| "Who controls a company," I often ask around here, and generally I am writing about some weird corner case in which the standard legal rules don't exactly match up with the practical realities. Sometimes they do though. For instance, if you are the founder and chief executive officer of a tech company, and you take the company public, and the company has a single class of stock and you own about 9% of it, then you work for the shareholders, but it is not exactly easy for them to supervise you. You are the CEO, and you mostly get to make the decisions. You answer to the board of directors, who are elected by the shareholders, but the directors are probably friendlier with you than they are with the shareholders, and as we discussed yesterday the election of directors is usually just symbolic. But if shareholders are really unhappy with you, there can be a proxy fight, which is a binding, non-symbolic director election: An activist shareholder can nominate its own director candidates to join the board, make changes and supervise you. This is expensive and difficult, but sometimes an activist will win some board seats. You can protect yourself, though, with a "classified board": Instead of having all of your directors elected each year, the directors have staggered three-year terms, so only one-third of them are elected each year. Then, even if an activist wins a proxy fight, it will get only one-third of the board seats, and can't outvote you. Of course at that point the board meetings could get very awkward, since your board is now two-thirds your buddies and one-third your critics. You can protect yourself against that, though, by, like, giving those guys the wrong address for the board meetings? Or, at least, you can freeze out the new directors a bit: They are formally in charge of the company, but you are actually in charge of the company, and if they ask to review documents or meet with your division heads you can just ignore them. The employees are loyal to you, not them. But if you do that, the shareholders might get even more annoyed, and the activist might run another proxy fight next year. And if it wins that proxy fight, it will control two-thirds of the board, not just one-third. And then a majority of directors will actually be able to make decisions about the company, including firing you. It takes a while, but at that point you really have lost control of the company and might as well just quit in a huff: Joe Kiani has resigned as chief executive of Masimo, the US-based medical technology company he founded more than three decades ago. Results published in a securities filing on Wednesday showed Kiani and another director were defeated in a shareholder vote by nominees from the hedge fund Politan Capital, which now controls the board. The filing also said Kiani had sued the company to ensure he received a change of control payment that had been previously valued at more than $400mn.
Here are the filing and the press release. Last year, Politan won a bitter proxy fight and got two of its candidates elected to the (at the time) five-member board. This apparently did not go over well with Kiani, the founder, CEO, board chairman and 9% owner of Masimo. Politan says that its directors (Quentin Koffey, who runs Politan, and Michelle Brennan, a former Johnson & Johnson executive) were frozen out of talking to employees: Promptly after the 2023 Annual Meeting, and regularly thereafter, the 2023 Newly-Elected Directors requested the opportunity to meet and speak with senior management, to receive and analyze information about the Company and its financial condition and operations, and to participate in other customary onboarding and orientation activities for new Board members. The Politan Parties believe that the Company failed to properly act on these requests.
And potential mergers-and-acquisitions decisions: On March 20, 2024, the Company entered into a confidentiality agreement with a potential joint venture partner in connection with the separation of the consumer business. The full Board knew nothing about the existence of the joint venture partner or any discussions that had occurred. The full Board was never notified that a confidentiality agreement had been entered into or that any confidential information had been exchanged until nearly eight weeks later on May 13, 2024.
So Politan nominated two more directors this year, there was another proxy fight, there was a fairly nasty campaign with lawsuits and claims of "empty voting," and the Financial Times reported last week: A sense of fatigue around Kiani is apparent. People close to Masimo and Kiani admitted to the FT that shareholders had become exasperated by the founder's aggressive 2023 proxy campaign tactics against Politan, even if they also believe giving up control to the hedge fund was the wrong move.
The shareholder vote was held last Thursday, and today Politan was declared the winner. Politan now has four of the six directors. So Kiani quit and sued for a payout under his employment agreement, and Brennan took over as interim CEO. The stock is up since the vote; apparently the Kiani fatigue was real. Once, in discussing another "who controls a company" situation, I wrote: It is sort of a miracle that hostile takeovers and proxy fights can work. You've got a company. The company is a collection of people who all go to the same building and do things together. ... As in any group there will be some infighting and dysfunction but it is basically a group of people who have come together for a common purpose and spend a lot of time together working toward that purpose. And then one day some stranger shows up and says "I have bought 4% of your company and I want you to do different things." … You could imagine it not working. You could imagine the CEO barricading himself in his office and saying "who put you in charge? 'Shareholders'? Sounds fake." ... A company is built around a set of fairly thick social ties, and also around knowing the computer passwords and having keycards that work on the doors and stuff like that. And then it is connected to its shareholders by rather thin social ties, and when the shareholders decide to come in and mess with the internal workings it is strange that they can.
And you see a bit of that here. Shareholders elected new directors last year, but the company — Kiani and his executives — allegedly froze them out; the employees and executives allegedly wouldn't talk to them or share information. In this year's proxy statement, Kiani wrote: This latest proxy contest—which threatens to hand control of Masimo to an activist investor—puts both our recent momentum and Masimo's spirit of innovation and success at risk. Our relationships with our customers and partners, and ultimately our value to stockholders, depend on the strong culture of innovation, honesty and unity that we have developed over 35 years. Similarly, our key talent, responsible for the advances that have driven and will drive our growth, deeply values Masimo's vision and commitment to innovation. If we lose our vision, our spirit and our talent through an ill-conceived change of control, I fear the long-term growth and potential in which we all have so much invested will die on the vine.
I think you can read that to say "if we lose this proxy fight, I will quit, and a lot of our best employees will go with me." And in fact Masimo's proxy-fight website — protectmasimosfuture.com — includes letters from various executives and employees saying things like "if Joe is no longer at Masimo, I would have to seriously contemplate if I would like to continue working at Masimo and I am sure many others feel the same" and "we, the undersigned from Masimo Healthcare Engineering, wanted you to be aware that we may not continue with the company if Joe Kiani is replaced by Quentin Koffey and Politan Capital." Here's one from Bilal Muhsin, saying "I intend to resign my position as Masimo's Chief Operating Officer in the event that Joe is removed as Chairman and CEO … and have no intention of remaining with the company if Quentin Koffey and Politan take control of it." And then Politan won, and Kiani really did quit. And I suppose it is possible that the culture that made Masimo work will fall apart in short order now that its founder is gone, that "the company" is not so much the set of assets and patents and public-company institutions that the shareholders control, but rather the set of social ties and relationships and knowledge that Kiani controls. Or not. From today's press release about the management changes: Chief Financial Officer Micah Young and Chief Operating Officer Bilal Muhsin, added: "We are excited about the strong momentum of the business and its future prospects for growth. We look forward to providing more details on the upcoming third quarter earnings call next month."
Muhsin "intend[ed] to resign" if Politan won its proxy fight, and "[had] no intention of remaining," but it's easier to say that you'll quit if your boss quits than it is to actually quit when he does. What does a private equity firm do? Here are two possible answers. One is an abstract financial answer, the sort of answer that a finance professor might give. What a private equity firm does, in this view, is essentially levered small-cap value investing: - It buys smaller companies with fairly low stock prices relative to their earnings, often companies with steady earnings in unglamorous or declining industries.
- It borrows money to pay for them.
- It waits a few years and then sells them for more than it paid for them.
This is, often, a lucrative strategy. Value investing often works — often companies with low stock prices relative to their earnings eventually get higher stock prices — and if you add leverage on top of it then you magnify those returns. The private equity business model, of borrowing money to acquire companies with those characteristics, just happens to track an investing approach that tends to do well. And so here is a 2015 paper by Erik Stafford, a finance professor at Harvard Business School, titled "Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting," that basically argues you can replicate private equity returns yourself (and save on fees) by (1) buying "a passive portfolio of small, low EBITDA multiple stocks," (2) using "modest amounts of leverage" and (3) not looking at the stock prices for a few years. And people sometimes build exchange-traded funds that capitalize on this idea, trying to buy shares of public companies with financial characteristics similar to private equity investments. This all strikes me as theoretically appealing but also a bit rude? Because the other possible answer to the question "what does a private equity firm do" involves describing, you know, what it does all day. It employs a lot of highly paid, well trained professionals who work long hours. Much of what they do is try to find companies that are undervalued, negotiate to buy them and borrow the money to do so. But also then, you know, the firm owns those companies for a while. The companies have board meetings, and the private equity firm sends its employees to the board meetings. It hires and fires the executives of the companies. It approves their budgets and business plans and gives them advice on cost-cutting and operations. It sometimes buys multiple companies in the same industry and combines them to try to get synergies. Private equity firms, in other words, are not in their day-to-day operations mainly in the business of passively buying an index of stocks with low EBITDA multiples. They are mainly in the business of owning and running companies. They are in the business of business; they make their money by running companies successfully rather than by leveraged exposure to the value factor. The great thing about finance is that both things can be true, that a private equity firm can employ all those people working so hard to find and manage the best possible companies, and a finance professor can be like "ah yes that's leveraged exposure to the value factor" and be basically correct. Everything they actually do all day can be extracted away into a factor model. The work of a private equity firm can be described in a detailed practical way and in an abstract theoretical way, and those descriptions are somehow both accurate and completely unrelated to each other. Anyway in recent years value investing has worked less well than it used to, which means that a strategy like "passive leveraged exposure to value" is less appealing than it used to be, which means that private equity firms have to do more stuff? Bloomberg's Marion Halftermeyer and Layan Odeh report: Financial engineering just isn't working as well as it once did for private equity shops. Some of the biggest, including Goldman Sachs Group Inc. and Blackstone Inc., have added veterans with operations experience from industry giants like Walmart Inc. and Honeywell International Inc. Others like Brookfield Asset Management Ltd. and Partners Group are leaning even more into their roots as operators. They're looking for tangible results such as wider margins and higher cash flow instead of gauzy "multiple expansion." It's a more hands-on approach that includes building five- and 10-year strategic growth plans for the companies they own, and sometimes helping them market and sell their products. Goldman, without being specific, said its efforts have yielded hundreds of millions of dollars in extra revenue. "Helping companies operate well should always be an important initiative," said Lou D'Ambrosio, the former CEO of Sears Holdings who leads Goldman's unit devoted to boosting growth at the firm's private holdings. "But if several years ago it was a 'nice to have,' now it's a 'need to have.'" They need it because private equity firms are contending with a drought in the deals market and holding periods as much as three years longer than historical averages. Acquisitions that seemed like a good idea when interest rates were at rock bottom are stuck shoveling cash into debt payments, and meanwhile, private equity clients are clamoring to receive long-delayed payouts.
Yes "buy a portfolio of small-cap low-multiple companies with leverage" used to be a good enough strategy that "help them operate well" was a "nice to have" addition, but now, if you are going to own a bunch of companies, you have to run them well too. We keep talking about it because the SEC keeps doing it: The Securities and Exchange Commission [yesterday] announced charges against 12 firms, comprising broker-dealers, investment advisers, and one dually-registered broker-dealer and investment adviser, for widespread and longstanding failures by the firms and their personnel to maintain and preserve electronic communications in violation of recordkeeping provisions of the federal securities laws.
Yesterday's fines for texting about work totaled more than $88 million, ranging from $325,000 for Focused Wealth Management Inc. up to $35 million for Stifel, Nicolaus & Co. ("For example, a Stifel desk head exchanged numerous off-channel business-related text messages with at least 15 Stifel colleagues and about 10 brokerage customers, investors, or other market participants.") But Qatalyst Partners LP won't pay a fine: "Firms that self-report and otherwise cooperate with the SEC's investigations may receive significantly reduced penalties. Here, despite recordkeeping failures that involved communications by senior leadership and persisted after our first recordkeeping matters were announced in 2021, Qatalyst took substantial steps to comply, self-reported, and remediated and, therefore, received a no-penalty resolution."
Still Qatalyst got in trouble; the SEC found that Qatalyst "willfully violated Section 17(a) of the Exchange Act and Rule 17a-4(b)(4) thereunder," and censured it, because some of its employees "sent and received a number off-channel communications involving other Qatalyst personnel and Qatalyst's brokerage customers or other participants in the securities industry." Two SEC commissioners, Hester Peirce and Mark Uyeda, dissented: Under the standard applied in this case, even well-intentioned firms could find themselves in the Commission's enforcement queue time and again. Qatalyst has been working to address the off-channel issue for at least sixteen years. The Commission's Order outlines some of the firm's efforts: "As early as 2008, Qatalyst personnel were advised that the use of unapproved electronic communications methods, including on their personal devices, was not permitted, and they should not use personal email, chats or text messaging applications for business purposes, or forward work-related communications to unapproved applications on their personal devices. Qatalyst reinforced its policies at least annually with regular, mandatory training and reinforcement from compliance and senior management. Qatalyst personnel were specifically advised not to list personal phone numbers in email signatures." Then, "beginning in March 2017, Qatalyst provided its personnel with a compliant text-messaging process that could retain business communications" and "instructed its personnel to use only this process to communicate about Qatalyst's broker-dealer business by text message." "Beginning in 2020, Qatalyst required all personnel to have a firm-issued device on which to conduct Qatalyst business, and encouraged personnel to use firm-issued devices when communicating with both business and personal contacts." Further updates to capture Slack and LinkedIn messages came in 2020 and 2022. Qatalyst trained its employees, monitored communications sent through firm-approved communication methods, and disciplined employees who violated the firm's policies. Even with all that, Qatalyst violated the recordkeeping requirements. ... If we assess reasonableness based on whether policies and procedures always are being followed, firms will never escape our enforcement net. People are not perfect and so compliance will not be perfect—even at a firm that tries as hard as Qatalyst. Firing up our enforcement machinery every couple years to haul the industry in for headline-making penalties will not make people perfect, so firms will continue to discover violations of firm policies. We cannot enforce to perfection, but there is a way to achieve better compliance.
Qatalyst had policies saying that its employees shouldn't text about work on their personal phones, "prohibited personnel from responding substantively to, or initiating a substantive business conversation with, a firm customer" on unapproved channels or personal phones, and put a lot of effort into making sure that its employees followed those policies, including encouraging them "to use firm-issued devices when communicating with both business and personal contacts." (The idea being that if you use your monitored work phone for all of your personal texting, you'll be more likely to reach for it to do your business texting. Maybe you'll get rid of your personal phone entirely.) But if you have a lot of employees, will a few of them (1) keep their personal phones and (2) sometimes text about work from them? Absolutely, yes. (Will a few of them send WhatsApp messages about work? I guess?) And so Qatalyst got in trouble. It didn't pay a fine, but it could have, and next time it might. Because there will be a next time! Because people will keep texting about work! Anyway Peirce and Uyeda think this is a bad thing, and I suppose I agree, but it depends on what you are optimizing for. If your goal is something like "be fair to companies that are trying their best to keep records of all their business conversations," then, sure, censuring Qatalyst seems rough. If your goal is "maximally threaten companies so that they try even harder to keep records of all their business conversations," then censuring Qatalyst might be good. And if — as I have suggested — the goal of the SEC's cell-phone fines program is to maximize revenue, by creating a machine for extracting fines from every securities firm, then this is ideal. Peirce and Uyeda object that the SEC has found a way to fine every financial firm, every few years, no matter what: "Firms will never escape our enforcement net," and "even at a firm that tries as hard as Qatalyst," the SEC can "[fire] up our enforcement machinery every couple years" to extract some more fines. Perpetual universal fines! You can see how a regulator might want that. A minimal theory of "stakeholder capitalism" goes something like this: - Modern theory and practice mostly measure corporate chief executive officers on how much value they create for shareholders. The more the stock price goes up, the better the CEO has done, and the more she gets paid.
- These things tend to be relatively easy to measure and hard to game: It's pretty easy to tell if the stock went up, and pretty hard to fake that.
- CEOs who are really good at making the stock go up will make a lot of money.
- But not every CEO will create a lot of shareholder value every year, and every CEO runs some risk of not creating enough value next year to get her bonus.
- It is good, for CEOs, to muddy things a little bit. If 100% of your bonus is contingent on meeting pre-set net income milestones, and you don't meet those milestones, you get no bonus. If 50% of your bonus is contingent on those net income milestones, and 25% is contingent on Being a Good Corporate Citizen and 25% is based on Treating Employees Nicely, things are fuzzier. Those milestones might be softer and more subjective than the net income ones. They might leave some discretion to the board of directors, who are probably your buddies and want you to get paid.
The general point is that if the job of a CEO is to maximize shareholder value, there will be a lot of variance in CEO pay: Maximizing shareholder value is hard, and some people will be better at it than others. But if the job of a CEO is to maximize shareholder value and any other thing, there will be less variance in CEO pay. Part of this is just that the variance might offset: Some CEOs might be good at shareholder value and bad at the other thing, some will be the opposite, and they'll both be lumped in the middle. But most of it is that the other thing will probably be fuzzier, easier to game and more CEO-friendly than maximizing the stock price. Therefore, you should expect (many) CEOs to want to get paid for things other than value maximization, to make their compensation larger and less risky. This was an argument I made a few years ago when the Business Roundtable, a group of chief executive officers, put out a statement saying that actually "the purpose of a corporation" is not just to make profits for shareholders but "to deliver value to all of [its stakeholders], for the future success of our companies, our communities and our country." What that means, I think, is that the CEOs don't want to be held accountable to shareholders: "Hold us accountable to shareholders and also all of our stakeholders" means, in practice, "don't hold us accountable to anyone." Anyway here's a paper by Adam Badawi and Robert Bartlett, titled "ESG Overperformance? Assessing the Use of ESG Targets in Executive Compensation Plans," finding that, when US public companies pay their executives in part based on meeting environmental, social and governance targets, they pretty much always hit those targets: We find that 315 of [S&P 500] firms (63.0%) include an ESG component in their executives' compensation and that the vast majority of these incentives are part of the annual incentive plan (AIA) rather than a part of the long-term incentive plan (LTIP). While executives miss all of their financial targets 22% of the time in our sample, we show that this outcome is exceptionally rare for ESG-based compensation. Only 6 of 247 (2%) firms that disclose an ESG performance incentive report missing all of the ESG targets.
One possible interpretation here is that corporate executives are much more focused on improving their ESG outcomes (and more skilled at doing so) than they are on increasing profits, so they meet ambitious ESG goals more reliably than they meet ambitious financial goals. That would not be a good interpretation: We ask whether the ESG overperformance that we observe is associated with exceptional ESG outcomes or, instead, is related to governance deficiencies. Our findings that meeting ESG-based targets is not associated with improvements in ESG scores and that the presence of ESG-linked compensation is associated with more opposition in say-on-pay votes provides support for the weak governance theory over the exceptional performance theory.
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