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The challenge of governing for value.

In the next five years, managers and boards will find themselves faced with new challenges from the stock market. Instead of episodic, confrontational challenges for control, CEOs and directors will find themselves subjected to continuous, ongoing scrutiny from both active investors and major long-term institutional investors, who will seek to engage in substantive debate about specific corporate policies and overall corporate performance.

This shift creates an unprecedented opportunity for corporations to create new mechanisms and new processes that allow them to govern for value. If this challenge is met, the result can be the attainment, perhaps for the first time in this century, of a truly cooperative, value-based corporate governance process.

We are in the midst of a revolution in American corporate governance that has been under way for over a half-decade now. One cause is the demise of hostile takeovers; the other, the growing activism of major institutional investors. Together, these changes are transforming corporate governance from an market-driven process to a more political one. The old regime was characterized by fragmented ownership, high turnover, and broad investor apathy broken by episodic, confrontational control battles. The new governance process is increasingly based on continuing dialogue and debate among key, long-term institutional and other investors about specific, substantive aspects of corporate policy.

In this newly politicized environment, managers will face two types of outside pressure for change, both very different from the takeovers of the past decade.

The first will come from active investors - the takeover practitioners of an earlier era - who will invent new mechanisms through which to influence corporate policy. These mechanisms will be based on negotiation, suasion of leading investors, and/or voting challenges aimed at seeking board representation rather than control. The goal will be to increase value through convincing shareholders that management should alter specific practices and strategies. For active investors seeking profits, these new goals are made necessary by the increased cost and tactical disadvantages that now attend full-control tactics. The new goals are made attainable by the increased ownership concentration of institutions that have the sophistication and expertise to judge complex dissident cases.

One can already observe this change at work in the market. Last year, there were only two large hostile tender offers for control - those for NCR and Square D - and both were launched by corporation, not active investors. But concurrently, there was a series of substance-based voting challenges. NYCOR sought three seats on Zenith Electronic's board; Harold Simmons sought representation on Lockheed's board; Carl Icahn nominated an independent, minority director slate at USX; investment fund manager Julian Robertson elected five independent directors at Cleveland-Cliffs. As we write this article, this trend is continuing in 1992. There have been no hostile tender offers announced yet this year; but in one recent week, investor groups announced their intentions to seek board representation to change current policy at three large public companies.

Activism Is Changing

The second type of outside pressure that management will face is economically motivated oversight by institutional investors. Five years ago, institutional activism began as a reaction to the excesses of the takeover era. The agenda was entirely governance and process-oriented, and often seemed divorced from value considerations. Now, with the virtual disappearance of takeovers - and also as a consequence of a concentrated learning experience on the part of major institutions - activism is changing. Institutions have recognized that in the long term, the focus of their efforts must be on ensuring good corporate performance. The goals and tactics of institutions will continue to evolve to focus on real economic issues and on poorly performing corporations.

Again, examples of change abound. The leading institutions now target their activism to companies that have underperformed their industries, using systematic, long-term measures to isolate underperformers. Many institutions are now focusing their efforts on the structure and conduct of the corporate board - clearly the most important long-term determinant of corporate performance - instead of on a host of arbitrary takeovers defenses. Moreover, the leading institutions, including CalPERS and New York State Common Retirement System, have begun to focus directly on corporate economic fundamentals. This year, CalPERS targeted a dozen under-performing companies, prepared expert evaluations of their strategy and performance, and engaged in conversations with management about deficient strategies. The New York State Retirement Fund is developing a system to target underperformers, and plans to publish short comments about possible deficiencies in corporate strategy.

For corporations and their boards, there may be a temptation to view these trends as yet another alarming source of financial market pressure. Instead of episodic challenges such as takeovers, which could at least be ignored when they did not occur, there will now be a continual stream of invasive and distracting interference from institutional and active investors, aimed at changing specific corporate policies or the group that oversees them - the board itself.

But to take this persuasive view would be a bad mistake. It would ignore perhaps the greatest opportunity for constructive change that corporations have had in the past 30 years.

To understand the opportunities that await management in the transformed corporate governance arena, it is necessary to inject the purely market-driven perspective of the 1980s with a more political perspective. The right perspective is no longer that of an embattled manager facing the lurking thread of takeover. Rather, it is closer to that of an incumbent elected official between elections.

Competing Ideas

Like incumbent politicians, managers continue to face some threat of defeat at the hands of an outside challenger - but it is a small threat. The rise of concentrated institutional ownership, and the increased reliance of active investors on the proxy process, is replacing a short-term market for trading in shares with a longer-term market for competing ideas about corporate policy. Institutional investors, with their resources, long-term interests, and political sensitivities, behave much like well-financed, professional interest groups. They care about making their views known and engendering incremental change but seldom benefit from displacing incumbents entirely. There is a wealth of opportunity to take their |temperature' - to find out what they are thinking and what they want - and thereby win their long-term support.

The reliance by active investors on substantive voting challenges gives managers the chance to respond to the issues. They can win by sticking to their existing ideas; or, if the challenger has identified a true weakness, they can win by adopting a new agenda. Either way, the battle is fought on substance, and management's strategic position is vastly superior to the days when they could lose control overnight in a quick financial transaction.

To fully exploit these advantages, corporate managers and boards must themselves adapt and begin to meet their investors halfway. By taking advantage of the opportunity, they can begin to fashion a governance process that comes close to the abstract ideal described by experts and sought by reformers for well over a century. In that ideal system, managers look to the market as an early warning signal about inefficient corporate policies. Policies that generate widespread investor antipathy are reexamined and, when necessary, modified. Concurrently, market participants, seeing the corporation as responsive to market signals, support management. The governance process thus corrects corporate mistakes and acts as a guide to corporate policy, but through a substantive exchange of ideas rather than financial reengineering or wrenching, wholesale changes in control.

For corporations, the key to success in the new environment is learning to read and analyze market signals and, hence, to take advantage of the input of long-term investors in shaping corporate policy. Pursuing this goal means developing new mechanisms for ongoing communication with the market.

A More Expert Function

A first, obvious focus is investor relations. In the past, investor relations has functioned as a largely custodial process in many major public corporations. It has consisted of recordkeeping on an anonymous and ever changing shareholder base, and stock watch, to detect the arrival of large and unwelcome investors bent on attaining control, and has been a source for official corporate information, such as press releases, often directed more to the analyst community than to investors. In the new environment, investor relations must become a more expert and higher-level corporate function. It must become a channel for serious, substantive, high-level feedback between large long-term shareholders and the board of directors and senior management. New resources must be devoted to setting up systematic communication and feedback channels that accomplish these goals.

A few companies have begun to take steps in this direction and have already reaped significant benefits. At Lockheed, a newly energized investor relations function has provided feedback that has significantly affected the company's board structure, corporate governance profile, and, more recently, its capital structure and share repurchase decisions. At Coca-Cola, a new shareholder ombudsman's office is devoted to meeting with investors. These efforts will continue and increase, backed by more analysis, more familiarity with investors, and more sophisticated techniques (such as surveys) for gathering shareholder opinion.

Changes in Board Structure

A second important level for structural change is at the board level. Investors have increasingly, and rightly, recognized that it is the board that is supposed to act as a guardian of shareholder interests and a channel for shareholder concerns. A program of market feedback that is to have true influence on the corporation must ultimately reach into the boardroom. This means changes in board structure and operation to permit such communication and feedback to occur.

A promising idea, which has been suggested by Lou Thompson, president of the National Investor Relations Institute, is a committee of the board devoted to investor relations. Such a committee could be comprised of a few outside directors and the CEO. Its charge would be to serve as the ultimate focus of a substantive investor relations process. Such a committee could receive twice-yearly briefings on the key concerns of investors. It could meet with major investors who have particularly strong concerns or specific suggestions for change. It could thus ensure that major concerns are incorporated directly into the corporation's planning process, injecting market signals at precisely the level of the corporation where shareholder concerns are supposed to be represented and ongoing governance is supposed to occur.

Mechanisms and communication by themselves will not inevitably lead to value maximizing and efficient corporate response. Underlying these new mechanisms must be a new commitment by corporate officers and directors to engage in substantive analysis that allows them to view the company as its outside investors see it. Without such analysis, investors communications, no matter how intensive, can become a form of window-dressing that does not uncover new corporate opportunities or correct long-term problems. Substantive, investor-oriented analysis is thus the second key ingredient to successful corporate governance in the modern environment/

Value Analysis

Our descriptive term is "value analysis." Properly executed, value analysis combines a stock market perspective with a detailed understanding of corporate operations, to assess overall performance and identify the specific aspects of strategy and structure that are increasing or detracting from long-term value. Simply put, value analysis asks: What would, or could, an active investor propose at this company to increase share values, in both the short and long term? By answering this question, value analysis links the ongoing concerns and viewpoint of financial markets to the direct operating questions that the CEO and the board confront as they plan and execute corporate policy. It thus ensures that new investment decisions are subjected to a rigorous market test, and that the performance of ongoing projects is measured in a manner that promptly alerts managers and the board to deficiencies.

Ongoing value analysis that links corporate operations to stock market value, and identifies sources of actual and potential value, has been relatively rare in the corporate boardroom. Indeed, in the past few decades, only one group of market participants has consistently and successfully conducted value analysis: corporate raiders, who based their activities on just such evaluations. Corporations have usually undertaken value analysis only in conjunction with a discrete corporate event, such as an acquisition or restructuring, not as a part of ongoing strategic planning or investor relations. Moreover, value analysis was often practiced defensively by corporations when it was practiced at all. It was viewed as a necessary evil - a tool to deter raiders - rather than a positive part of long-term corporate planning.

Corporations' lack of emphasis on value analysis can be traced to the nature of the corporate organization, coupled with the old structure of financial markets. Corporations and the people who run them are primarily operations driven, and the financial market perspective often seems peripheral, especially in the presence of high cash flows and little need for external financing. In the atomistic and high-turnover stock market of the past, absent the appearance of a raider, the market did little to send vivid, ongoing signals to management. This enhanced managers' well-established tendencies to blame low valuation or poor stock price performance on market ignorance. In addition, there was little opportunity to unpack the "black box" by seeking the opinions of real investors. One could conduct analyses of value - but the conclusions could seldom be confirmed by direct interaction with identifiable long-term investors.

All that has changed with the new ownership structure and the new willingness of institutions to commit resources to analysis and discussion of corporate operations. It is now possible to ground a value analysis in the real concerns of professional investors. Concurrently, the practice of value analysis has become more sophisticated, driven in large part by the takeover experience of the past two decades. For better or worse, that experience provided a laboratory for analyzing how various types of corporate strategies and operations affect value. In effect, it resulted in a broad understanding of the kinds of mistakes that corporations make that can lead to low value, and clues as to how to reverse low value while minimizing disruption to the corporation.

Need for a Baseline

Value analysis serves as an important predicate to investor communications in an enhanced, participatory corporate governance process. The first step in an expanded governance process is to undertake a rigorous value analysis that ranks the company relative to its industry peers and links long-term stock market performance to operating policies, cost structure, and investment policy. After an extensive value analysis has been performed systematic communications with major investors can test whether market participants' concerns square with what the numbers show. Before a value analysis has been performed, it is next to impossible to structure a meaningful investor dialogue, because there is no baseline information about where the corporation stands and the potential weaknesses that may be causing market pessimism. Value analysis is thus the first, not the last, step in the governance process.

The 1990s may be the first decade since the turn of the century in which corporate CEOs and boards can make "governing for value" a reality rather than a catchphrase. The opportunity is due to the revolution in ownership structure that has occurred in the past two decades, together with the demise of the market for corporate control. Together, these changes have created a newly politicized governance process in which corporations can engage in dialogue with investors and thereby respond incrementally to market concerns.

Governing for value has two elements. The first is new mechanisms that permit the corporation to seek market feedback on a systematic basis and ensure that this feedback is ultimately incorporated in a company's decisionmaking. The second element is rigorous, value-based analysis. Such analysis must serve as the foundation for market communications, alerting the corporation to potential weaknesses and strengths and posing questions that can then be explored with major investors. By blending new mechanisms and new analysis, corporations can govern for value without the need for the episodic, confrontational corporate control market of the past decade. If both investors and corporations rise to the challenge, the result could be the first economically efficient and politically sustainable equilibrium that the corporate governance system has seen in more than a century.
COPYRIGHT 1992 Directors and Boards
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Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Chairman's Agenda: Governing for Shareholder Prosperity
Author:Gordon, Lilli A.; Pound, John
Publication:Directors & Boards
Date:Mar 22, 1992
Previous Article:'Surprise' governance.
Next Article:The long and short of it.

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