEO, and two more were added in response to Pershing Square.

Measuring the Influence of ISS

2/20/2012

Though the influence of ISS varies from company to company, the proxy voting advisory firm’s impact can be measured. (Originally published on Directorship.com)

There has been much ink spilled, angst and teeth gnashing about the outsized influence that Institutional Shareholder Services (ISS) holds, much of it based on broad averages—such and such a percentage of institutions subscribe to ISS, for example, or the average company in the S&P 500 has X percent of it shareholder base subscribed to ISS.

So exactly how much attention should you pay to these numbers? The truth is that the influence of ISS varies drastically from company to company. The best part—this can be measured.

In calculating ISS’s influence at a target company I once asked a well-known proxy solicitor working the case with me, “Roughly what percent of ISS’s subscribers end up voting along with ISS’s recommendations?” After some thought, he said “Oh, about 50 percent.” There is no need to break out the spreadsheet here. In this case, despite boasting a subscriber base holding over 20 percent of outstanding shares, ISS had exactly 0 influence. You’d expect the same level of agreement with the phases of the moon.

That said, I’ve worked on other cases where ISS was the absolute key to victory. (By the way, having a big effective-shareholder like ISS, who does what it says, isn’t all bad when compared to many large shareholders who will tell you what you want to hear and then vote the other way.)

Knowing ISS’s influence on your elections isn’t hard and isn’t abstract. You just need two things: a little information about your shareholder base and an analysis of where the voting power lies. The former tells you who subscribes to and votes with ISS. The latter tells you how much influence those shares have over the election.

Here is an example from a company I worked on recently: 12 shareholders representing 16 percent of the total outstanding shares subscribed to ISS. Of those, only seven with nine percent of outstanding shares regularly voted with ISS’s recommendations. In this company, this bloc of ISS-swayed voters, had a 53 percent chance of winning an election and a five-percent chance of swinging the election. An ISS recommendation for management would increase management’s odds of victory by 14 percent, while a recommendation against would only decrease their winning odds by 3 percent.

There you have it. ISS has been weighed and has been measured.

It won’t be the same answer for your company but the key point is that there is an answer. ISS’s influence is not abstract and cannot be calibrated by “a gut feeling.” It is measurable. Once you know how much sway ISS has on your election, you can plan accordingly, stop worrying about what the talking heads are saying and put that chunk of bandwidth back into making the company better.

The Real Source of Activists’ Positive Returns?

2/14/2012

(Originally a Guest Post for The Activist Investor. )There is a perception among many that granting an activist significant board representation over and above what ownership might indicate grants unfair and detrimental control to the activist. Such an action is often derided as a stealth takeover, or a takeover with no premium.

However, granting an activist significant board representation, to balance the secured votes of management, actually transfers significant power to the unaligned board members already serving. Those unaligned board members (with significant ties to neither management nor the activist) are utterly familiar with the company and its problems, but have not had sufficient voice to cause change. It may be that the best effect an activist has, even one without a detailed, 30 point, 5-year plan, is to cause this shift in power towards these already serving board members.

The unfolding drama between the current management of Canadian Pacific Railway and Bill Ackman of Pershing Square Capital Management, L.P. offers a prime example. Pershing is seeking 5 board seats on a 15 member board while owning only 14% of outstanding shares. To some, this may seem like an undue amount of representation. However, we find that far from concentrating power in the hands of Pershing Square, granting Pershing significant representation would actually result in a much more even distribution of power on the board of directors.

Since things are in the late negotiating stages, with management offering Pershing a single seat, we looked at what would happen to the distribution of power on Canadian Pacific Railway’s board of directors if Pershing Square were granted 1, 2, 3, 4, 5, or 6 additional seats. As Pershing is granted more seats the unaligned board members’ power increases significantly, as seen in the graph below. In fact, when Pershing Square is granted four seats, matching management’s secured votes[1], the power of the unaligned board members more than doubles to 25%!

Exhibit 1: As Bill Ackman and Pershing square receive more seats the unaligned board members’ control increases, more than doubling at 4 seats for Pershing. Notice that the unaligned board members’ power grows even as their percentage of the vote shrinks steadily. As we move to the right on the horizontal axis we see the percentage of the total vote (black) and Control (Green) of each unaligned board member if Bill Ackman is given 0, 1, 2, 3, 4, 5, or 6 seats added to the board.

It can, and perhaps ought to, be argued that this spreading of power on the board is exactly what one would hope for at a time when a new direction is necessary. Such a leveling effect will allow new ideas to more effectively compete, whether they come from Pershing or the unaligned board members familiar with Canadian Pacific’s problems.

We wonder how much of activists’ proven effectiveness at delivering returns stems from this simple redistribution of power to previously disenfranchised, but established board members. Let us know what you think in the comments below!

[1] For these calculations we have assumed that management controls 4 of the 15 votes on the board of directors. We have no inside knowledge and have never spoken to anyone on the board. However, we do believe this is a conservative assumption, given that 5 board members have been on the board for 10 years, one board member is the CEO, two board members joined the board in the same month as the CEO, and two board members were appointed in the face of Pershing’s activism.

The Power of Measuring Control: ModusLink Global Solutions

11/29/2011

A case in the news beautifully highlights a fact we observe in engagement after engagement: going from qualitative fuzzy adjectives (traditional proxy strategy advice) to quantitative hard numbers can be a gamechanger! Even when the situation appears blatantly obvious, cold hard numbers give a new perspective like no other. Case in point: ModusLink Global Solutions, Inc (NasdaqGS: MLNK ) featuring Peerless Systems Corp. (PRLS) and Steel Partners.

For the second year in a row, ModusLink is having an eventful proxy season. For a great summary, check out the October 28th edition of the always useful Catalyst Equity Research Report . This year, management faces Peerless Systems’ seasoned activist Timothy Brog. He is backed by an amalgam of varied and vocal supporters, totaling roughly 11% ownership. This is significant activist power. Peerless is seeking to replace two directors up for election this year.

As far as we've been able to determine, Steel Partners, the 800-pound gorilla in the room and largest shareholder by far with nearly 12% ownership, has not publicly announced allegiance to either side. One might rightly assume the obvious: that Steel Partners is a huge prize in the contest and that they may have significant negotiating power with both management and Peerless Systems.

However, as a decision executive at one of the involved parties, how do I use this information? What do I do with an adjective like “significant” or “huge”? How do I weigh "significant" against the actual costs and changes that Steel Partners might like to see in order to support me? And what does “significant” really mean, coming from an advisor who may have a different gut-calibration than myself? Answer: It is a big fat ambiguous term that in turn results in a big fat clumsy strategy.

We can do better. Rotary Gallop's Control Measurement techniques crush fuzzy adjectives and presents tangible numbers. Numbers that you can touch and feel, weigh and measure, and then use to think. Numbers that exactly measure the power and influence of each shareholder. In the case of ModusLink, at Rotary Gallop we take “significant” and give you:

Steel partners has a voting power of 53%. In the upcoming proxy battle this January, there is a 53% chance that Steel Partners will cast the deciding vote.

Take a moment to appreciate what just happened. We've gone from an adjective like "significant", to knowing the odds that Steel Partners will be the deciding factor in the election. Now that is a giant leap forward! And the beauty of numbers is that we can make the connection between Steel Partners and the fate of the opposing campaigns even more direct.

Presenting Exhibit 1: Management and Peerless’s Risk of loss

We have directly measured the "significance" of Steel Partners’ decision to Peerless and ModusLink. Look at the middle gray columns in the graph below. With Steel Partners remaining undecided, ModusLink has a 65% chance of losing, while Peerless has a 35% percent chance of losing. That is a fairly wide-open race, with management winning 7 out of 20 times.

Exhibit 1: Measuring the Risk of Steel Partners’ decision to ModusLink and Peerless.

If Steel Partners sides with ModusLink (blue columns) the tables turn but the race still remains quite wide open. Peerless has a 61% chance of loss while ModusLink now has only a 39% percent chance of loss. (ModusLink now wins 12 out of 20 times). If, on the other hand, Steel Partners sides with Peerless (red columns) we have a much more drastic change in the character of the race, with ModusLink's risk of loss shooting all the way up to 92% percent and Peerless’s dropping to only 8%!

Using an adjective, like significant, to communicate the importance of Steel Partners completely misses the key observation that their value is asymmetric. In siding with ModusLink, Steel Partners does not change the character of the race – it still remains essentially open. However, in siding with Peerless, Steel Partners makes a proxy win nearly impossible for ModusLink’s and the game changes from a contest to one of negotiations. Thus, from Peerless’s point of view, Steel Partners represents a primarily offensive opportunity (a game winning strategy), while ModusLink should see them as primarily defensive (a stay-in-the-game strategy).

Now Peerless, ModusLink, and Steel Partners all know just how valuable Steel Partner’s decision is to each party and they will all be able to make much more intelligent decisions about what concessions are and aren’t worth Steel Partners' support. Having at least this part of the competitive landscape in sharp focus will help the decision makers at Peerless and ModusLink as they head towards the election in January. And for other decision makers and advisers our there: You don’t have to put together your strategy while viewing the battle field through a dirty coke bottle. We have satellite images!

As I sign out, I’ll note that we can go another step further and put a monetary value on Steel Partners' Vote for both Peerless and ModusLink, but that’s a post for another day. Let me know what you think!

-Travis