Relationship InvestingJudith H. Dobrzynski
A provocative new investment idea is starting to roll through Corporate America. On the bandwagon, trumpeting its virtues, are dozens of academics, management experts, and legal advisers. Key institutional investors are trying it out at some of the nation's most troubled companies. Last fall, the Securities & Exchange Commission gave it a push by relaxing federal proxy regulations. And lately, some chief executives have heard the music.
It's called "relationship investing," and it's already changing the way U.S. corporations are run.
Simply put, whenever there's an established, committed link between a company and one or more shareholders, that's relationship investing. "It begins with shareholders taking a real interest in a company--asking questions of the board and not trading the stock like pork bellies--and goes all the way to taking a big stake, a board seat, and maybe even some debt," says Ira M. Millstein, a corporate-governance expert at Weil, Gotshal & Manges, a New York law firm.
So far, there are more examples of the weaker approach. Thanks to the shareholder activism that caused shakeups or restructurings at such companies as Sears, Westinghouse Electric, and Eastman Kodak, investors are meeting with CEOs with unprecedented frequency. This interaction is spreading.
A more powerful, organized kind of relationship investing is cropping up, too. Corporate Partners LP, an affiliate of Lazard Fr eres & Co., has negotiated big stock purchases at seven companies since 1989 and taken seats in their boardrooms. Two new groups are trying to raise money for similar funds: One is led by activist Robert A.G. Monks, the other by Dillon, Read & Co. in conjunction uith General Mills CEO Bruce Atwater, Goodyear Tire & Rubber CEO Stanley C. Gault, and other CEOs. If they succeed, "I suspect that very soon the famous Wall Street Xerox machines will start humming, and you can expect others to come into the patch," says Monks.
NEW CLASS. To backers, relationship investing has two charms. First, it helps solve a problem executives have complained about for years: short-term investing. By creating a class of enlightened investors who give companies patient capital, relationship investing should free management to focus on the long term. Over time, that should lift profits, productivity, and prospects. And that would boost U.S. competitiveness.
Second, the very existence of a new breed of active capitalists fixes another failing of U.S. corporations: the imperial CEO, unchecked by a pliant board of directors. "In the U.S., we have the George Patton model of governance--one person with all the authority," says SEC Chairman Richard C. Breeden. "It works great if the person is Sam Walton--a person with the vision and the skills to do the job. But you're vulnerable to an all-powerful dud." Investors who actively monitor their holdings would introduce a badly needed measure of management accountability.
Those two virtues--patience and accountability--are more common in governance systems outside the U.S. In Japan and Germany, for instance, banks or companies take permanent stakes--and put representatives on the board. With no need to worry about quarterly results, management can make investments that may not pay off for years. But those systems have other drawbacks: Individual shareholders have few rights, entrepreneurs can't easily raise capital, and managers invest wastefully.
Instead of mimicking the overseas systems, experts say, the U.S. should invent a new, American brand of relationship investing: It would adopt the good traits of systems abroad but not the bad. In recent months, the U.S. Council on Competitiveness, the congressionally sponsored Competitiveness Policy Council, and the Twentieth Century Fund have endorsed the concept. Individual supporters include Michael E. Porter and Michael C. Jensen of Harvard business school; former SEC commissioner Joseph A. Grundfest, now of Stanford Law School; Lester C. Thurow, dean of the business school at Massachusetts Institute of Technology; and Columbia Law School professors Louis Lowenstein and Bernard S. Black.
Big investors have good reason to like the concept, too: It may fatten their returns. Some public pension funds in particular are interested. They prospered in the 1980s by "buying the market" via index funds. But the investment climate is tougher in the '90s. And long-term investing suits their payout schedules. "Indexing did well for us in the '80s, but we need periodically to reevaluate our investing strategy," says Dale M. Hanson, CEO of the $70 billion California Public Employees' Retirement System. Hanson wants to try out the Monks and Dillon Read funds and plow $1 billion into big stakes on his own--if the CalPERS board lets him.
`NONTAKEOVER TAKEOVERS.' It's too early to prove the value of relationship investing conclusively, but the evidence looks favorable. Investor-inspired revampings have sent the stocks of many companies climbing, suggesting that the market believes long-term prospects have been enhanced. The shares of Avon, Kodak, Sears, and Lockheed, for example, have soared. And Stanford's Grundfest says management changes at General Motors, Goodyear, Tenneco, and AlliedSignal added some $3.7 billion to their value, after factoring out overall market increases. Monks, who was a key player at Sears and Kodak, has already taken some gains. Says his partner, Nell Minow: "Corporate governance is our tool for making money. We are talking about nontakeover takeovers. Like the raiders, we hope to realize value that's buried. We've found a better, earlier way to do it."
Relationship investing stands up statistically, too. Consultant Gordon Group Inc. evaluated two kinds of active investments--those that were negotiated with management (the kind Corporate Partners makes), and those that weren't. On average, the nonnegotiated investments beat the Standard & Poor's 500-stock index by 30 percentage points over two years. "The negotiated block investments were less consistent, but they show the promise of yielding the same high returns when undertaken at the right companies by the right individuals," says Gordon's president, Lilli A. Gordon.
Would-be relationship investors also find encouragement in a folksy Omaha resident named Warren E. Buffett. The Berkshire Hathaway Inc. chairman has become a billionaire by buying and holding chunks of many companies--sometimes taking a board seat, sometimes counseling from afar. Several of his gains can be traced to savvy stock-picking or preferred stock deals, and not every investment has turned to gold. But this real-world relationship investor's returns are the stuff of dreams.
WIDE GAP. As Buffett attests, even in the U.S., relationship investing isn't entirely new. It flourished in a different form in banker J.P. Morgan's days, until federal regulators decided that it concentrated power in too few hands. As the U.S. economy grew, private companies in search of capital became public corporations. Individuals supplied it, but the gap between managers and so many faceless owners was wide. Boards were supposed to discipline managers; if they didn't, takeovers would oust them.
But as takeovers raged to new heights in the '80s, executives pushed states to pass antitakeover laws--and most have. Ever since, the system has been out of whack. "Our corporate-governance structure depends much too heavily on the personalities of boards of directors," says Columbia's Lowenstein. Many simply have been too tolerant of poor performance by top executives.
In the past, investors who were upset with the way a company was run simply sold their holdings. But the rise of pension funds, which now hold nearly 55% of all U.S. equities, created a new dynamic. These huge institutions can't easily trade out of stocks. And even a 1% stake in many companies is worth tens of millions of dollars--enough to provide incentive for activism. Almost inevitably, angry pension funds, which organized in the '80s to protest greenmail and antitakeover devices, stepped into the disciplinary vacuum. They've now taken many a CEO and corporate board to task.
Still, there's growing sentiment that such catch-as-catch-can activism, despite several big victories in 1992, is too slow and too spotty. By the time IBM directors decided in January to replace CEO John F. Akers, Big Blue had lost 64% of its market value from January, 1991, alone. And to date, the activist movement consists of only about a dozen public pension funds, a few ideologues such as Monks, a group of individuals called the United Shareholders Assn., and the occasional stray mutual-fund manager. They can't police all of Corporate America.
What's more, their leverage depends largely on media attention--a sort of governance by embarrassment--which rarely extends beyond brand-name companies. It also puts CEOs through what Columbia's Black calls "public calumny," which could either prompt too-quick firings at the top or delay remedial action by boards reluctant to capitulate to outsider pressure. Says Black: "What's happening now is too visible and too dependent on publicity and not on insider influence."
DIALOGUE. Relationship investing solves many of these problems. The simplest and, in all likelihood, the most widespread variety simply transforms the contacts initiated by disgruntled shareholders into regular, constructive dialogue among CEOs, directors, and shareholders. That's exactly what happened at Lockheed Corp.
Back in 1990, raider Harold C. Simmons was besieging Lockheed, trying to gain control. To fend him off, Lockheed CEO Daniel M. Tellep reached out to institutional investors. He listened to their complaints and promised them a voice in the selection of new outside directors. Thus began what Tellep calls an "ongoing relationship" between him and many of the company's big shareholders.
"As I look back, Lockheed wasn't uninterested in corporate governance," Tellep told BUSINESS WEEK last year. "But we directed all of our communication to shareholders through Wall Street. I thought we were talking to our shareholders that way. It wasn't so. Many wanted face-to-face meetings." The talks haven't changed Lockheed's strategy--an important point for CEOs who think shareholders may try to make management decisions. Says Tellep: "We convey the strategy options with the rationale and ask them for comments. That satisfies them, and that's why I have no fear."
Still, the talks have mattered. They made management more sensitive to the use of capital, for example. Tellep has sought investor counsel on Lockheed's dividend policy. And he asked some shareholders how they thought a stock buyback that began in late 1991 should be financed--by borrowing or by using free cash flow. They chose the latter.
At first, Tellep's actions were viewed as extraordinary. Some CEOs criticized him for setting a precedent they might have to follow. Things look different now. Like it or not, several CEOs are coming to the table when shareholders call. CalPERS, the most activist fund, has ongoing relationships with about two dozen companies. The California State Teachers' Retirement System, the Florida State Board of Administration, the Wisconsin Investment Board, the New York State Common Retirement Fund, and the Oregon Public Employees' Retirement System are among the others that have links with companies.
Ralph V. Whitworth, president of United Shareholders, likewise is engaged in talks with several companies. In the past year, Whitworth has met with 10 corporate chieftains, plus officials from 12 other companies. One CEO, Stewart Bainum Jr. of Manor Care Inc., came in on his own, Whitworth says.
QUIET MUSCLE. So far, only a handful of private money managers have gotten active. Wellington Management Co.'s John B. Neff, who manages money for Vanguard Group Inc., is one. A year ago, Neff and Loomis Sayles & Co. voiced concern about the need for Chrysler Corp.'s board to find a successor to then-CEO Lee A. Iacocca, who wanted to stay beyond his expected retirement. Within days, directors called a special meeting and appointed Jack Eaton. Fidelity Investments, whose $175 billion in assets makes it the largest U.S. mutual-fund manager, occasionally throws its weight around, too--usually behind the scenes.
But private money managers have to hurdle a few economic disincentives before getting too involved. For starters, they often handle investments for corporate pension funds, which hardly makes them want to antagonize CEOs. And unlike public funds, big private money managers regularly see corporate executives, though usually not the CEO. So they're already well-informed about a company's direction and, say, the alternatives for fixing an ailing unit.
Since money managers are judged on quarterly performance, that's how they view companies, often selling out when earnings lag behind expectations. Mutual funds also must maintain more liquidity than public funds. Plus, "we have to compete on the basis of fees," says Robert Pozen, Fidelity's general counsel. So any form of activism that increases costs has to have a high chance of financial reward.
Still, the cost of jawboning is minuscule, and lately, more private managers are jumping into the fray. When James D. Robinson III tried to hang on as chairman of American Express Co., ceding only the CEO slot, Alliance Capital Management, J.P. Morgan, and others met with the new CEO, Harvey Golub, and cried foul. Two days later, Robinson--architect of the company's failed strategy--was out. For activists, the episode was a milestone.
The proxy reforms that Breeden pushed through the SEC last fall improve the odds that institutions of all stripes will start calling on companies. In the past, any time shareholders communicated with more than 10 other shareholders, they had to meet costly legal requirements. Breeden lifted restrictions on most such communications. Says Pozen: "For us, the framework of analysis is the same, but the cost-benefit analysis has changed because of the proxy rules. There will be more communication." A united front of 20 or so institutions would powerfully influence managers. In time, institutions would likely divvy up responsibility for monitoring specific companies--much the way public funds now approach proxy resolutions.
EASIER TASK? That kind of activism may well smooth the way for the more potent form of relationship investing: big stakes and big influence. Corporate Partners, which began with $1.65 billion and has $430 million left to invest, plans to go back to the market for more money this year. Senior Managing Director Lester Pollack expects an easier task this time around despite a fraud scandal at one investment, Phar-Mor Inc. "When we started, one of the issues was whether companies would accept a large shareholder--that's no longer a question," he says. "The fact that a company is not on track doesn't mean that the return won't ultimately be there."
Meanwhile, Monks, who tried to raise $1 billion for his Lens Inc. fund a year ago and came up empty, and Dillon Read, which has been trying to find $1 billion for its Allied Partners LP, are making progress. Allied has commitments totaling about $250 million and plans to start operations when it hits $500 million or $600 million. By spring, both could get a boost from CalPERS, which is likely to put at least $100 million in each. Says Monks: "In the new environment, I believe I will raise money."
Each of the three funds has a slightly different approach. Corporate Partners invests in companies where its capital and management expertise will help a company solve problems. First Bank System, which had lost money in trading and merchant banking, is an example. With capital from Corporate Partners, it went back to basic banking--and profitability.
In Corporate Partners' friendly deals, the relationship predates the investment, and management has to pass muster. But the partnership always takes at least one board seat to monitor management's progress against a pre-agreed strategy. Once at the table, Corporate Partners improves governance and incentive systems--making sure that compensation is substantially linked to return on equity, for instance.
`TIME TO PERFORM.' Allied, which would also take friendly stakes, talks up the name-brand expertise it would bring. At each investment, Atwater, Gault, or another sitting CEO would join the board. Allied stresses the patient nature of its investments, which would be made after a company has made a change. IBM, under a new CEO, would be a candidate. "The investment would take off the pressure from active shareholders and give management time to perform," says a source familiar with the fund. Dillon Read envisions making a dozen investments.
Monks's fund, which stresses accountability, fits the opposite situation: It ferrets out companies whose 1-, 5-, and 10-year returns lag behind the market and which aren't fixing their problems. Monks--a shareholder-rights crusader--and four partners put up $10 million of their own last summer to start Lens. They bought into Sears, Westinghouse, Kodak, and AmEx to foment change.
The Lens treatment starts with a letter and leads to meetings and phone calls with management. It includes a detailed analysis of the company's performance, problems, and alternatives. A Dec. 11 missive from Monks to Kodak CEO Kay R. Whitmore ran to 20 pages of text plus plenty of analytical tables. It suggested financial changes, including consideration of asset sales to raise cash for debt reduction, and governance modifications, such as annual election of directors.
Whitmore is responding, and Monks takes some credit for many of the announcements that have emanated from Rochester recently. He calls Whitmore "a model of the way in which management and ownership can interrelate to mutual profit." No question, Whitmore has mellowed with regard to shareholder input over the past year.
If management doesn't react, though, Monks and his partners aren't afraid to get strident. Says Minow: "The most important thing we did at Sears was taking out an ad calling its directors `underperforming assets.' We made things uncomfortable for the board." Now, she adds, Lens has a constructive relationship with Sears management: "We're always able to pick up the phone and talk."
NATURAL DEVELOPMENT. There's no mystery to why relationship investing seems to work: It aligns management with owners. As one big investor puts it: "Often, the CEO tends to identify with the people he works with 8 hours a day, 365 days a year, and not with the people he sees at the annual meeting once a year. CEOs who understand that they have an owner behave a little differently from those who think they are a law unto themselves."
Any relationship between a CEO and an investor is bound to vary according to the personalities involved and the expertise they offer. Buffett has said that he lets it develop naturally, rarely initiating contact with management. Robert E. Denham, who as CEO of Salomon Inc. is on the other end of a Buffett investment, confirms that. Yet he adds: "When you have an owner of that size and intelligence, it's crazy not to get his input. That doesn't mean you always take his advice." One clear benefit that someone such as Buffett can bring to the relationship is his vast knowledge of the business world--which is particularly useful in making capital-allocationdecisions.
For General Mills's Atwater, who also heads the Business Roundtable's task force on corporate governance, the close monitoring by shareholders is key: "I'm for it, if you interpret it as regular, ongoing monitoring." He believes that relationship investing will lead to more timely action at poor performers: "When communications are regular and continuing, we'll start getting earlier recourse."
And the benefits can go beyond that. "The problem with many companies is that they become so insular," says Howard G. Haas, a senior lecturer in business policy at the University of Chicago and author of a new management book called The Leader Within. Exposure to long-term shareholders "will help break down an insulated culture. The CEO will get a fresh input of ideas and a sounding board." As long as investors understand that they can't micromanage, Haas, who headed Sealy Corp. for 19 years, is an enthusiastic advocate of relationship investing. He and others think shareholders who fully grasp a company's strategy and the alternatives, unfiltered by analysts, will stick with the investment in down times. It's a way for companies to manage expectations.
But if relationship investing has promise, it's no panacea. A lot depends on whom the relationship is with. "It's great to have a long-term investor who can really add value when you ask him a question," says Salomon's Denham. "But what if you've got an investor with a sizable position who wants to be consulted all the time but doesn't add value?" Naysayers foresee a world in which CEOs spend too much time communicating and not enough acting. They sketch a world where shareholders want to approve every management move.
Other skeptics say relationship investing might lead to more, not less, short-term thinking, because CEOs who are always being watched could turn risk-averse. There's a chance, too, that Wall Street will pervert the idea. "Relationship investing is a hot subject, and whenever the money-management business sees a trend, they immediately try to design products to cash in on it," says a major investment manager. A Monks-style fund run by fast-buck speculators could hold managers hostage.
CREATIVE TENSION. Most of that is nonsense, Haas says, promulgated by executives whose power would be curbed. "You'll get all kinds of people who say this won't work, but they can't hold back the tide. Relationship investing is the wave of the future." Adds Stanford's Grundfest: "Look, there are serious problems with our corporate-governance system. Just because there are problems with the new regime doesn't mean it shouldn't evolve." He worries that silence by shareholders will be misconstrued by boards as approval, for example. And eventually, investors could get too close to management, destroying what should be a creative tension between them.
No system of governance is perfect. But relationship investing might well take the U.S. system closer to what it was in years past, before computerized stock-picking, program trading, derivative instruments, and all the other devices that have turned the stock market into a casino. By restoring the virtues of patient capital and management accountability to Corporate America, it could be a tonic for the nation's economy.
TABLE: WHERE IT'S WORKING
In November, 1989, Chartwell Associates sought board seats at Avon, which suffered from poor diversification and outdated selling methods. It won two. Meanwhile, other shareholders complained. Avon met with them and created a board panel to find ways to maximize shareholder value. It changed marketing methods and cut costs--prompting its stock to soar by 136.3% since Chartwell appeared, vs. a 51.3% gain in the S&P 500.
Last July, Robert Monks of Lens Inc. wrote CEO Kay Whitmore. Public pension funds also contacted the company. They wanted Kodak to restructure and reduce debt. Kodak is now cutting costs, trimming staff, and expanding pay-for-performance. Since July, its stock is up 30.8%, vs. 9.2% for the S&P.
FIRST BANK SYSTEM
For a 15% stake, Corporate Partners in July, 1990, gave $145 million to First Bank, which had lost $500 million in bond trading and merchant banking. It now sends a nonvoting observer (to comply with bank rules) to board meetings, meets often with management, and monitors execution of a back-to-basics strategy. Its stock is up 131.6%, vs. a 39.4% increase in the S&P.
In November, 1990, Robert Monks launched a proxy battle for a board seat. He wanted the giant to sell its financial-services units, focus on retailing, and reform board practices. Although he lost, he and several institutions kept pressing for change. Last summer, Monks bought more shares and started a dialogue with the company. Sears is now spinning off the financial units, remodeling its stores, and cutting costs. Since November, 1990, its stock has jumped 138.4%, vs. 58% for the S&P.
DATA: GORDON GROUP, CORPORATE PARTNERS, BW
TABLE: THREE PIONEERING FUNDS
Dillon, Read & Co. is raising $1 billion to buy friendly stakes in companies that have started to change for the better but need time to do it. A fund representative would join the board.
This independent affiliate of Lazard Freres is putting $1.65 billion into big negotiated stakes in companies that need new capital. To influence corporate policies and monitor management, it takes at least one board seat.
Activist Robert A.G. Monks is trying to raise $1 billion to invest in poorly performing companies--expanding a $10 million effort started last year. Lens contacts management and tries through negotiation with the CEO to change strategy.