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Corporate Combat: The single largest growth area in the alternative investment universe
Activist investing looms large in the future of the alternative investment industry. Indeed, the future has already begun, in battles to control corporations and in skirmishes between managements and stockholders. Carl Icahn is just the best-known alternative investment manager active in this arena today. Because the profit potential is huge and the risks and technical issues are relatively small, I expect activist investing eventually to become the single largest growth area in the alternative investment universe.The business issue is this: With all too few exceptions, corporate managements seem to run their corporations for their own benefits first, and second and grudgingly, for the benefits of the corporations’ stockholders. No reasonable person expects corporate managers to act like angels, of course. To the contrary, all of the most eloquent defenders of capitalism—Adam Smith, for example—assume that most people act like jerks most of the time. But for a variety of reasons, the situation has degenerated considerably in recent decades from its previously low base. Assuming the reader has been awake once or twice during the last few years, he has probably noticed the huge and, in many cases, unwarranted salaries corporate managers pay themselves. In many cases, I suspect, no one, not even corporate management, really believes management is worth the money they are paid. Consider, for example, Richard A. Grasso, the former head of the New York Stock Exchange. Grasso was sued by the State of New York, which contended that his astronomical pay violates the state’s laws governing nonprofits. In a way, this is really none of New York’s business. This is the business of the people who pay his salary. But according to a recent article in The New York Times, “the details of Mr. Grasso’s pay were not disclosed to the exchange’s membership until shortly before his ouster.” Why not, if he was fairly paid? I can’t think of a group more financially sophisticated and more willing to pay for performance. As in Grasso’s case, the details of top management pay are commonly hidden from the people who pay their salaries. Indeed, the details of top management’s pay are typically so occult that when an analyst deduces the details from other accounting information, that deduction often appears in the financial press as news.
The amount paid to management is really only a symptom, of course. When a company isn’t run to make money for its shareholders, it always makes less than it could. Often, a lot less.This is the insight that allows KKR to make its billions. In effect, KKR arbitrages the difference between the value of a company run primarily for the benefit of its managers and the same company run for the benefit of its stockholders. KKR does this by taking the company private, and making management the primary stockholders. The leverage and legal vehicles KKR has used to take companies private has gotten a lot of press over the years, but these are only tools. More important, these tools, and especially leverage, work only on companies with unused assets and relatively stable earnings. The management problems KKR exploits are far more widespread than that, of course.
Feet to the fire
Alternative investment management can earn extraordinary returns by buying stock in underperforming companies and then forcing their managements to focus on creating shareholder value. Investment analysis is still necessary in order to distinguish between viable businesses run by management that has grown fat and lazy and businesses that cannot be saved. It is also necessary to determine a fair price for the business as is and a fair price for the business investor’s control.And this is only the beginning of the work. The alternative investment manager will have to take over the board of directors and hold corporate management’s feet—or other valuable body parts—to the fire. Steel Partners II, for example, has taken a large position in Angelica Corporation, a supplier of textiles and on-the-job apparel for the service industry, and put its own people on the board of directors. (Disclosure: I have done no business with Steel Partners or Carl Icahn.) On the plus side, compared with the work done in the alternative investment industry right now, the analyses are remarkably straightforward. On the negative side, few alternative investment managers are familiar with this kind of work.Worse, in order to control a corporation, you have to buy much of its stock. Which means the alternative investment manager’s portfolio will be radically underdiversified. A failure on a single investment might well mean financial ruin. Curiously, this is one of the few situations in which other investors (with the exception of KKR and its ilk) will be allies, not competitors. The competition will be corporate management and its toadies.The position of brokers and mainstream fund managers here has been on their knees, eating the toads. As one pension fund manager said to me a few decades ago, “There are two types of corporate management: those who own our funds and those who might. We don’t want to offend either group by getting into proxy battles with management.” In its most refined form, this has led to what is called the Wall Street Rule: “If you don’t like the stock, sell it.” I suspect that among alternative investment managers, this will be replaced by what I call the LaSalle Street Rule: “If the reason you don’t like the stock is its management, terminate the management.”LaSalle Street is the center of the Chicago financial district (the CBOT is on LaSalle Street, for example) and, in my mind, at least, the center of the alternative investment industry. Few people I know on LaSalle Street would use the word “terminate” here; most would use a different copulative verb. I doubt alternative investment managers will treat corporate managements with the respect and deference they have come to expect from Wall Street fund managers and their brokers. Alternative investment managers are among the most sophisticated and aggressive people in the investment industry, after all. If brokers and Wall Street fund managers don’t start acting in the best interests of their clients, and if corporate managers don’t start acting in the best interests of their stockholders, alternative investment managers are going to rip their heads off, pull out the stuffing and hand them their heads, shrunk to one-third size, skin tanned, eyes and lips sewn shut.