Monday, June 26, 2017

Hedge Fund Set to Hack Nestlé Up: A Case of Sensationalistic Over-Kill

Does the fact that an earnings-per-share figure has not meaningfully improved over, say, five years justify an overhaul pushed by a hedge-fund activist investor?  Put another way, is a steady earnings-per-share tantamount to failure? Especially for an established company, steady numbers do not evince bad performance. An airline would only foolishly fire a pilot for not climbing once having attained a cruising altitude. Maintaining such an altitude during a flight is hardly a reason to turn a plane around or set it in a radically different direction.

With 40 million shares, which amounts to about $3.5 billion, in Nestlé, Third Point hedge fund urged the company’s management in June of 2017 to “sell its stake on L’Oréal and sell off nonessential operations as part of a broad shake-up.”[1] The conglomerate’s shares had appreciated nearly 15% over the preceding 12 months—behind Unilever but better than Mondelez and Kraft Heinz. So why a shake-up? 

Dan Loeb of Third Point.  Relax, Dan, Nestle is not on a nose-dive. 

To be sure, the conglomerate structure is itself arguably too much of a strain on the extant science of management, especially in the United States given the penchant for specialization over “big-picture” management. Selling L’Oréal thus may make sense so the management can concentrate on food. It was not as if such a focus would leave corporate managers with nothing to do.

In May, Nestlé announced a joint-operation with Amazon to offer a cooking companion with recipe instructions and other help for customers. At the same time, Nestlé set to work eliminating unpopular ingredients to its Maggi line. The company had been working to remove preservatives from its ice creams. Lastly, the company announced in June that it was the lead investor in a $77 million in Freshly, a subscription meal service. Such adaption to changing consumer tastes and changes in the industry is a solid means by which an established company improves its profitability. Slogans like “a bold strategy” and a “broad shake-up” make for good press, but they do not fit with a company that has achieved cruising altitude. In other words, severing arms and legs should only be attempted in the more dire of cases, rather than as business as usual.

[1] Michael Merced, “Third Point, a Hedge Fund, Sets Its Activist Sights on Nestlé,” The New York Times, June 26, 2017.

Sunday, June 18, 2017

Apparent Gains in Corporate Governance Accountability as the U.S. Economy Shifts

In 2016, Sacred Heart University purchased G.E.’s headquarters in Fairfield, Connecticut for $31.5 million. Gone were the Persian rugs and lavish artwork. The property acquired included the “Guest House,” the company’s 28-room hotel “to serve visiting executives and others, with no expense spared on the parquet floors, wood-burning fireplaces and a Steinway piano.”[1] Jack Welsh oversaw the ornate construction, leading to the obvious question of just what his sense of fiduciary duty to the company’s stockholders was. An artificial distinction between managers—only some being styled “executives”—was doubtless behind the luxuriant excess only for those certain employees “in the club.” From the standpoints of a board and its stockholders, “executives,” managers, and other employees are all employees. Why then should some of them be associated with luxury while they are at work? Historically, the aristocratic luxuriated precisely because those people didn’t have to work, and more importantly, they viewed work (and even their own money) as not worthy of much attention—there being finer things in life. “Executive” employees are not aristocratic, for they labor even when they could live off their accumulated wealth and pursue loftier aims, such as aiding humanity, furthering knowledge, or engaging in the arts with an eye toward advancing civilization. Bill Gates got this memo; Warren Buffett did not.

The presence of extremely rich people in the executive ranks of large corporations interferes, I submit, with the accountability that corporate governance is designed to deliver for stockholders. Lavish business expenses run counter to such governance and the very notion of a corporation as the stockholders’ combined wealth.  In the era of American industrialization, the huge profits in the industrial sector gave cover to managers such as Jack Welsh, who felt free to exploit the obvious conflict of interest in spending lavishly for the upper-echelon managers themselves, as if the company were their own country club rather than a business. Doubtless managers themselves assumed that paid country-club memberships were necessary to get and even retain (well qualified?) fellow “executives.” The underlying conflict of interest was somehow invisible to sycophantic boards and even large stockholders who looked the other way. In the succeeding high-tech era, the same obliviousness has surely existed in that sector in spite of the rise of activist stockholders.

To be sure, indications can be found that suggest more activist pressure. Even as stockholder activists’ assets were increasing from 1997 to 2015, the number of publically traded U.S. companies decreased from 7,507 to 3,766.[2] Meanwhile, the activists were getting more, well, active, and they were finding it easier to win board seats as fewer companies staggered their elections over three-year cycles. More than 300 U.S. companies were targeted in 2015, up from about 100 in 2010.[3] Boards were better positioned, at least formally, to hold C.E.O.s accountable as the percentage of joint C.E.O.-Chair positions decreased. “In 2001, more than half of new C.E.O.s also assumed the position of chairman when they took over. By 2016, only 10 percent occupied both roles.”[4]

Yet the actual impact from activist stockholders may have only been in decreasing the average tenure of the C.E.O’s. Boards were “still willing to dole out huge golden parachutes to C.E.O.’s, even if they fail.”[5] Furthermore, even though G.E.’s swanky executive suites went from 44,000 square feet in Fairfield to 7,800 square feet in Boston, C.E.O.s of high-tech companies were under less activist scrutiny in spending from soaring profits and stock prices.[6] A study looking at shareholder proposals from 2003 through 2015 concludes that “managers often seek to avoid the implementation of legitimate shareholder interests.”[7] In 2017, the U.S. House of Representatives passed the Financial Choice Act, a deregulatory bill that would require a shareholder to own at least 1% of a company’s shares for three years to get a proposal on a proxy ballot. At the time, a stockholder needed to own only $2,000 worth of stock for at least a year. Clearly, the power of activist stockholders was quite far away from Congress, whereas that of corporate managements was very close by.

Even the increased power of activists to pressure the firing of a C.E.O. of an underperforming blue chip company may actually be a manifestation of frustration over stagnant revenue and profits in the sagging industrial sector; the real question, still unanswered in 2017, is whether activist stockholders would ever go after the lavish spending of “executives” of profitable companies. Even those managements, such as of Amazon, Apple, Google, and Facebook were obliged even in their hay-day by the legal doctrine of fiduciary duty to not be profligate, and to authorize spending for legitimate business reasons because cost management is in the stockowners’ financial interest. This interest, rather than those of “executives,” is legally hegemonic, rather than to be dismissed or even rebuffed. Luxury, in other words, does not go with the work inside a corporation, but, rather, with the ownership of wealth, even if some of the employees are themselves extremely rich. Their independence and association of themselves with luxury does not fit with the corporate model, especially as concerned the ability of corporate governance to exert accountability in the interests of stockholders. As for the apparent strengthening of corporate governance in the industrial sector, the alleged improvement may actually have been a function of a major sectoral shift within the American economy. It is only natural that the old guard would be frustrated at the shift, so what looks like better accountability may only be infighting. To gauge real accountability, we would need to look at the newly hegemonic sector: Are the “executives” in it taking liberties at their stockholders’ expense?  

[1] Nelson D. Schwartz, “The Decline of the Baronial C.E.O.,” The New York Times, June 17, 2017.
[2] Ibid.
[3] Ibid.
[4] Ibid.
[5] Ibid.
[6] Ibid.
[7] Gretchen Morgenson, “Meet the Legislation Designed to Stifle Shareholders,” The New York Times, June 16, 2017.

Thursday, June 1, 2017

ECB Poised to Approve Italian Bailout of Monte dei Paschi Bank: An Instance of Federal-State Collusion?

Under the E.U.’s banking law enacted after the 2008 financial crisis, the state governments “are not supposed to inject fresh taxpayer money into a bank if it is deemed insolvent. When a bank gets into financial trouble, shareholders and bondholders, assumed to be sophisticated investors aware of the risks, are supposed to take the hit and bear the losses.”[1] Much of the banking reforms were intended, moreover, “to prevent banks from becoming so big and so risky that they could hold the global economy hostage. Politicians and policy makers didn’t want taxpayers to be on the hook for the banks’ mistakes.”[2] What about a mid-sized bank whose financial plight puts a state’s economy and reigning political elite in jeopardy? Should the E.U.’s central bankers look the other way and allow the state’s government to finance a bail-out so stockholders and bondholders need not feel the brunt?
Monte dei Paschi di Siena, one of the largest banks in the E.U. state of Italy, having been “marred for years by scandal, management upheaval, and hefty losses,” stood along with other troubled lenders in the state to gain as much as €20 billion in 2017 from the state government in a massive bail-out.[3] With the bank having lost €3.4 billion in 2016, the European Central Bank had estimated that the beleaguered bank would need €8.8 billion “to plug a shortfall in its capital.”[4] State officials were doubtlessly motivated at least in part out of concern that they would lose power, for “legions of angry middle-class savers” who had bought the bank’s bonds that financed a horrible deal that went bust “would destabilize Italy’s already wobbly government and nourish far-right parties.”[5] Plain and simply, the state party in power was exploiting a conflict of interest wherein the party and its state lawmakers would benefit at the expense of moral hazard—the sending of a signal to bankers that they could take on too much risk without fear of suffering negative consequences because the state would be there to infuse any needed funds. Under federal law, if a bank is insolvent, it is not supposed to be bailed out, and yet on June 1, 2017, ECB regulators “gave their preliminary approval” to the state’s planned bailout of the bank.[6] Because “the finances of [the bank] are open to significant interpretation,” the ECB’s final decision on whether to allow the state government to bail out the bank was deemed to be “in a regulatory gray area.”[7] Therein lies the rub!
Generally speaking, discretion in even a seemingly iron-clad law can enable self-interested political aggrandizement at the expense of the obligation to 1) safeguard the public good, 2) allow the state’s voters to hold the state officials accountable, “come what may,” and 3) stand back as the market holds a reckless and incompetent bank management accountable. Besides making a bad mega-deal and misleading the supporting bondholders as to the risk, the bank’s managers had concealed increasing losses from shareholders and regulators.
In July, 2016, the ECB had conducted stress-tests on the bank. The central bankers determined that the bank’s capital “would be wiped out in the event of a severe economic crisis. No other bank tested fared so poorly.”[8] I would be surprised, therefore, that without the bailout the bank could remain solvent. Hence the purported “gray area” was very likely in actuality manufactured by the sordid collusion between state officials and the federal regulators at the ECB—the latter agreeing to look the other way, in effect, and approve the state’s bailout rather than have the banks stockholders and bondholders—who were admittedly misled—and the bank’s management suffer the consequences as the law required. Power it would seem, flows downhill, circumventing even seemingly iron-clad carved out channels if they are not in the power’s immediate interest. In the end, this case points to the relative frailty of parchment.

1. Jack Ewing, Gaia Pianigiani, and Chad Bray, “Bailout for Italy’s Oldest Bank Tests Too-Big-to-Fail Rules,” The New York Times, June 1, 2017.
2. Ibid.
3.  Ibid.
4. Ibid.
5. Ibid.
6. Ibid.
7. Ibid.
8. Ibid.