Victory of financial terrorists

By Shin Jang-sup

What would happen if Samsung Electronics and LG Electronics, the leading and number two electronics companies in Korea, merged and announced that, within two years, that the merged company would be split into three, say, SLG Smartphones, SLG Consumer Electronics, and SLG Semiconductors? Most people would probably be baffled by this news and take it negatively.

It is common wisdom among business experts that it normally takes quite a long while for a merged company to proceed from "physical merger" to "chemical merger" especially when big companies with different cultures are combined. In fact, we have more failed cases than successful ones in mergers and acquisitions (M&As). Moreover, it is very difficult to find a business rationale of dividing the merged company into three almost immediately.

However, this is what is actually happening in the U.S. Dow Chemical and DuPont, the leading and second largest chemical firms, which decided to merge last December and, within two years, to break this merged company into three separate ones ― agriculture, material science and specialty chemicals. DuPont's central research lab, the first industrial science lab in the U.S. founded in 1912, would disappear in history in the process. Massive layoffs are being carried out in order to achieve the $3 billion cost-cutting goal set out by the merger plan.

What is conspicuously missing here is any mention of extra costs that would be incurred when the three separate companies will need to rebuild R&D and marketing forces in two years' time. The merge-and-split decision is largely a mystery from the business point of view, although DowDuPont painstakingly emphasized that it was an effort to survive increasingly intense competition in the world market.

It is no longer a mystery, however, if one examines what had been going on in Dow and DuPont before they eventually agreed to the merger-and-split. Both companies received attacks from activist hedge funds and the decision can be better understood as "financial engineering" by those activist funds.

In the middle of 2013, Trian Fund Management, which claims to be a champion of "constructive activism," demanded that DuPont break its current businesses into three and cut costs by as much as $1 billion by, for instance, shutting down DuPont's central R&D center. It also requested the company to buy back as much as $5 billion in stocks to prop up its stock price. Trian had not been in the shareholder list of DuPont but it made the demands immediately after buying about 2 percent of the company shares from the public market. Moreover, DuPont was then performing quite well, its operating profits rose from 9.5 percent in 2008 to 14.9 percent in 2014.

Ellen Kullman, then CEO of DuPont, was appalled by the demands and fought back. The battle continued for two years and DuPont narrowly won it at the proxy voting in May 2015. Major proxy advisory firms such as Institutional Shareholder Services (ISS) and Glass Lewis sided with the activist fund. Even CaLSTRS (California Teachers Retirement System), a long-term shareholder of DuPont, sided with Trian. (It was later learned that it had already invested a substantial amount of money in Trian.) DuPont won the proxy battle mainly due to the support from its retail shareholders.

On the other hand, Dow Chemical was on the receiving end of attacks from another activist hedge fund: Third Point. In January 2014, the hedge fund bought 2.3 percent stake of Dow shares and requested Dow management to split its low-value-added businesses and increase share buyback. As Dow management refused to do so, Third Point opened a website specifically designed to criticize Dow management and their alleged "broken promises." Dow eventually agreed to a one-year truce with Third Point in November 2014 by accepting two directors nominated by the hedge fund in return for its discontinuing criticisms of the management. The two new directors were under "golden leashes," special extra compensation made by Third Point.

The merger-and-split deal was mainly engineered by these two activist hedge funds. Ellen Kullman, who won the battle against Trian, retired in October last year and her place was filled by Edward Breen, former CEO of Tyco, who was strongly backed by Trian. Breen immediately started a talk with Dow for the merger.

How could activist hedge funds, which hold only small minority stakes of 2 to 3 percent, exert such a strong influence on corporate giants such as Dow and DuPont? This is mainly because giant institutional investors including pension funds and mutual funds are often throwing their support for the actions of those hedge funds. These institutional investors claim they pursue long-term investments. However, their executives and fund managers are normally evaluated and paid by their short-term performance and naturally have a strong incentive to ally with activist hedge funds. The term, "co-investments," is therefore employed by financial experts to describe this kind of alliance. A Silicon Valley executive who had to fend off activist attacks even called them "terrorists".

Professor Steven Solomon who runs a DealBook column in the New York Times said, "companies, frankly, are scared" and now "the mantra in corporate America is to settle with hedge funds before it gets to a fight over the control of a company." He even argued, "When historians look back at this era, they will see this [Dow-DuPont] deal as a turning point when corporate leaders threw up their hands and surrendered to activist shareholders." In fact, corporate giants such as Apple, GE and Qualcomm, recently all settled with hedge funds as soon as they were targets of these attacks.

What should be done about this then? One way to tackle this is to rebalance regulations over corporations and those over institutional investors. The current financial regulations in the U.S. as well as in Korea are based on presuppositions that corporations are stronger entities while institutional investors, often grouped as "minority shareholders," are weaker entities. That might have been true in the past. But the reality in the financial and business world now is completely reversed. A handful of institutional investors often hold the majority in a public company. By reflecting the new reality, regulations on institutional investors should be strengthened while those on corporations should be relaxed.

The most important one, to me, among the new regulations seems to make institutional investors behave in the interest of the real owners of the money. They are simply "fiduciaries" of the real owners and are allowed to cast votes on their behalf. In the U.S., for instance, about 40 percent of the money entrusted in hedge funds came from pension funds. Pensions are future claims of ordinary people in preparation for their retirement. If hedge funds are using this money to damage the long-term viability of companies and remove job opportunities for workers, this behavior goes against the objective of pensions. Regulators should remain vigilant and devise measures to keep the behavior of institutional investors in line with the interest and intention of the true owners of the money entrusted to them.

Shin Jang-sup is an economics professor at National University of Singapore and former adviser to Korea's finance minister. He can be reached at ecssjs@nus.edu.sg.