So what happens when the board of directors does not look out for the Shareholder's best interests? Stock prices are suppressed (aka they are lower than they should be). For example, if the board of directors pays the CEO $100M a year, when he is only worth $5M per year- the company is worth $95M dollars less than it would be if the directors paid the CEO an appropriate salary. (Note: I only use the salary of a CEO as an example because it is relatively straight forward. In world of corporate governance, overpaying the CEO is a minor offense- the board of directors is capable of squandering much-much more than $95M).
This loss of $95M is reflected in the stock price. So instead of each share of stock being worth, say, $10 (as it would be if the CEO received a salary of $5M), the stock is only worth $8.
In a perfect world, this would not be a huge problem. We could simply recognize the board's error, vote out the old board, and replace them with a new board that would rectify the problem.
Now, here is the problem (well there are actually lots of problems- but here is the meta-problem); It is really expensive to vote out the incumbent board. There are lots of reasons for this (many of them having to do with corporate governance- which I will be the topic of many subsequent posts). Because it is so expensive- it is only worth attempting to replace the incumbent board if you own a significant portion of stock.
For example, it can cost tens of millions of dollars to even attempt to replace a board of directors. If you only own $1,000 shares of stock- each worth $8 ($8,000 in total) then you are obviously not going invest millions of dollars. Even if you are successful at ousting the incumbent board, and you raise stock prices to $10 a share- you have only earned $2,000.
Therefore, we generally must rely institutions that have access to large amounts of capital to discipline boards that do not adhere to shareholder interest (at least for the time being). (Note: hostile takeovers can serve a similar function- more on hostile takeovers in another post).
These institutions often take the form of hedge funds- which we deem activist hedge funds (or activist invstors).
Their investment strategy is to buy a large stake in a company with a suppressed stock price due to the waste of the board of directors, then replace the board with their own (alternatively they can discipline the existing board). In turn, the company's price rises (thanks to the reduction of wasteful activities- like overpaying the CEO) to reach its full potential, and the activist hedge fund realizes a profit.
Showing posts with label The Basics of Activist Investing and Corporate Governance. Show all posts
Showing posts with label The Basics of Activist Investing and Corporate Governance. Show all posts
Tuesday, September 8, 2009
The Basics
Before we get into activist investing and corporate governance, we need to understand the basic structure of a corporation.
So- corporations can be broken down into two types. Private and public. Private companies are companies that are NOT listed on a stock exchange, and public companies ARE listed on a stock exchange (there are some details here that I am glossing over- but nothing important for our purposes). Some examples of a stock exchange are: New York Stock Exchange (NYSE), NASDAQ, etc...
In terms of activist investing, and corporate governance- we don't have to worry to much about private companies- our focus is public companies.
Public companies are interesting because a substantial portion of them are owned by us- regular people. If you own stock in a company, then you own a piece of that company. In fact, approximately 40% of any given company is owned by individual investors (the other 60% is owned by institutions- for example- pension funds, hedge funds, mutual funds, etc...).
While investors (both individual and institutional) own these corporations, they don't run their day to day operations.
Investors (which are also known as Shareholders) vote for a board of directors, and those directors run the corporation. Every year, shareholders have the right to vote for board members.
It is the board members responsibility to hire the CEO (or fire the CEO), set compensation for managers, and perform lots of other important functions that we will talk about in later posts.
The board members are supposed to represent OUR interests- and that usually means- they are supposed to make us money. They are our employees. However, sometimes, the board looks out for their own interests. Or, sometimes, they are just incompetent.
This is where activist investing can come into play.
So- corporations can be broken down into two types. Private and public. Private companies are companies that are NOT listed on a stock exchange, and public companies ARE listed on a stock exchange (there are some details here that I am glossing over- but nothing important for our purposes). Some examples of a stock exchange are: New York Stock Exchange (NYSE), NASDAQ, etc...
In terms of activist investing, and corporate governance- we don't have to worry to much about private companies- our focus is public companies.
Public companies are interesting because a substantial portion of them are owned by us- regular people. If you own stock in a company, then you own a piece of that company. In fact, approximately 40% of any given company is owned by individual investors (the other 60% is owned by institutions- for example- pension funds, hedge funds, mutual funds, etc...).
While investors (both individual and institutional) own these corporations, they don't run their day to day operations.
Investors (which are also known as Shareholders) vote for a board of directors, and those directors run the corporation. Every year, shareholders have the right to vote for board members.
It is the board members responsibility to hire the CEO (or fire the CEO), set compensation for managers, and perform lots of other important functions that we will talk about in later posts.
The board members are supposed to represent OUR interests- and that usually means- they are supposed to make us money. They are our employees. However, sometimes, the board looks out for their own interests. Or, sometimes, they are just incompetent.
This is where activist investing can come into play.
Our First Post
Welcome to the SharePower Blog! My name is Lee Drucker, I am a third year JD/MBA student at NYU. Also, writing on this blog is Eric Diamond, a 3L at NYU School of Law. If we are lucky, we also may have guest posts from time to time.
We are both passionate about activist investing, and the world of corporate governance- and that is what we are going to write about here. Don't worry- it is not as boring as its sounds. We hope to expose you to a world of hostile takeovers, multi-billion dollar gambles, outsized egos, and global-economy-shifting transactions- basically we are going to give you a behind the scenes look at the game of world domination (financially speaking).
If you don't know what activist investing or corporate governance is-stick around-we plan on explaining all the details as we go.
We are both passionate about activist investing, and the world of corporate governance- and that is what we are going to write about here. Don't worry- it is not as boring as its sounds. We hope to expose you to a world of hostile takeovers, multi-billion dollar gambles, outsized egos, and global-economy-shifting transactions- basically we are going to give you a behind the scenes look at the game of world domination (financially speaking).
If you don't know what activist investing or corporate governance is-stick around-we plan on explaining all the details as we go.
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