Management's Plans and Strategies

Hedge fund activism, soaring stock buybacks, and new boardroom technology committees may signal a need to balance compliance with strategy.

The demands of the current legal and regulatory environment have taken up much of management's time in recent years and forced boards to concentrate on their monitoring function. So it's not surprising to see the emergence of a counter-force that pushes the pendulum in the other direction, forcing management and boards to spend more time on plans and strategies. Evidence of this swing can be found in hedge fund activism, soaring stock buybacks, and emerging technology committees.

Hedge Fund Activism

Hedge funds have become very aggressive in pushing companies for change. Basically, these funds are pools of money created and owned by pension funds and other institutions as well as wealthy investors.

These funds target companies whose stock is believed to be undervalued, then pressure management for changes that can boost the value of their holdings in the company.

Characteristics of companies that may be targeted by hedge funds include companies that are seen as not doing a good job on cost control. For example, some funds may regard executive pay as excessive and indicative of poor cost control. Hedge funds may also target companies with excess cash or real estate that is not increasing in value as fast as the funds think it should. A typical goal is to persuade these companies to use their cash and take more risk, for example by increasing capital expenditures or investing more in research and development.

By taking large stakes in companies, hedge fund activists can pressure management to take drastic actions, such as splitting up the company and selling off pieces of it to free up cash for investment or for return to shareholders.

Because hedge fund tactics can be hostile in nature, they may be onerous to management and boards who must prepare time-consuming and costly legal, financial and operational responses. They can be equally troublesome to shareholders who may believe the goals of the hedge funds are inconsistent with theirs. This is especially true if the hedge fund's holdings are believed to be of short duration and involve complex transactions, such as short-selling and borrowed shares, that can give them voting power without economic risk.

Where the holdings are longer term, the tactics used by hedge funds may produce faster results than the shareholder resolutions voted on at annual shareholders meetings because they may begin during proxy season and then continue throughout the year. Smaller public companies tend to be less able to withstand these year round battles. Opponents of these tactics have criticized hedge funds for being for short-sighted and forcing companies to sacrifice long-term growth for short-term returns.

Stock Buybacks

While it is difficult to gauge the full impact on hedge fund activism, studies confirm that a key financial trend of the past few years has been the accumulation of cash by many companies.

Data compiled by Standard & Poor's shows these financial trends:

• Corporations in the S&P 500 have five or six times as much cash as they had ten years ago.
• The ratios of cash to stock market value and cash as a percentage of long-term debt are at unusually high levels.
• Stock buybacks as a use of excess cash are at an all-time high. The amount of money spent on stock buybacks by the S&P 500 has almost doubled over the past year.

The trend toward increased stock buybacks as a use of excess cash has pros and cons for shareholders. The pros are that it can increase earnings per share, an important metric of corporate performance. The cons are that it may indicate the company has no higher return project in which to invest the money, e.g., new products or new factories.

In addition, complexities in financial reporting can arise, if the company is simultaneously issuing stock options to employees. In such cases, the buybacks may offset the additional shares issued. However, companies may choose to disclose the buybacks more prominently than the options. In effect, some critics say, a significant portion of the buybacks may be viewed as "backdoor compensation" for employees.

The boom in stock buybacks may also raise the question of why the company didn't choose to pay out the money in dividends instead.

Technology Committees

A small but growing number of boards are setting up technology committees, a trend that bridges their monitoring role with their role of providing strategic business advice.

The Corporate Library, a corporate governance watchdog, reports that dozens of publicly traded companies now have some sort of board-level technology committee that is separate from the audit, investment, and compensation committees.

Basically, the technology committee's responsibility is to understand and evaluate the money the company is spending on information technology. As a result, the committee's activities may include probing the business outcomes from investment decisions and ensuring objectives are set and results measured.

One objective may be to ensure effective internal controls; another may be to improve profitability. Hence, the committee is called upon to balance monitoring and strategic activities and to oversee management's balance of short and long term goals.

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