October 3, 2014

We have argued in several blog posts that we are witnessing a new era of activist investing, characterised by larger, bolder and more powerful activist funds. In this context Cheverny believes that the importance to a company and its board of an independent adviser – a firm without the many conflicts of interests at integrated investment banks that flow from trading in the securities of a company (sometimes with an activist fund as a customer), having advisory and debt-lending relationships with a company and/or its rivals, owning asset management arms that may hold shares or debt in a company or its rivals, having stock lending business, and so forth – has never been greater. We strongly believe that clear articulation of strategy and constructive engagement with activists is generally the best way forward for a company.

Three recent, inter-related, news stories underscore these trends.

The first is a rancorous public spat between a billionaire hedge fund manager and a billionaire owner and operator of casinos. This highlights the risks of using lawsuits.

The second is the news that Mr William Ackman’s Pershing Square Capital successfully raised permanent capital in an initial public offering on the Amsterdam Exchange. This underscores the fact that activisim as a strategy is here to stay.

The third is the replacement of the Board of Darden and the lessons of engagement versus willful opposition.

Lawsuits As A Tool: The Risks

Mr James Chanos is the founder of Kynikos Associates, a New York-based hedge fund best known for short-selling. Perhaps his best-known trade was against Enron, where his analysis of that company’s mark-to-model accounting and (low) return on invested capital proved entirely prescient (and profitable).

He is being sued by Mr Steven Wynn, the well-known operator of casinos in Nevada and Macau; Mr Chanos is alleged to have implied that Wynn Resorts had contravened the Foreign Corrupt Practices Act. The lawsuit also refers to Mr Wynn’s emotional distress.

Interestingly, the offending statement was not made in a particularly obvious place: on CNBC, for example, or in a press release backed up by a public relations campaign. Instead it was before an audience of students during a panel discussion at the University of California, Berkeley on a questioning PBS documentary on gambling in Macau.  It could easily have been ignored and quite possibly forgotten.

The New York Times reports Mr Chanos as having  remarked “We were actually long Macau for a while. I wanted to be long corruption and short property… But even I got nervous the deeper we dug into Macau… Although I was long the U.S. casino operators – like Mr Adelson and Mr Wynn – I began to get really concerned with the risk I was taking with clients money under the Foreign Corrupt Practices Act.”

The rights and wrongs of this case will be judged by a U.S. court. What is relevant to our discussion of strategy is what it says about how companies address statements by hedge funds that they deem to be incorrect, misleading or injurious.

Companies taking to the courts may feel that they are defending their rights. Yet can this backfire? Mr Wllliam Ackman (more on whom below) once noted that lawsuits were potentially helpful to a short seller or an activist. Having termed Herbalife a “pyramid scheme” he noted “We welcome their suing us. If they sue us, we get access to inside information on Herbalife that can prove we are telling the truth.”

The Wynn/Chanos lawsuit marks a clear escalation in a battle between the rights of investors to state a view and the rights of companies to combat libel. It may be that lawsuits can work, but the discovery process in any lawsuit surely offers a diligent lawyer the opportunity to unearth a document, or an email, that casts the company in an awkward or counterproductive light.

Pershing Square Gets Permanent Capital

Some companies may hope that acitivist investing will fade as a strategy. Perhaps they hope that recent moves by Californian pension giant CALPERS to withdraw from hedge funds would cut into the muscle mass of some of the well-known activists.

Such hopes are likely to be dashed in the wake of Pershing Square Capital announcing that it had trod the paths of the private equity giants before it and had raised $3 billion of equity in an initial public offering on the Amsterdam Bourse.

This provides Mr Ackman and Pershing Square with a sizeable pool of permanent capital: to put this in context the current Pershing Square funds have approximately $14 billion under management in structures offering investors various forms of liquidity. This will surely allow him to launch more – and more ambitious – campaigns (though perhaps the current $53 billion partnership with Valeant Pharmaceuticals to purchase Allergan will be hard to top).

Board Self-Immolation: Darden Versus Activists

Darden Restaurants (DRI-NYSE) operates several chains including Red Lobster, Olive Garden and Longhorn Steakhouse. The company currently has a $6.3 billion market capitalisation.

During the fourth quarter of 2013  two activist funds – Starboard Value and Barrington Capital Group – approached Dardens with a series of suggestions and requests. Barrington had amassed a 3% stake whilst in December of 2013 Starboard announced a 5.6% position. Their core proposal was to split the company: dividing more mature chains such as Red Lobster, Olive Garden and LongHorn away from high growth brands. Traditionally in the US a new food or retail concept can be proven in one or more regional markets,  funded via an IPO, and then command a very high price/earnings ratio as it spreads across the USA cookie-cutter style.

The activists also had suggestions about executive compensation and corporate overheads.

Mr Clarence Otis Jr., the Chariman and CEO, and the board of Darden elected not to engage with the activists. They did not aggressively defend the strategic rationale or go above and beyond in defending their vision. Nor did they comply with the activists’ suggestions.

Instead they took the ignore-and-raise barriers route. When the activists refused to quite the scene the board decided to spin off part of the mature portfolio – the Red Lobster chain. The activists retorted that this was foolish insofar as it left Red Lobster as a sub-scale entity. They also focused on the failure to monetize the chain’s real estate value. 57% of shareholders called a special vote: the spinoff was clearly going to be blocked.

At that point, it could be argued, effecting a compromise could have averted much cost and trouble. DRI’s board however chose to pivot and sell Red Lobster to Golden Gate Capital for $2.1 billion.  The activists were outraged, asserting that this substantially undervalued the asset. Institutional Shareholder Services, the proxy advisory, called the price “very close to a giveaway”. The activists won over the broad base of shareholders.

The outcome? Mr Otis, the Chairman and CEO, has announced his resignation. Eight directors are resigning and the remaining four directors seem to have an uphill battle to retain their seats.

Cheverny’s conclusion: this situation highlights the value of boards – in conjunction with their independent advisers – constructively and openly engaging with activist investors.