Private Equity Governance

Private Equity Governance

Andrew Shapiro is founder, president and portfolio manager of Lawndale Capital Management, an investment advisor that manages activist hedge funds focused…


Andrew Shapiro is founder, president and portfolio manager of Lawndale Capital Management, an investment advisor that manages activist hedge funds focused on small- and micro-cap companies. A Businessweek article in May 2000 referred to him as “The Gary Cooper of Governance.” His firm plays what Shapiro calls “a constructive, relational role by aggressively promoting improvements in a company’s governance and operational structures.” He has a special message for small- to mid-cap company boards: “Perform for your investors, make governance your business, and if you don’t, then I make it mine.” His goal is to find the investment, orchestrate change using his own regimen for running the company and its board through governance bootcamp, then facilitate the changes he would like to see along with improved performance, and exit when the market rewards the company with an expanded valuation multiple.

What are you looking for in a target company?

Very undervalued companies where investors are pricing an expectation of perpetual deterioration or perpetual stagnation at best.

What do you believe this circumstance reveals about the CEO’s performance?

We look for a deeply undervalued security where investors are wise to the dysfunction, and then we also want to determine that poor operating performance is improvable. This implies the problems are already at the surface. Because the CEO is in the know, or should be, this CEO isn’t necessarily equipped to perform the turnaround.

Do you find this dysfunction generally extends to the board?

Good boards are capable of recognizing what we and other investors see and making changes. We like and invest in those situations, too. However, the biggest potential upside is to be found with those boards that are doing nothing. Some boards are simply disengaged, overly delegating to management and giving [it] too much benefit of the doubt, while other boards are either co-opted or co-conspirators.

How would you describe your investment thesis?

Our portfolio is structured like that of a private equity fund. We are very focused on 10 companies at a time and dedicate ample resources to analysis. Then we begin close communication with the management and the board. We screen for deep undervaluation, which is not difficult in that investors— institutional and retail—are manic-depressive, and so they tend to oversell, really punishing the valuations. That’s what creates an opportunity for outsized returns.

What other activist investors would you compare yourself to?

We are most like Ralph Whitworth’s Relational Investors or Bill Ackman’s Pershing Square Capital Management, but with much smaller target companies to go along with our fund’s smaller asset size. I think they believe, as I, that good governance adds to and improves operational performance, and secondly, but importantly to our thesis, investors will also expand valuation multiples and lower a company’s cost of capital in return for good governance. So my investors are doubly rewarded for finding companies in our sweet spot.

What typical corporate governance symptoms do you look for?

We break down what you might call “corporate governance dysfunction” into four areas. First, [a] lower return on assets is a symptom of an improvable problem, which is poor capital allocation. But a…higher return on assets but a lower return on equity are symptoms of poor capital structure. Both the lower return on assets and the lower return on equity issues are improvable problems. Then you have companies that have high expenses relative to peers. Now that’s an improvable problem related to either costs and/or compensation. And last, but not least, there are those companies that are actually running well but the multiple is greatly underperforming relative to their peers, and that’s an example of poor disclosure and poor investor relations, which are improvable as well.

Ralph Whitworth also believes that small-cap companies lack the necessary sophistication in dealing with public markets, and his approach is to help them become more sophisticated about this area. Do you agree?

I can’t tell you how many companies I run into in the small- and micro-cap space that are extraordinarily dysfunctional when it comes to interacting with the public markets, their investor relations activity or disclosure, or both. All they’re doing is issuing press releases. So we very much focus on that aspect, and I think we bring a unique set of skills and experience to help them improve if they want to.

What about staggered board terms? We hear from those who strongly oppose annual terms that this can lead to short-term thinking and the removal of directors who are standing up to management.

While understandable, the argument misses the forest for the trees, because your point is that we have a minority reformer on the board and he or she is losing the benefit of the three-year term to create reform against a board filled with a majority of badly performing cronies. I would prefer to see all or most of the cronies replaced in one fell swoop.

What about social activist agendas?

I think there are many social activist agendas that are economically based, which is our focus. However, funds that won’t invest in defense companies because of their views on war are different than a climate risk issue, which is also different than environmental risk. One can find direct connection to the long-term sustainable value created from environmental compliance vs. noncompliance. A little less connected to a company’s direct actions or policies may be risks and impacts from climate risk to a company’s business model. It is a greater stretch to demonstrate that involvement in defense is bad for a defense company’s business future.

How strongly is CEO compensation a value creation or value drag?

You know, after you start paying your CEO $10 million to $15 million, when should the balance between pay equity and compensation methodology kick in to decide that someone’s going to get $15 million a year and someone’s going to get $40 million a year? At some point, pay equity has valid moral ground. I think it still has an impact on the morale and productivity of the company, and so pay equity is a fair argument for value improvement.

You were concerned about the JOBS Act scaling back governance protections for companies that did not deserve it.

I preferred the Democratic-sponsored Senate amendment, which greatly circumscribed most of the unfortunate rollbacks of governance protection for investors that the GOP House version of the JOBS Act rushed through without sufficient thought. I raised this issue with our two California Democratic Senators, Dianne Feinstein and Barbara Boxer, to constrain the desire to expand the number of companies qualifying for the legislation’s governance exemptions.

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