These days, you can't pick up a newspaper -- or this magazine, for that matter -- without seeing a story involving a voracious hedge fund. An estimated 8,000 of them are marauding across the corporate landscape, doing some of the biggest deals around. The hedge-fund hoo-rah really came above radar when Edward Lampert parlayed his stake in Kmart to merge it with Sears () last year. Now, a half-dozen hedge funds are circling ailing legacy airlines such as Delta () and Northwest (). The funds are everywhere -- and increasingly, their presence is being felt in an unlikely place: boards of directors.
The spreading influence of hedge-fund representatives on corporate boards makes sense. For years, governance experts have said a board should reflect a company's shareholder base. That's why boards added female faces as more women entered the workforce and became employee shareholders and Wall Street investors.
Bringing on sometimes-arrogant hedge-fund managers hungry for short-term profits may prove a tougher task, since so many corporate boards are staid affairs obligated to taking a "long-term" view for shareholders. But as such funds proliferate -- and snap up bigger stakes in an increasing number of companies -- integration will likely be easier, say headhunters.
PARAGONS OF GOVERNANCE. And guess what? If handled right, that could be a good thing, especially given the rising pressure on boards to deal diligently with everything from compliance with financial reporting rules to fending off hostile takeover bids. Case in point: long-distance giant MCI (), infamous as the former WorldCom. The one-time telecom titan was struggling just to exit bankruptcy when Stasia Kelly joined it as general counsel in 2003. It had huge debts and shrinking markets.
And MCI also had a newly constituted board that included paragons of corporate governance. It included court-appointed monitor and former Securities & Exchange Commission Chairman Richard Breeden, former U.S. Attorney General Nicholas Katzenbach, and Dennis Beresford, ex-head of the Financial Accounting Standards Board.
Alongside them sat Mark Neporent, chief operating officer of Cerberus Capital Management. The firm had snapped up MCI debt to become one of the company's largest shareholders. As the creditors' committee wrangled with MCI, Cerberus cut a deal to name Neporent as the committee's representative. That put him in the position of being both a board member and an investor. Neporent declined requests to discuss his role on MCI's board. Kelly, a former general counsel at Sears, says there was great interest in seeing how "[Neporent] would balance doing what was best for [Cerberus], vs. doing what was best for the company."
"VOICE OF REASON." The opportunity to find out came quickly. As MCI neared its exit from Chapter 11 in 2004, the creditors' committee began wrangling over the company's future direction. How should it satisfy remaining creditors? And how should it meet fiduciary requirements demanded by the bankruptcy court?
Rather than look for a quick return on Cerberus' investment, Neporent became a "voice of reason," says Kelly. He offered suggestions on how to reach compromise with other creditors on such mind-bogglingly arcane subjects as subordinated debt. And he wasn't afraid to twist the arms of competing hedge funds, says Kelly -- a group that included such heavyweights as Matlin Patterson Global Advisers.
Neporent's hedge-fund hustle became even more valuable as MCI's board tussled with Verizon () and Qwest () in a takeover battle this year. Hedge funds such as Omega Advisors squawked repeatedly when MCI accepted lower bids from Verizon and a final one that was $1.4 billion less than Qwest's.
RAPTOR ATTACK. But Neporent counseled them to stand firm, says Kelly, because he understood the insider game of how hedge-fund shareholders, eager for short-term profits, were driving up MCI's share price in order to coax more money from both bidders. Neporent cautioned the board that it shouldn't automatically accept the highest price. "Mark would say that the market's reaction does mean something, but it was naive to think the market knows everything," says Kelly, who was often in the room for board meetings.
Of course, once-bankrupt MCI had little say in hiring Neporent. And hiring hedge-fund managers has risks, which is why building a firewall between a board's fiduciary duties and a hedge fund's profit motives is vital. Directors' contracts and an emboldened SEC will go a long way to preventing insider dealing. Indeed, sitting on boards may even tame the velociraptor-like instincts of some hedge funds.
Still, the more impatient funds will avoid the boardroom for just those reasons, say headhunters. And slip-ups are sure to happen. But with the corporate-governance spotlight shining brightly on Big Business -- and increasingly, hedge funds themselves -- taking inside advantage of director-level information is a risk that those who want a spot in the corner suite aren't likely to take.
STRAIGHT TALK. What's more, many hedge funds, such as Highfields and Third Point, claim to be motivated to clean up mismanaged firms. Daniel Loeb, who oversees the $3.6 billion Third Point fund, has made sport out of sending blunt missives about alleged incompetence to corporate chief executives, then sharing the same letter with the press and public. And as companies struggle to comply with Sarbanes-Oxley's demanding financial-reporting rules, a professional number-cruncher on the audit committee could come in handy.
While many corporate boards will inevitably prefer yes-men directors to the in-your-face style of some fund managers, at MCI at least, having a hedge-fund guru on the board turned out to be its ace in the hole. Maybe more companies should hedge their bets -- and hire one for themselves. By Brian Grow in Atlanta
EDITED BY Patricia O'Connell