The topic of corporate governance has gained prominence in the post-Enron world as more and more people realized that unethical practices in this realm could have disastrous consequences for the economy and individuals. Most generally, corporate governance is defined as “the set of processes, customs, policies, laws, and institutions affecting the way a corporation is directed, administered or controlled” (Wikipedia, 2006). These policies affect the outcomes in the business: its long-term prospects, profitability, productivity, and appeal to investors.
The realm of corporate governance defines relationships between multiple stakeholders in a corporation. The list of stakeholders can be extended. It should at least include corporate shareholders, management, the board of directors, employees, consumers, suppliers, lenders, community, regulators, and other external agents.
Of particular importance to corporate governance is the relationship between senior organizational management and corporate shareholders.
The management acts as a representative of shareholders. However, recent experience such as accounting scandals in Enron, WorldCom, and other companies have highlighted the fact that corporate management can deviate from its duties in representing shareholders’ interests and pursue their own, often unethical, goals.
It underscores the need to pursue new trends in corporate governance, most notably involving increased transparency of all operations and organizational decision-making. Recently, an emerging trend in corporate governance was also hedge funds activism. Hedge funds emerge as entities ready to take an active part in the process and shape it, relying on the buyout and other strategies.
Blockbuster case study
The case of Blockbuster, US’s largest video retailer, demonstrates the impact hedge funds can have on the a corporate background. Carl Icahn, the person behind Icahn Partners LP, took a shot at the company that was beset by problems. Frequent changes of CEOs in the past years did not produce stellar performance, and Icahn critically highlighted “the management’s strategy of spending heavily to fight back competition from rivals like mail-order distributor Netflix” (Schoen, 2005). The company’s shareholders supported Icahn’s attack on Blockbuster displeased that the CEO stood to receive a $50 million bonus if he parted with the company since the contribution of Mr. Antioco, the then CEO, did not seem impressive.
The victory for Mr. Icahn occurred in May 2005 when he was elected to Blockbuster’s board of directors. He won in the proxy fight that, as proxy fights go, was accompanied by a series of nasty exchanges between himself and Mr. Antioco. Mr. Icahn who held only a 10% stake in Blockbuster actively campaigned among other hedge funds that also invested in the company to pressure the current management out. As a result, his campaign for putting himself and two other candidates on Blockbuster’s board proved to be a success.
Icahn’s support came from dissatisfaction by the management’s failure to resist the threat from emerging competitors. A few years ago, “with some 9,000 stores worldwide, the company has enjoyed a dominant position as the leading provider of home video and games in the U.S. and 24 other countries, taking in $6 billion in revenues” in 2004 (Schoen, 2005). The emergence of Netflix from obscurity and it’s grabbing a large share of the market with its online subscription service caused Blockbuster serious problems that hedge funds managers were willing to exploit.
McDonald case study
Even the venerable company like McDonald’s, with its record in the the fast food industry, could not escape an attack from hedge funds. At the time, McDonald’s is the most extensive fast-food chain in the world. It operates approximately 30,000 stores around the globe that cater to about 50 million people in 119 nations (McDonald’s). The company possesses a valuable brand that contributes to its success in the market. However, the company’s current operating strategy is not without problems, and Europe, for instance, remains its weak point.
Pershing Square Capital Management L.P is a hedge fund that holds a 4.9% stake in McDonald’s. Its general partner is William Ackman who masterminded the attacks on McDonald’s.
In late 2005, Pershing Square Capital Management L.P. pressured the company to restructure corporate investments. In particular, their suggestion involved a spin-off of 65% of fast food restaurants that had to be put out for sale in a stock offering of about $3.27 billion (“Pershing Square Capital presents…”). This plan was rejected by McDonald’s on the grounds that it “would not benefit shareholders and also that it would be a “distraction” from its primary business of running restaurants” (“Pershing Square Capital presents…”). In January 2006, Pershing Square came up with a new plan “presented at the Millennium Broadway Hotel in Times Square via Internet video” (“Attack of the Hungry Hedge Funds”).
Although in this case, the hedge fund activists did not attempt to take control of the board, the plans prepared by Pershing Square were paid attention to. Following about a week after the January plan presentation, the fast-food chain announced a plan that would supply more financial disclosure, much in the vein of Mr. Ackman’s proposals. It also voiced the intention “to sell 1,500 company-owned restaurants and buy back $1 billion of stock in the first quarter” (“Attack of the Hungry Hedge Funds”).
MCI case study
Another recent target of hedge fund activism was MCI, a huge telecommunications company. The past of the company is tainted by its unfortunate decision to merge with WorldCom, a company that became a symbol of accounting fraud and unethical governance. The merger ended in a bankruptcy reorganization that “turned into a train wreck by accounting fraud, flawed business strategies and incompetent management” (Knight 2005: E01). Today, most of MCI’s stock is in the hands of hedge funds.
The company received in 2005 two buyout offers from other telecommunications giants, Qwest Communications Inc. and Verizon Communications Inc. The one from Qwest Communications Inc. was higher at $30 a share amounting to $9.85 billion. Verizon offered less, $26 a share equal to $8.54 billion. However, MCI’s management favored Verizon “because the board felt it was a more stable and financially secure partner for the long-term” (Beck 2005).
The board finally approved the deal with Verizon. However, this decision came against strong resistance from hedge fund investors. In May 2005, “a hedge-fund led investor contingent representing about 28 percent of MCI shareholders withheld their votes to re-elect the MCI board” (Beck 2005). A drop in support for the board resulted from hedge funds’ campaigning to get MCI’s shareholder vote under control. The support lent to Qwest by hedge funds investors who favored a more lucrative deal raised concerns that the company could reconsider its decision of sale to Verizon.
Hedge fund investors, in this case, brought a new perspective to the merger negotiation. While the management claimed to be interested in long-term prospects of the company and preoccupied with the search of a comfortable, strategic partner, the hedge fund investors were interested in the deal that would provide cash here and now. Cashing out quickly is a strategy hedge funds are more likely than other investors to pursue, and in this case, their participation in the deal impacted strategic decision-making, even if unable to reverse it.
This week, a hedge-fund led investor contingent representing about 28 percent of MCI shareholders withheld their votes to re-elect the MCI board. That no-confidence vote from a solid MCI shareholder base is raising some suspicion Qwest may re-enter the fray.
The consideration of these cases highlights the vital role hedge funds have begun to play in the corporate governance of US companies. Today, more than ever before, they are ready to come to grips with corporate management when they as shareholders are not satisfied with the company’s performance. Even owning small stakes in the business, hedge fund managers are often able to raise broad opposition and get other shareholders to rebel against the management. At times, it can lead to board re-shuffles and management displacement. At different times, this is not required as hedge fund managers can dictate a change in the strategic course of the company, threatening them with shake-ups.
Hedge funds play an important role as another opportunity to influence the activities of corporate management. There is an additional incentive for managers to perform when they fear a takeover from hedge funds management. This pressure can induce managers to act in the interests of shareholders and increase shareholder value. On the other hand, hedge funds are not “white knights” that come to rescue a struggling company for the sake of its investors. They pursue their interests, and with these benefits being usually short-term, they can support decisions that are good from the long-term perspective.
In any case, hedge fund activism is apparently there to stay. In the future, corporate managers will increasingly come under pressure from hedge funds that will be able to manipulate their strategies under the threat of buyout or spin-off. The emergence of such active agents among investors will naturally lessen the agency problem.
The long-term impacts of their activism on corporate governance and performance are still to be evaluated.
Bibliography McDonald’s. About McDonald’s. 2 August 2006 <http://www.mcdonalds.com/corp/about.html>. “Attack Of The Hungry Hedge Funds.” Business Week 2 August 2006 <http://www.businessweek.com/magazine/content/06_08/b3972103.htm>. Corporate Governance. Wikipedia. 2 August 2006 <http://en.wikipedia.org/wiki/Corporate_governance>. Knight, Jerry. “Plan to Merge MCI, Qwest Has A Sour Ring to It.” Washington Post March 28, 2005, E01. “Pershing Square Capital presents Yet another plan for McDonald’s”. Fund Street. 2 August 2006 <http://www.fundstreet.org/2006/01/pershing_square.html>. Schoen, John W. “Icahn prevails in Blockbuster battle: Dissident group wins proxy fight over strategy.” MSNBC 11 May 2005. 2 August 2006 <http://www.msnbc.msn.com/id/7805560/>.
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