When does active investment need to be even more active?

PM Capital

Recent takeover activity, including that surrounding Australia’s Spotless Group and Dutch paints and coatings maker AkzoNobel, has investors asking the question: what’s in a company’s long term interests and who’s to decide?

Here, PM Capital Analyst, Annabelle Symons, looks at one of the more famous boardroom battles detailed in Jeff Gramm’s book Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism and how its effects and lessons reverberate today. Jeff Gramm is visiting Australia in May.

Author: Annabelle Symons, Investment Analyst

Dear Chairman - What can we learn from one of the most famous shareholder activist battles?

In today’s world of proxy advisers, divestment campaigns and ‘two-strikes’ voting, shareholder activism has become mainstream. That wasn’t always the case, and Jeff Gramm ’s Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism provides a fascinating account of how this trend developed over the past century.

One of the most famous was Carl Icahn's pursuit of Phillips Petroleum, and even today it provides lessons for boards, management and shareholders.

During America's merger wave of the 1980s, 22,000 mergers and acquisitions (M&As) deals were brokered, but the small percentage of hostile acquisitions garnered the lion's share of attention. It was different to the previous waves because it was driven by the rise of Drexel Burnham and Michael Milken, who used the large, highly liquid niche market in junk bonds to fund hostile takeovers.

One such takeover was that of oil company Phillips Petroleum (now a combination of ConocoPhillips and Phillips 66). In 1984 Phillips was trading in the mid-to-upper $30 range. After becoming the largest individual shareholder in Phillips Petroleum corporate raider T. Boone Pickens launched a hostile tender offer to buy an additional 15% of the company at $60 per share. Phillips management counter-proposed with a complicated recapitalisation plan. It would pay Pickens $53 per share, entrench current management and commit Phillips to asset sales to fund a reduction in debt, increased dividends and an additional $1 billion in share repurchases.

The result? Management remained in place, Phillips’ share price fell 18% to the low $40s and Pickens walked away with $53 a share in cash and all expenses covered.

Enter Carl Icahn. His activism strategy centred on taking large positions in what he saw as undervalued businesses, seeking control then attempting to realise the valuation gap. One of his key motives for going after these companies was to highlight a lack of accountability at the board level.

Icahn knew that Pickens was an astute energy investor who was prepared to pay $60 per share. This, combined with an enraged minority shareholder base whose investment value had dropped set to receive $45 per share, gave Icahn an opening -but he needed a lot of cash. Enter Milken, who raised $4 billion for Icahn and claimed he was 'highly confident' Drexel could raise more if needed.

Armed with the Drexel cash, on February 4, 1985 Icahn sent a letter to the Chairman and CEO of Phillips Petroleum, William Douce. Apart from announcing that he owned 5% of the company, making him one of the largest shareholders, he said the recapitalisation plan was 'grossly inadequate'. He said that if Phillips did not offer $55 each for the outstanding shares, he would use a leveraged buyout to buy Phillips for $55 a share: $27.50 in cash and $27.50 in subordinated notes. If Phillips were to reject the two options, Icahn would wage a proxy war to defeat the recapitalisation and make a hostile tender for the company.

In an offensive / defensive two punch, Phillips promptly sued Icahn for violating proxy solicitation and anti-manipulation rules. At the same time Phillips’ management sweetened the proposed recapitalisation to feature a new preferred stock dividend and a cash repurchase plan.

In a move that reverberates today, Phillips also introduced a 'rights plan' – one of the first versions of what we now know as a poison pill. If a buyer crossed the 30% ownership, other stockholders would convert each share into $62 worth of senior debt in Phillips paying 15% interest. The buyer would be left owning a dangerously over-leveraged company with $7 billion of short-term debt. As Gramm puts it: “…it served as a sharp repellent”.

Phillips Chairman and CEO, William C. Douce, underestimated Icahn. The next day Icahn sent a letter announcing his intentions to initiate a tender offer for 25% of Phillips common stock. This, along with his 5% stake, would trigger the poison pill. On February 13, 1985 – less than three months after Pickens had put Phillips in play, Icahn commenced the tender for Phillips at $60 per share, contingent on shareholders voting down the recapitalisation plan at the shareholders’ meeting on February 22. According to the New York Times, ‘Without using the word, Mr. Icahn said he would not accept greenmail, that is, would not sell his stock to the company unless the same offer was made to all shareholders.’ Shareholders believed Icahn and voted the plan down.

Less than a month later, Phillips announced it had lost the recapitalisation plan entirely. It settled with Icahn, eliminating the plan to put shares in the employee trust and covering Icahn for $25 million in expenses. Icahn walked away $50 million wealthier in just 10 weeks. He had avoided the poison pill by leaning on shareholders to accept his version of the truth.

How is the Phillips case relevant for investors today?

Pickens and Icahn realised that management’s actions were affecting Phillips’ market valuation, creating an anomaly that could be exploited. Pickens believed the anomaly was so large that he offered around a 55% premium for the stock. The same is true today – if the market doesn’t recognise the intrinsic value of a company then a businessperson will in the form of a corporate action like a takeover.

Although lawyers and company management can do their best to fend off what they may see as corporate raiders, poison pills and other protective measures may not be effective if the board doesn’t have the support of shareholders. If shareholders don’t feel that value is being maximised they won’t give the company its support and, in the long term, it’s difficult to defeat the Street.

Finally, corporate raiders like Icahn were helped by Milken but they were also assisted by a larger group of passive, institutional investors, who failed to act against management decisions that would leave shareholders worse off. With more money flowing into index and passive investment vehicles now, it means active, institutional managers need to monitor their investments in businesses more carefully - not simply outsourcing corporate governance issues to proxy advisers, but thinking about the calibre of the management team and board of directors steering the capital allocation decisions in the business. If there is a lack of accountability for bad decisions then institutional managers need to step up and question the board, question management and have the hard conversations.

It is bad enough when active managers run portfolios that resemble the index, it is worse when they behave just as passively in matters of corporate governance.

This article reflects the opinions of the author as at the time of writing and may change. They may not represent the views of PM Capital. PM Capital may now or in the future deal in any security mentioned. It is not investment advice.

1 http://www.nytimes.com/1985/03/05/business/the-big-winners-in-the-phillips-deal.html


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PM Capital

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We aim to build long term wealth together with our co-investors by finding and exploiting investment anomalies around the world, using a focused, patient and considered approach to finding simple investment ideas.

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