Wednesday, December 31, 2008

CNBC: The Bull Case for Hedge Funds

The bull case for hedge funds, with Eric Jackson, of Ironfire Capital, and Paul Kedrosky, of Ten Asset Management

Last Update: Wed. Dec. 31 2008 11:35 AM

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Saturday, December 27, 2008

The Bullish Case for Hedge Funds


By Eric Jackson

12/26/08 - 12:56 PM EST

The one group of investors that's been vilified more than any other by the business press and government officials alike in 2008? Hedge fund managers.

After years of rapid growth in terms of both assets and numbers of funds in operation, the hedge fund industry has taken a PR black eye this year. Media reports would have you believe that the industry is about to collapse in size, see its revenue drop dramatically through fee reductions and become heavily regulated to protect unsuspecting investors from another Bernie Madoff scam.

Hedge funds certainly make an easy target. They've had a bad year, along with every other retail and institutional investor. But the industry is about to grow dramatically over the next five years. This coming year will mark the beginning of the next wave of this industry's growth.

The 12 months of 2008 have proved an abysmal year, and every investor can't wait to be done with it. While hedge fund managers have done terribly, (with the exception of maybe Bill Miller) no one in the media seems to criticize the mutual fund managers or other wealth advisors for lousy performance.

It seems to be an unstated opinion in many articles that hedge fund managers should know better than other investors. One simple reason for this, a reason that draws endless attention and criticism, is hedge fund manager compensation. It's true that the best-performing fund managers over the last few years have been well compensated.

I don't have a problem if a hedge fund manager, the CEO of Yahoo! (YHOO Quote - Cramer on YHOO - Stock Picks) or the head of risk management at Citigroup (C Quote - Cramer on C - Stock Picks) gets paid boatloads of compensation year in and year out, on two conditions: (1) they should only be paid well based on their direct contribution to the performance of their firms, and (2) that performance should be "real" performance, meaning that there is real value created, not some illusory accounting profit.

Hedge fund managers have an advantage over those who hold the types of positions mentioned above. First, as with a sales rep, you always know how a hedge fund manager is doing. With the exception of managers that dabble in private equity or illiquid assets, which are more difficult to manage on a daily mark-to-market basis, any hedge fund investor could get a daily report on how a manager is performing.

And hedge funds -- even the big ones -- are still small shops. If a fund has a good year or a bad year, its manager, whether it's Stevie Cohen or Bill Ackman, gets the credit or the blame. They don't get to punt responsibility to a foreign office or a snowstorm that kept away retail shoppers.

The second advantage hedge fund managers have over others when it comes to their compensation is that their performance is "real" at the end of each calendar year. Simply put, the market value of your portfolio this year gets measured against last year's market value.
Whether or not these profits were aided by leverage, hedge fund managers must perform in order to be compensated. While others can use their political skills to keep their jobs, hedge fund managers have to live with their fund's performance and the consequences that performance brings.

After a disastrous 2008, the big commercial banks are holding back recently injected capital from taxpayers to pay out year-end bonuses. However, few hedge funds (with the exception perhaps of the 10% that made money this year) will pay out bonuses.

What's more, many of the hedge funds that lost money for their investors this year adhere to "high-water marks." This means they have to make back their 2008 losses in 2009 before they are eligible for future bonuses. Investors get made whole and their managers only get bonuses when they actually deserve them. Citigroup investors sure wish they could get that kind of arrangement.

Hedge fund managers -- unlike mutual fund or other private wealth managers -- get paid for performance, not assets. Their incentives are perfectly aligned with their investors. They make calculated bets and expect to be highly compensated only when they succeed. This arrangement has attracted and will continue to attract talent. The best managers will migrate to hedge funds because they can be more successful financially.

They also accept the financial and reputational pain of performing poorly. Even with less leverage and more regulation, the hedge fund industry is still the best game in town for the most talented managers.

And it's also the best game in town for investors -- which is why the industry is set to begin its next wave of growth in the next five years. The most sophisticated investors still need help managing their money. They are not going to hoard Treasury bills forever.

Do you want to invest in a mutual fund manager incentivized to grow assets but not necessarily performance? Would you not, if you had the opportunity, want to invest in the best qualified money manager?

It's true that Bernie Madoff's Ponzi scheme has shaken the trust of investors in all money managers, and that will have a fallout effect on hedge fund managers. However, the hedge fund industry will be much bigger in 2013 than 2008.

Here are some other fearless predictions for the industry:

  • The number of hedge funds will decrease by 30% between the start of 2008 and the start of 2010, but the assets under management will actually increase as investors seek out the best managers.
  • This growth will come at the expense of the mutual fund industry and wealth management.
  • The due diligence industry, which researches hedge funds and their managers, will quadruple in size. Today, there are few firms with expertise in this area (Due Diligence Consulting, Kroll and Backtracks are on a short-list of firms with expertise in this area). Investors will need to invest in hedge funds, but won't be able to rely on the Securities and Exchange Commission to conduct their due diligence. They won't mind paying for this work themselves.
  • The "2 and 20" fee structure for the industry (under which hedge funds charge 2% annually for management fees and 20% for the share of the profits created) will persist. Investors will not object as long as they receive the performance they expect.
  • Fund-of-hedge-funds will be most negatively affected by 2008. Larger institutional investors will become much more hesitant to invest in fund-of-hedge-funds over the next two years in the wake of the Madoff scandal for fear of criticism from their own investors. These types of funds will not go away, but there will only be so many people that can say, "I can get you into John Paulson's fund."
  • There will be more hedge fund regulation from Washington but not to the extent that it kills the industry. What purpose would that serve the Obama administration? A greater administrative burden dealing with new regulation will become the new cost of doing business for hedge funds. It will make it harder for newer/smaller hedge funds.
  • Hedge fund managers will become better risk managers and learn to perform without the benefit of leverage. Those with enduring strategies that can create value will grow.

Hedge funds are not going away. They're actually going to greatly increase in size over the next five years. The level of dissatisfaction in mutual fund managers and private wealth managers will cause investors to seek out better-performing investment vehicles for their cash. Although there will certainly be changes to the industry as a result of the events of 2008 -- including hedge fund failures in the next six months -- the future looks very bright for hedge fund managers and their investors because their interests are so well-aligned.

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Monday, December 22, 2008 Reasons Behind Yahoo!'s Four-Year Slump


12/22/08 - 10:33 AM EST
YHOO , C , AAPL , HPQ (Cramer's Pick) , GOOG , MSFT

By Eric Jackson

The press has shown little mercy in criticizing Yahoo! (YHOO Quote - Cramer on YHOO - Stock Picks) this year. And deservedly so.
The four reasons most often cited for the Internet company's missteps over the last four years have namely been the people at the top:

(1) Terry Semel;
(2) Jerry Yang;
(3) Sue Decker;
and (4) the Board of Directors.

They all received glowing press coverage when Yahoo! was riding the general ad market recovery and shift to digital ads in 2002 to 2004. But now they are being slammed in various business media for their actions, and in some cases inactions, that have since led to stagnation and decline.

It's normal to blame organizational failures on the leaders at the top -- consider Dick Fuld at Lehman Brothers, Vikram Pandit at Citigroup (C Quote - Cramer on C - Stock Picks) or even a market-maker like Bernie Madoff. Group leaders and their choices are, in the end, responsible for group actions and outcomes.

But there are four other reasons to account for Yahoo!'s decline in the past four years: (1) A lack of product leadership; (2) self-isolated leadership; (3) a culture tolerating non-performance; and (4) the use of a matrix organizational structure.

Each of these problems traces back to choices made, consciously or not, by senior leadership. Until Yahoo! recognizes and understands these issues, the company won't be changed. This is why the choice of the company's next CEO is so important.

The right CEO will see these issues clearly from Day One and change them; the wrong CEO will be oblivious to them. Unfortunately for Yahoo! shareholders, the people selecting the next CEO will be the people on the board who've missed the four reasons for the company's recent poor performance of late.

Even though they had moved on to exciting new jobs, they expressed regret about the current state of Yahoo!, especially since they felt that they had gained a lot from their time at Yahoo!. Each person agreed that the company was fixable and that the decision about who will be named as the next CEO was critical. Most were pessimistic that the company would achieve its potential.

Here are their top four reasons for Yahoo!'s decline:

1. Lack of Product Leadership

Google (GOOG Quote - Cramer on GOOG - Stock Picks) had search. Apple (AAPL Quote - Cramer on AAPL - Stock Picks) had the Mac. Yahoo! has always had a collection of multiple products, and that has been a blessing and a curse.

It's a blessing because -- unlike AOL, which had just the dial-up business -- Yahoo! has always had multiple revenue streams that were mutually reinforcing (e.g., home page, Finance, Mail, Search). It's never been a one-trick pony.

But the multiple products are a curse because, from Yahoo!'s founding, the company has had its fingers in a lot of pies, and that has hindered it from developing a corporate focus. Through Bubble 1.0 and Bubble 2.0, the Yahoo! M&A machine was always humming to suck up venture-backed firms at healthy valuations. Integrating them cohesively was a different story and left a string of disparate businesses under the Yahoo! roof.

Several former Yahoo! employees complained about the lack of vision and the lack of product leadership from the top executives to string all the pieces together. Said one, "I always wanted to know 'what's our North Star?'" They felt that there was a lack of focus from the executive team about what Yahoo! did that created value and what it should be moving toward to better create more value.

In their views, the next CEO needs to be great at products. The core of Yahoo! is a great user experience and great products. Discussions about undertaking a search deal with Microsoft (MSFT Quote - Cramer on MSFT - Stock Picks), spinning off Asian assets, and closing the revenue-per-search gap with Google are secondary.

2. Self-Isolated Leadership

Several years ago, I worked with Dartmouth Business School Professor Sydney Finkelstein on building a consulting practice based on the research from his book Why Smart Executives Fail. He researched more than 60 one-time industry-leading companies that in the end drove off a cliff in terms of their performance.

These companies' executive team members always looked great on paper: the best business schools, the perfect career trajectory, many achievements to point to. Yet, these same people were responsible for bringing down their companies. One key reason for this -- common across all the failures -- is that the top executives got rid of or discouraged anyone around them who voiced a different perspective than theirs. This appears to have happened at Yahoo!.

According to those I spoke with, executives often didn't engage in detailed discussions with lower-level managers responsible for areas that were under-performing. "I would have liked to talk to them more," said one ex-Yahoo!. "I had one good conversation with [one Yahoo! executive] and one good one with [another executive] in [the last few years]. That's it. I know others tried to educate them on the issues. Nothing came of it."

There was not enough debate about key decisions made at Yahoo!. The last six months have seen a steady drain of senior talent. One employee contrasted that with how President-elect Barack Obama has selected key members of his Cabinet: "He's put former rivals around him in Clinton and Richardson, who definitely don't agree with him on some issues. You know they're going to speak up. You also could see any of them leading the country if necessary. We definitely don't have that depth of talent on the Yahoo! senior team."

One group that Yahoo! executives were not shy about consulting in the last four years: the consultants. "There were way too many consultants and too many planning sessions. We needed more execution," said a former employee.

3. Tolerating a Non-Performance Culture

It's obvious that every company has a unique culture. No one working there would be able to tell you step-by-step how it was created, and yet they all live and breathe it every day. The best cultures give that company an amazing advantage vs. its peers. The worst cultures hang around the company's neck and are next to impossible to shake.

"When I first started at Yahoo!, people cared. They'd challenge you if they disagreed. That changed," said one ex-employee. Another added, "Transparency about problems or mistakes used to be rewarded. Not anymore. There were some people who made mistakes and ended up getting promoted."

Over time, it appears most employees stopped pushing for the changes they wanted to see. When they tried and it fell on deaf ears, they backed down. "I think a lot of people also knew they wouldn't get similar jobs elsewhere and decided to keep quiet." The tone got set from the top, and it trickled down to permeate the organization.

4. Matrix Organizational Structure

One of the recommendations that Yahoo!'s consultants made a few years ago was to institute a so-called matrix organizational structure across the company. A matrix structure was popular about 10-15 years ago, especially in engineering-oriented companies. It seeks to overcome the complexity of a large global organization by assigning multiple bosses to employees in different geographies working on similar product or functional tasks. In other words, you report up to two or more bosses -- a product or functional boss and a geographical boss.

The intent of a matrix structure is that you understand what your local peers are working on as well as what your functional peers are working on globally. In theory, the company becomes tighter-knit, despite its size.

In practice, matrix organizational structures have greatly fallen out of favor in the last five years because they create confusion about who is responsible for certain actions. The "shared" ownership of tasks and projects across multiple groups and bosses means that it's difficult to go back and assign blame for and learn from failures. Whose throat do you choke? "It was hard to point out who specifically was responsible for mistakes because of that," said one former employee.

Thankfully, this structure has recently been done away with and products have now been centralized. Combined with the risk-averse culture described above, the legacy of this structure has been deadly for Yahoo!.

Yahoo! executives and directors aren't the first "smart" ones to fail. Otherwise, Professor Finkelstein wouldn't have a book full of stories on Enron, Worldcom and Webvan. The solutions for Yahoo! senior executives, based on the lessons in the book, are:

  • admitting when you/the company have screwed up and dissecting the underlying reasons for the failure;
  • encouraging others to admit their mistakes and learning from the mistakes instead of shooting them or encouraging them to cover up mistakes;
  • surrounding yourself with other smart people who often will disagree with you in search of the best answer for the company; and
  • demanding accountability from everyone in the company including yourself.
The right new CEO can spearhead this kind of effort for change. Mark Hurd at Hewlett-Packard (HPQ Quote - Cramer on HPQ - Stock Picks) is probably the best example of this type of turnaround. He didn't have to fire the old senior team and board. They got with the program early on and supported it further once they started to see evidence that the ship was turning.

The rest of Yahoo!'s senior team and board will have to buy into a new approach as well, admitting their own past mistakes at the same time. This assumes they pick the right person to serve as Chief Yahoo!, and that remains a big question mark.

At the time of publication, Jackson's fund had no position in YHOO. Jackson owns a small long position personally.

Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

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Thursday, December 11, 2008 Take the Long View With GeoEye


By Eric Jackson

12/11/2008 1:59 PM EST

GeoEye (GEOY - commentary - Cramer's Take) operates three geo-spatial satellites that take images of Earth up to a color high-resolution of 0.5m. The company sells these images to governmental and commercial customers. Starting next month, these images will start appearing on Google (GOOG - commentary - Cramer's Take) Maps and Google Earth.

The stock trades at a major discount to its earnings potential next year and should appreciate considerably in the coming months. Yesterday, after the close, GeoEye announced a $144 million contract with its largest customer for 2009; this almost equals its trailing 12 months of revenue.

GeoEye is part of a duopoly in the U.S. with DigitalGlobe (a smaller, private and less well-capitalized competitor). GeoEye had been doing $183 million a year in revenue with 45% operating margins until six months ago, when the company gave up some market share to DigitalGlobe, which launched its newest satellite in the fall. GeoEye's revenue and earnings have recently dropped, as customers opted to use DigitalGlobe's newer satellite. The market has punished GeoEye's shares -- especially during the recent selloff of small caps -- taking the price from a 52-week high of $37.37 in January to below $19 yesterday, near its 52-week low.

A number of events are about to happen in the coming weeks -- beginning with yesterday's new contract news -- that should dramatically reverse the direction of GeoEye's shares.

Recall that the primary reason for GeoEye's stock slide this year was that its nearest competitor launched its latest and greatest satellite. In the geo-spatial imagery industry, higher-resolution images keep improving. GeoEye is now about to leap-frog DigitalGlobe's technology, as it launched GeoEye-1, the newest and most advanced geo-spatial satellite in space, in early September. GeoEye-1 will have the best images in its industry in full color for the next 18 months, until DigitalGlobe puts up its next-generation satellite. However, if DigitalGlobe fails to go public during that time, there is a possibility its launch gets delayed, and that would give GeoEye an even longer advantage.

BCC Research estimates that GeoEye's industry market is increasing from $1.9 billion this year to $3.2 billion by 2012. The key buyers of geo-spatial images are U.S. governmental agencies such as the National Geo-spatial Intelligence Agency (NGA) and Homeland Security. The NGA is GeoEye's largest customer, accounting for half of its revenue last year. The NGA also paid half the $500 million in costs to launch GeoEye-1. The agency is therefore expecting to continue to buy a significant amount of images from GeoEye in the coming years. The NGA's investment came, in part, from a presidential directive for governmental agencies to rely as much as possible on buying services and products from best-in-class companies, as opposed to replicating such services or products internally.

Earlier this fall, the Pentagon floated the idea of building and launching some new geo-spatial satellites of its own to supplement its reliance on GeoEye and DigitalGlobe. This plan was quickly quashed by Congress in November, because of budget concerns. This clears the decks for increased business for both GeoEye and DigitalGlobe in the coming six years.

In yesterday's announcement, GeoEye signed a service-level agreement with NGA, whereby NGA will pay $12.5 million a month up to $144 million in 2009. These payments are for planned purchases of images from GeoEye-1. There might be more. If the payments stay at just that level, they will represent a doubling of GeoEye revenue from NGA compared with 2008.

NGA still needs to certify the quality of the images from GeoEye-1. The images are at a high resolution now, but GeoEye is trying to make them even more finer-grained. This certification is expected to happen on Dec. 15 or slightly thereafter. Once that certification takes place, many other commercial and governmental customers for GeoEye's images will likely begin to strike their own deals and purchase the images.

GeoEye's trailing price-to-earnings ratio yesterday was below 9. Its forward P/E, assuming it does $250 million in revenue next year with 45% operating margins, is 3. Other satellite and space/defense companies trade currently at forward P/Es of 7 to 21.

The key reason why the stock has been at depressed levels since the launch is that it wasn't yet clear that the satellite was operating properly. Yesterday's announcement suggests that NGA is ready to spend money on the new images from the satellite once it certifies the images. NGA's planned spending next year almost equals GeoEye's 2007 total revenue of $183 million, after which the stock hit its all-time high of $37.37. That stock price was achieved prior to worries about delays in the launch of GeoEye-1 that depressed the stock.

The table has now been set for significant revenue and operating margins to accrue to GeoEye over the next 18 months, as NGA, Google and other commercial and governmental customers purchase these images. It is highly unlikely that a technical flaw will crop up this long after the launch. The customers who buy these images (e.g., governmental agencies and Google) are also much less affected by the broader economic malaise compared with most companies operating today.

Assuming GeoEye can double its sales and earnings by the end of next year and is rewarded with an increased price-to-earnings multiple more comparable to its related peers, I believe it could trade up to between $60 and $80 by early 2010, up from its current price of $19.

Days before GeoEye launched GeoEye-1, the company announced a relationship with Google. GeoEye would provide its images from GeoEye-1 to no other online portal except Google. Google is not under any restrictions, meaning it could still buy images from DigitalGlobe. No financial details about the agreement between GeoEye and Google have been released. The first hint of what those details might be won't come until early February, when GeoEye holds its fourth-quarter analysts' call.

However, here is what we do know about the relationship and about Google's interest in space:

  • Google's co-founders (Sergey Brin and Larry Page) attended the September launch of GeoEye-1.
  • Google's logo was on the side of the rocket that launched GeoEye-1.
    Google will begin using images from GeoEye-1 on Google Maps and Google Earth in January and start paying GeoEye for them.
  • GeoEye recently paid Google to get its help in improving their search tools so that GeoEye customers could more easily search GeoEye's inventory of images. (DigitalGlobe has no comparable search tools to offer its customers.)
  • Google's first acquisition post-IPO was for a small company called Keyhole, which is now the basis for Google Earth.
  • Larry Page has signed up to be launched into space himself in 2011.
  • Google has recently been investing in building up its relationships with the federal government, to which it sells its Search, Apps and Earth products. Recently, Google was a Gold Sponsor of an NGA Industry Day, of which GeoEye was also a sponsor and DigitalGlobe wasn't.
  • Google received special permission from NASA to land its corporate jets at Moffat Field near its Mountain View, Calif., headquarters.
It's difficult to say what this adds up to in terms of a long-term relationship between GeoEye and Google. It's quite possible that Google would look to acquire GeoEye in the future to control the images and search tools from GeoEye and develop a deeper relationship with the NGA and the federal government. And Google could be interested in the possibility of designing proprietary search-imagery applications to use within Search and Android (its mobile operating system used in Google's G1 mobile phone). Google is deeply interested in space and space-based imagery. What is clear is that the market is assigning no value to GeoEye from its ongoing revenue relationship with Google or the possibility that Google might acquire the company in the future.

When GeoEye-1 was launched in September, the company said that the NGA should certify the satellite's operation and sign off on a service-level agreement (outlining its planned imagery purchases from GeoEye) within 60 to 90 days. The service-level agreement with NGA was signed on Tuesday, and certification is expected within the week. Expect new customer announcements to trickle out, now that NGA has gone first. In February, GeoEye will hold its next analysts' call, at which time it should start to shed light on its revenue ramp-up with the GeoEye-1 satellite and on the expected revenue from the Google relationship.

Four remaining risks could negatively affect the stock:
  • The satellite could suffer a technical error whereby it becomes inoperable. This is highly unlikely at this point but possible. A major malfunction would slash the company's future earnings dramatically. GeoEye has insurance for this scenario, but it would still not prevent a sharp drop in the stock price. This possibility always exists for the lifetime of every satellite.
  • Management offers poor communication. I have been an activist investor in GeoEye since March. Its CEO and management team have done a poor job in managing the Street's expectations and communicating the GeoEye story. This still remains a problem area, despite criticism from me and from other investors. Management needs to win over the trust of institutional investors and hedge funds to see its price-to-earnings multiple increase.
  • The company has had delays in filling the CFO position. In yesterday's announcement about its new contract with NGA, GeoEye disclosed that its current CFO would be leaving. There are many possible reasons for this, and I don't take it as a sign of problems. The company restated its financial statements recently. The board could have decided to make a change. What is important is that GeoEye hire a first-class CFO to fill the role before the next analysts' call in February.
  • DigitalGlobe could move up the launch of its next-generation satellite sooner than 18 months from now. This is almost impossible. In fact, it's more likely that DigitalGlobe will delay their launch, given that it is waiting to go public to raise needed capital, and the IPO window appears to be shut for the foreseeable future.

In GeoEye, you are getting a world-class leader in a growing and recession-proof industry. Its stock has the chance to triple or even quadruple in the next 15 months. What's more, you're getting a call option on a potential buyout by its partner Google. Put it together, and you have a compelling entry-point at these levels.

[Eric Jackson's fund holds a long position in GEOY.]

Sphere: Related Content Why 2009 Will Bring More Activism


By Eric Jackson

12/11/08 - 09:59 AM EST

With the market's tumultuous last few months driving down the price of equities, activist investors around the world have seen their stock investments take major hits.

  • Carl Icahn has watched the value of his Yahoo! (YHOO Quote - Cramer on YHOO - Stock Picks) stake drop in half since May;
  • Ralph Whitworth of Relational Investors recently resigned from the board of Sprint Nextel (S Quote - Cramer on S - Stock Picks) but kept his stake in the company, even as shares have dropped 80% this year;
  • Chris Hohn of The Children's Investment Fund exited his J-Power position at a loss earlier this year, after his calls for change were beaten back by the Japanese utility. Some market-watchers suggest that after 10 to 12 years of growth as a strategy, investor activism is dead. Why? Poor returns, they say, and because the freezing-up of the credit markets prevents activist shareholders from calling on companies to lever up with debt to fund stock-buyback plans or increase dividends.
However, 2009 could very well prove one of the busiest years for activist investors in the last decade. I count 10 reasons why.

1. Obama will look favorably on pro-shareholder measures. Republican Securities and Exchange Commissioners have typically supported pro-management/Business Roundtable policies. Democrats have been much more supportive of shareholder activists. The Business Roundtable and other pro-management groups have portrayed shareholder-friendly measures -- such as making it easier to run alternative board candidates on the company's proxy -- as moves that empower fringe, or special interest, shareholders such as the AFL-CIO and Teamsters at the expense of plain-vanilla investors (retail or institutional).

Obama supports a different view and will likely equate more shareholder rights that promote better governance with better shareholder returns over time.

2. The new SEC Chair will sponsor several new shareholder-friendly measures. Obama will appoint an SEC chairman in the image of the last Democrat to hold that position, Arthur Levitt -- someone who will fight for openness, fairness and rights for all shareholders.
"Proxy access" was an initiative supporting the rights for shareholders to put forward alternate names of directors to be elected at the annual meeting proxy vote. Instead of having to fund a proxy contest themselves (vs. an incumbent board funding their re-election with the shareholders' money), "proxy access" would have allowed for these alternate names to appear on the company's own proxy and let the shareholders simply vote for the most qualified people to represent shareholder interests. This initiative died when the two Democratic SEC Commissioners retired and were not replaced.

Expect "proxy access" to return in the new administration in some form, helping to ensure the best possible people are serving as directors on our boards.

3. Valuations are on the floor. Activist investors are typically value investors who layer their activist efforts on top of a buy-and-hold approach to an undervalued stock. Value investors have been especially hard hit this year. Fortunately, the mass selling appears to have stabilized. While cheap should never be confused with value, it's likely that valuations will rise over the next 12 months and take the fortunes of activist investors with them.

4. A flight to quality in hedge funds will benefit activist investors. The hedge fund industry is going through a remaking of itself and will no doubt be a much smaller industry two years from now. The biggest and most successful ones will grow in a flight to quality. Activist investors with long and successful track records will benefit, even if their returns in 2008 are poor. Institutional investors can understand the activist strategy and how it's executed. It's not a black box and that is going to be helpful to activists in raising capital over the next few years.

5. Management and corporate boards will not want to be viewed as anti-shareholder. After seeing their market capitalizations decimated over the last 12 months, boards and management teams at public companies are sensitive to criticism. Lavish pay and executive perks are out. Assuming activists have legitimate arguments about actions that will unlock shareholder value, it will be much easier for them to get the ear of managements and boards in the next 24 months.

6. There will be a wave of industry consolidation. M&A has dried up in 2008 as corporate acquirers and targets kept their heads down in the foxhole. That's about to change. With valuations so low, there's never been a better time for stronger players to pick off the weaker ones in their industry.

At the same time, no board wants to make the mistakes that Yahoo! and Take-Two (TTWO Quote - Cramer on TTWO - Stock Picks) did this year by playing hard to get when a rich buyout offer came along. Activist investors will play a background role. For example, look for Bill Ackman of Pershing Square to push together Barnes & Noble (BKS Quote - Cramer on BKS - Stock Picks) and Borders (BGP Quote - Cramer on BGP - Stock Picks) (as he has a stake in both companies).

7. Activists have the longest lock-up periods of any hedge fund class, so they can put fresh capital to work. With hedge funds reeling from heavy redemptions, the funds in the strongest position this year are the ones with the longest lock-up periods. A lock-up is the amount of time a hedge fund investor must keep his/her money invested in the fund before being able to redeem.

Activists, at least the most successful ones, have among the longest lock-ups in the hedge fund industry, at 3-5 years. The logic for asking for such a lock-up is that activists understand that their hold period in a particular position might be many years, comparable to a private equity holding period. Unlike private equity, though, activist investors have their positions marked to market every day.

Activists know a six-month investment return in Sprint is likely to differ from a three-year investment return. With these long lock-ups, activists will be less affected by heavy redemptions this year than most other hedge funds. This means they'll have more money to put to work next year.

8. Limits on short-selling will benefit activists. As previously mentioned, the SEC is about to become more shareholder-friendly under the new administration. The agency also will likely seek to promote growth in the stock market. Short-sellers could come under more restrictions, promoting long-biased investors. Although no outright ban on short-selling will occur, a return of the uptick rule is likely. Any limits on short-selling like this will help long-biased investors like activist investors.

9. Activists will become more balanced on the long and short sides. Even though activists have typically been long-biased or long-only before 2008, the only investments that have made money this year are short bets. Activists will learn from this year's action to have a more balanced portfolio of investments on the long and short sides. Some activist investors like Greenlight Capital and Pershing Square have always taken this balanced approach. Expect others to follow their lead. This will improve performance and provide them with more capital to put to work in additional activist campaigns.

10. There's more to get "active" about than ever. Even post-Enron and post-Sarbanes-Oxley, 2008 has shown shareholders that there is more than ever to get outraged by in the actions and inaction of corporate boards.

Where was the oversight at Bear Stearns, Lehman, Citigroup (C Quote - Cramer on C - Stock Picks) and GM (GM Quote - Cramer on GM - Stock Picks) this year?

We hear a lot of CEOs and boards refer to a "perfect storm" occurring this year, an attempt to place responsibility for their companies' results on events outside of their control. Bob Rubin, director at Citigroup, recently said it wasn't realistic to expect a year ago that housing prices would drop as precipitously as they have. Although no omniscient board has yet been found, there are many that did an excellent job at protecting and growing capital in the last year.

As activists challenge the poorer-performing boards, the result will be stronger companies and better performance in the future. If these shareholder representatives are not questioned and are allowed to continue rubber stamping the will of management, we will have learned nothing from the debacle of the last 12 months.

At the time of publication, Jackson and his fun had no positions in stocks mentioned.

Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

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Tuesday, November 18, 2008 Activist Investor: Goodbye, Yang, Hello, Change?


by Eric Jackson

11/18/08 - 03:14 PM EST

Jerry Yang still bleeds purple, but he announced Monday night that he'll no longer do so in the CEO cubicle.

His agonizing 16-month tenure as CEO of Yahoo! (YHOO Quote - Cramer on YHOO - Stock Picks) has been marked by intense shareholder upset over his rebuffing Microsoft's (MSFT Quote - Cramer on MSFT - Stock Picks) offer to buy his company at triple its current valuation, as well as a continuous outflow of top talent.

Yang is a good man and will always be associated with co-creating an Internet icon. Unfortunately, he will also now be inextricably linked to his turbulent tenure as CEO and the busted Microsoft deal. And now Yahoo! needs to find someone to take over the helm. It's a huge decision.

The Yang Months

Yang's two biggest weaknesses as a leader were people-picking and tough decision-making. He was instrumental in Terry Semel being selected as his predecessor, and Semel probably played a strong role in him getting the top job last year. Both picks, in retrospect, severely hamstrung the former high-flying company. Once in the CEO role, Yang promised 100 days to analyze the business and come to some important strategic decisions about the redirection of the business. That self-imposed deadline came and went with no action.

While Yang should be consulted regarding the selection of the next CEO of Yahoo!, he clearly should take a back-seat role to the rest of the search committee. While many viable candidates are out there, I doubt any will want to jump to the sinking S.S. Sunnyvale. It would have been much different a year ago, but most of the best candidates will not want to take a two-month stop-gap stint awaiting Microsoft to return to claim Yahoo!'s assets.

There's lots of blame to go around for the current sad state of affairs at Yahoo!, but the press has focused too much on Yang as CEO and not enough on the board. Ultimately, Yahoo!'s failures in negotiating the deal with Microsoft rest with the board.

Chairman Roy Bostock was tied at the hip to Yang for most of the Microsoft discussions. He also received less than 50% shareholder support for his re-election last August, if you also count the votes that Carl Icahn's proxy slate received before he called off his proxy contest. Now, Bostock will lead the search for Yahoo!'s next leader. This is how dysfunctional boards beget dysfunctional boards.

Looking Beyond Yang

Tech bloggers Kara Swisher and Henry Blodget have already floated the names of some potential successors. Here's my take of the much-talked-about top candidates to take over the chief Yahoo! role:

  1. Steve Ballmer, CEO of Microsoft. The best outcome for Yahoo! shareholders of course would be if the new search committee never selected a CEO. This company should use this change in leadership to go back and open discussions with Microsoft about selling the company. This made sense when Microsoft made its initial offer last January at $31 a share, and it makes sense (triply so) now that Yahoo! trades around $11.
  2. Peter Chernin, COO of News Corp. An ideal candidate who probably wants to spread his wings without CEO Rupert Murdoch looking over his shoulder any longer. Although News Corp's (NWS Quote - Cramer on NWS - Stock Picks) stock price has dropped precipitously over the last three months, it's still a safer bet than Yahoo!. Chernin probably would have considered moving last year, but not now.
  3. Jonathan Miller, former AOL CEO. Great relevant experience and well-liked by his staff and peers despite being unceremoniously dumped out of his former role heading up AOL. Miller recently set up a new venture fund called Velocity Interactive Group with Ross Levinsohn (ex-head of Fox Interactive Group). Icahn tried to draft him many times over the summer to take the top spot at Yahoo!, but Miller declined because he didn't want to turn his back on his new venture and his investors. He is also not likely to take the job, if asked.
  4. Ross Levinsohn. See the Miller description above. Levinsohn would be a solid choice but is unlikely to leave his current gig.
  5. Tim Armstrong, senior vice president at Google. The revenue head at Google (GOOG Quote - Cramer on GOOG - Stock Picks) has relevant experience and is probably ready to take a CEO role. Even though Google has struggled in this recession along with everyone else, it still has much more upside than Yahoo!. It would be tough for Armstrong to turn his back on that safety.
Fresh Perspective

I favor an outsider taking the reins at Yahoo! -- preferably someone who has enough experience and reputational capital that he or she can insist on reshaping the board, as well as the rest of the company. Yahoo!'s board is still very much the board Terry Semel hand-picked, and it's in desperate need of a refresh.

An insider CEO, or someone coming from the current board, would most certainly keep the company on its current trajectory, which is the slow boat to China. For that reason, Yahoo! President Sue Decker or board member Maggie Wilderotter would be poor choices. Former eBay (EBAY Quote - Cramer on EBAY - Stock Picks) CEO Meg Whitman defines "big company Internet CEO," but her last few years, marked by questionable acquisitions, and eBay's subsequent performance have diminished her luster as a candidate.

This board will be under intense scrutiny from the media but also its largest shareholders. I hope that people like Gordy Crawford of Capital Research and Mark Casey of Capital World will be heavily involved in the deliberation discussions to keep the current board members in check.

The Yahoo! board probably wants to make the "safe" choice of a big company/Internet experience/former CEO/outsider. Peter Chernin fits the bill. Miller, Levinsohn, Armstrong and Whitman would all be good choices. However, I expect none of them to be interested.

So, ladies and gentlemen, the last man standing to take the Yahoo! CEO job will be a woman: Sue Decker. She has too much baggage to be an acceptable selection for a majority of Yahoo! shareholders, but such concerns haven't stopped this board before.

At the time of publication, Jackson's fund held a short position in NWS, and Jackson held a small long position in YHOO in his personal account

Eric Jackson is founder and president of Ironfire Capital, LLC, and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

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CNBC Asia: Time for Yang To Move On

From CNBC Asia:

Mon. Nov. 17 2008 9:37 PM

Following news that Yahoo CEO Jerry Yang would step down once a replacement is found, Eric Jackson, Yahoo shareholder and managing member of Ironfire Capital tells CNBC's Oriel Morrison why it was time for Yang to go and who might take over the helm.

Click here for the video.

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Friday, November 07, 2008

CNBC Asia: Micro-Hoo by Year-End?

From CNBC Asia

November 7, 2008

A deal between Yahoo and Microsoft could come as early as the end of the year, believes Eric Jackson, managing member at Ironfire Capital, following Google's pullout from an advertising deal with Yahoo. He tells CNBC's Amanda Drury more.

Click here for the video

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Tuesday, November 04, 2008

Reuters: Yahoo’s deal with Google: Band-Aid

November 4th, 2008

From Reuters

Posted by: Anupreeta Das

So Yahoo and Google scaled back the terms of their search advertising deal in what looks like a last-ditch, attempt — at least for Yahoo — to get it past U.S. regulators.

Some analysts called it the Band-Aid deal, while others said it smacks of desperation.

Frost & Sullivan’s digital media global director Mukul Krishna said the revised terms were “more of a Band-Aid than the extensive surgery” Yahoo needs.

Barclays Capital’s Douglas Anmuth had a similar take: “We have long viewed the search outsourcing deal as a Band-Aid-not-a-panacea for Yahoo, but compromised terms or an outright rejection of the deal would likely force Yahoo to consider other strategic measures.”

Those “other” measures are a merger of Yahoo and Time Warner’s AOL unit, or Yahoo shareholders’ ultimate dream: Microsoft coming back to woo Yahoo.

Eric Jackson, the dissident Yahoo shareholder who sold his fund’s 3 million Yahoo shares in September after being convinced regulators would nix the Google deal, said: “You just gotta hope that the love bug bites Microsoft again and they want to come back.”

Sanford Bernstein analyst Jeffrey Lindsay said he expects Yahoo’s deal with Google to falter and for Microsoft to come back next year with a bid of around $20 per share. That may not sound too bad considering Yahoo is trading at $13, but remember that the last Microsoft offer had been for $33 a share.

Meanwhile, Needham & Co’s Mark May outlined six scenarios in his research note this morning:
Regulators approve Yahoo-Google deal with no additional conditions, which would likely cause short-term jump in Yahoo shares and add no more than $80 million to $100 million to Yahoo’s earnings before interest, taxes, depreciation and amortization in the first year. Remember, Yahoo had said it was expecting a cash flow boost of between $250 million and $450 million.

Regulators approve, but with stipulations, which could lead the companies to call the deal off, or if they stick with it, even smaller financial benefits.

Deal terminated, Yahoo sells search to Microsoft — but May says that would be a bad long-term strategy for Yahoo because it wouldn’t add much to earnings.

Yahoo-Google deal terminated, Yahoo and AOL merge. May says this deal would be problematic and not good for shareholders, listing integration challenges and cultural differences among other issues.

Microsoft buys all of Yahoo, which is what shareholders seem to want, but does Microsoft want it? May estimates Microsoft might offer between $20-$25 a share for all of Yahoo, but Yahoo’s board would probably not want to negotiate at that price.

Yahoo-Google deal terminated, Yahoo continues status quo. May calls it the “worst possible scenario” of the six he laid out.

The thing is, Yahoo just might choose to do nothing if the deal with Google doesn’t get through regulators. But if Yahoo does that, “stakeholders will want some blood, and Jerry (Yang, Yahoo’s CEO) will be a target,” Frost’s Krishna said.

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Tuesday, October 28, 2008 Activist Investor: Liberty Global's Spinning Wrong Way

By Eric Jackson
10/28/08 - 11:17 AM EDT

About 10 days ago, Liberty Media (LINTA Quote - Cramer on LINTA - Stock Picks) Chairman John Malone sold $18 million worth of stock in Liberty Global (LBTYA Quote - Cramer on LBTYA - Stock Picks), a video and broadband service provider catering to Japan, Europe and Chile. Although Liberty Global's stock price is down 55% in the last month, you should follow his lead and get out now ahead of earnings, which will be announced in early November.

Malone's multiple Liberty-related entities (e.g., Liberty Communications, Liberty Global, Discovery Communications (DISCA Quote - Cramer on DISCA - Stock Picks)) have one thing in common: a love for opaque corporate structures with multiple classes of voting shares. In early 2007, before the words "CDS" and "subprime" had entered our collective lexicon, such complexity mattered little compared with high-growth businesses fueled by acquisitions. Liberty Global complied with this preference and its shares peaked at $44 in July 2007. However, there's been a slow descent since then until this month when the stock has fallen off a cliff. They traded yesterday under $13.

Malone's large stock sales this month are not unique for corporate chiefs these days. Sumner Redstone of Viacom (VIA Quote - Cramer on VIA - Stock Picks) and CBS (CBS Quote - Cramer on CBS - Stock Picks) and Aubrey McClendon of Chesapeake (CHK Quote - Cramer on CHK - Stock Picks) both had to unload large amounts of shares in the face of margin calls a few weeks ago. Malone gave no explanation for his sale, although he presumably faced similar pressures, considering that Liberty Global had spent $1.621 billion repurchasing its shares in the first six months of this year at weighted prices between $34.37 and $35.55.

That cash spent on share repurchases at triple the current market price could come back to harm Liberty Global in the coming quarters, as it only had $1.2 billion in cash at the end of June and just under $20 billion in debt.

Liberty Global is essentially a Comcast (CMCSA Quote - Cramer on CMCSA - Stock Picks)for non-U.S. markets. It delivers video and Internet via broadband instead of traditional cable. It derives no revenue from subscribers in the U.S.; its customers are principally in Japan, Western and Eastern Europe, Chile and Australia. In the first half of 2008, when the notion of emerging markets being decoupled from a flagging U.S. economy was in vogue, such a portfolio would be envious. Now, it appears all these countries are in for a longer recession than the U.S.

Aside from country recession risk, Liberty Global is exposed to currency risk. Virtually all the currencies tied to Liberty Global's customers have weakened significantly between June 30 and Sept. 30. In October, the pace has dramatically increased. Hungary's forint is down 30% this month vs. the dollar, the Chilean peso is down 22.5%, and the Aussie dollar is down 31%. These three countries counted for 16.4% of Liberty Global's total revenue last quarter.

Liberty Global does have extensive derivatives to mitigate this currency fluctuation risk. And some of its debt held in these currencies will surely benefit from the strengthening of the dollar in the past few months. However, the explanations given in the most recent 10-Q make don't make clear the extent to which the company is protected. We will probably have to wait for a more complete explanation during the company's next analysts' call. What is clear is that many companies that believed they were protected from currency risk have experienced deep pain in the last few weeks (such as Citic Pacific's $2 billion loss on a wrong bet against the Aussie dollar).

Liberty Global's assets also include stakes it owns in Sumitomo and News Corp. (NWS Quote - Cramer on NWS - Stock Picks). These investments were worth $682 million at the end of June using fair value accounting. Both companies dropped 25% in the third quarter, and more in October.

When you stack up Liberty Global vs. Comcast, Liberty Global's valuation still appears too rich. Liberty Global's trailing price-to-earnings ratio is 98, with a forward P/E of 26. That is starkly higher than Comcast's trailing P/E of 16.8 and forward P/E of 13. Liberty Global also has a much lower operating margin, return on assets, and return on equity compared to Comcast. Additionally, Liberty Global's debt-to-equity ratio stands at 3.84 vs. 0.81 for Comcast.

We have seen highly levered companies with high P/E ratios -- such as Las Vegas Sands (LVS Quote - Cramer on LVS - Stock Picks) and MGM (MGM Quote - Cramer on MGM - Stock Picks) -- punished in the last few weeks, even though they had both experienced significant sell-offs over the last eight months. (Las Vegas Sands' debt-to-equity ratio is only slightly larger than Liberty Global's.) Liberty Global needs to win back the trust of shareholders by simplifying its corporate structure and fully explaining the extent of its currency exposure in next month's analyst call. Until then, investors should follow John Malone's lead and stay away from Liberty Global.

At the time of publication, Jackson's portfolio was short Liberty Global, CBS and News Corp.
Eric Jackson is founder and president of Ironfire Capital, LLC, and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

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Wednesday, October 22, 2008 Activist Investor: Ballmer Needs to Live Up to the Hype


10/22/08 - 10:00 AM EDT

By Eric Jackson

Following Tuesday's disappointing Yahoo! (YHOO Quote - Cramer on YHOO - Stock Picks) earnings, we'll see many press articles Wednesday congratulating Microsoft (MSFT Quote - Cramer on MSFT - Stock Picks) CEO Steve Ballmer for walking away from the $31-a-share deal to acquire Yahoo! a few months back. Jerry Yang and his board will be pilloried again for their arrogant decision to dismiss the buyout offer.

Yet, shareholders might soon plant a bull's-eye on Ballmer's back.

Microsoft's stock sits around $24, as it did in 1998. Like the S&P 500's returns over the past 10 years, you could also refer to that period as Microsoft's lost decade.

Microsoft has more revenue, more businesses and more employees today than in 1998. But with this, it has become more bureaucratic. It's paid out dividends and bought back stock with its considerable cash hoard. And shareholders see its grip on the PC loosening as the world moves to Web services, and Microsoft is a distant competitor to Google (GOOG Quote - Cramer on GOOG - Stock Picks) in that sphere.

Although some Microsoft shareholders I spoke to this summer were pleased that the company abandoned its foray to purchase Yahoo! at a significant premium, Ballmer's reputation among his shareholders was damaged from that episode.

More than ever, Microsoft shareholders are wondering where Ballmer is leading the company. Will Microsoft be a large cash-cow conglomerate that pays a nice dividend and grows much more slowly?

Will it make a splashy and expensive acquisition of Yahoo!, Research In Motion (RIMM Quote - Cramer on RIMM - Stock Picks), or SAP (SAP Quote - Cramer on SAP - Stock Picks) to try to keep up a faster rate of growth? Or will it be stuck in the middle of those two very different strategies, trying to do both?

It's up to Ballmer to articulate first to his board and then to shareholders (and potential shareholders) what his plans are. Eight years into his tenure, he hasn't done this.

A classic stereotype about CEOs is that those who come from a sales, engineering, or finance background tend to be more short-term focused and analytical. Those from marketing or a variety of functional background experiences tend to be more strategic and long-range thinkers.
It's not either/or, of course, as the best CEOs have a combination of short-term decision-making and street smarts, balanced with a long-range vision.

Ballmer is often described (even in his official corporate bio) as ebullient, hard-charging, passionate and dynamic. These are all fine characteristics, but clearly he's not spent enough time with shareholders selling the overall plan for Microsoft.

If you're a value institutional investor and buy into Microsoft now because of its low price-to-earnings ratio and dividend yield, you face the possibility that Ballmer might change the rules of the game next week with another "transformational" acquisition. This "undefined strategy risk" is a weight on the stock price.

Ballmer can easily correct this problem, and Microsoft has such wealth, talent and market leadership that it cannot be counted out. Despite Ballmer's enormous personal wealth, it's likely he views the next 10 years of his career as the most important. This is his time to step out of Bill Gates' shadow and truly leave his mark on Microsoft.

I believe the "growth model" of Microsoft is a more compelling vision than the "utility model." To execute that vision, he will probably need to shed some businesses to increase its focus.

We'll see whether Ballmer can make this elephant dance.

At the time of publication, Jackson's fund owned no Microsoft or Yahoo! Jackson still personally holds a small long position in Yahoo! in his personal account.

Eric Jackson is founder and president of Ironfire Capital, LLC, and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

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Wednesday, October 15, 2008

Directorship: Election Disconnection

From Directorship
October 01, 2008

Yahoo’s flawed shareholder vote casts a shadow on the proxy-voting process.
by Django Gold

In the year since the furor surrounding Yahoo’s 2007 shareholder meeting and then-CEO Terry Semel’s subsequent resignation, the beleaguered Internet giant’s affairs have continued to slide. Facing a botched—some critics would say sabotaged—deal with Microsoft and the increased ire of investors who had endured a steady decline in stock value, the Yahoo board looked like it was heading for another trip to the woodshed. Shareholders and the media were calling for reorganization among upper management, and though Carl Icahn had secured his three board seats and was for the moment placated, there were many other shareholders who were out for blood.

Despite the energy of Yahoo’s critics in the weeks leading up to the August 1 annual meeting, the event itself seemed remarkably sedate. In fact, when the proxy votes were posted that afternoon, no director earned less than 78 percent approval—by no means a show of rousing support, but nowhere near the revolution that some had expected. Members of the media consequently dubbed the meeting a virtual non-event; the board had successfully weathered the storm and shareholders seemed more content than anyone had expected. “It’s almost as if the past six months never happened,” noted BusinessWeek in its coverage of the annual meeting.

Many dissident shareholders weren’t pleased with the meeting’s benign results. Others, among them Eric Jackson, founder of Ironfire Capital, an activist investment firm that owns about 3.2 million Yahoo shares, didn’t believe them. In a blog post on his website, Jackson questioned the validity of the election.

While allegations of wrongdoing in director elections are extremely rare, Jackson is not the first to cry foul. The proxy voting process is complex, obscure, and, as underscored by Jackson’s complaint, woefully imperfect.

Through the complications of custodial ownership (85 percent of shares are controlled by custodians—banks and brokerage firms) and the sheer scale of an election in which hundreds of millions—and sometimes billions—of votes are cast and counted, the proxy-voting process can be a web of confusion. A widely circulated essay on proxy voting titled “The Hanging Chads of Corporate Voting” describes the process as “noisy, imprecise, and disturbingly opaque.” Edward Rock, one of the paper’s co-authors, claims that “most of the people who run companies and administer the rules that govern them do not understand how proxy voting works.”

For example, Jackson knew that something was wrong with the Yahoo results, but he didn’t know how to prove it. Instead, he noted an inconsistency in the number of votes cast. He found that the publicly posted results from Yahoo’s 2007 proxy indicated a total of 1.2 billion votes, with the 2006 vote count closer to 1.3 billion. The 2008 vote count? Just under 1.05 billion—200 million fewer than the average of the last two years.

“It was bizarre,” says Jackson. “Given the increased scrutiny and media attention, there’s no reason for such a drastic drop [in shareholders casting votes].” Jackson posted the findings on his blog and shareholders took notice.

Gordon Crawford, portfolio manager for Capital Research Global Investors, which owns a 6.2 percent stake in Yahoo, immediately requested a recount from Yahoo and Broadridge Financial Solutions (formerly ADP), the proxy-services manager that administered the vote. Broadridge performed the recount with disarming speed: On August 5, Yahoo issued a press release claiming a “truncation error” that resulted in some directors getting fewer “withheld” votes than had actually been cast. The modified count added 200 million votes to three directors’ “withheld” column—CEO Jerry Yang and chairman Roy Bostock among them—and 100 million to two others. The changed votes weren’t enough to dislodge any directors (Bostock’s 39.6 percent disapproval was highest), and the overall vote count—1,046,098,584—remained the same. Yahoo maintains that the mishap was an honest mistake. Critics aren’t so sure. The problem is that without much transparency in the system, shareholders like Jackson are forced to take Yahoo’s and Broadridge’s word for it.

Nuts and Bolts

When a proxy vote occurs, the “issuing company” must perform a number of duties besides producing the proxy card and its accompanying literature, including identifying the shareholders. As most of the shares are held by custodians, the issuer must identify these custodians and determine the number of shares held by each. This is accomplished by soliciting the Depository Trust & Clearing Co. (DTCC), the holder and “bookkeeper” of the vast majority of all securities held in the United States. The task is complicated by the fact that custodians frequently lend the shares out to other institutions.

Because most investors prefer not to let the issuer know their vote, it is necessary to use a third-party administrator to find the beneficial shareholders. The administrator’s duties also include issuing and collecting the vote. The administrator is hired by the custodians, but is paid by the issuing company. The dominant administrator in this process is Broadridge, which administers most of the proxy votes in the United States—“the lion’s share,” according to a company representative. An archived SEC filing on Broadridge’s website claims the company processed 70 percent of all U.S. shareholder votes in 2006.

It is only after the voting rolls have been determined that the vote can take place. The administrator collects proxy-voting materials from the issuing company and transmits them to the beneficial shareholders. This is accomplished by either mailing voting materials (which include an individual ballot along with a proxy statement and the issuing company’s yearly report) to the beneficial owner, or posting them online so electronic votes may be cast.

After voting has closed, the administrator sends the returned votes to a separate transfer agent (also paid by the issuing company), who counts the votes and determines the
results. For votes that could be contested, such as elections at companies with shareholder unrest, a tabulator instead counts the votes. Two major tabulators are IVS and Corporate Election Services (which tabulated the contested Yahoo vote). After the tabulator or transfer agent counts the vote, making sure that the total number of votes cast matches the issuer’s records, the results go back to the administrator, who reports them to the issuer, and then the issuer releases them to the public. “It is a difficult, obscure, and complex system,” says Rock, “and with a system of this complexity, things will invariably go wrong.”

It’s not just complexity that raises the possibility of problems. Another obstacle is the narrow window in which the vote must be conducted. Delaware corporate law mandates that the “record date”—the point in time prior to a shareholder meeting at which the shareholder voting rolls are determined—must be within 10 and 60 days of the meeting. Most companies take the full allotment to allow for potential hiccups, but sometimes 60 days isn’t enough. Each of the steps required to ensure a smooth vote can take days and even weeks, and there are innumerable reports of voting materials never making it to shareholders, or of voting materials arriving well after the vote has concluded.

Another problem that accompanies the record date is the routine practice of securities lending. Voting rights go to the borrower of the share, usually a short seller, who ostensibly has an interest in seeing the share price decline. Therefore, short sellers may be inclined to vote against directors to foster the impression of turmoil at the company.

As in many corporate affairs, the specter of conflict-of-interest also rears its head during the proxy-voting process. In a given shareholder vote where the issuing company’s board is at stake, the conflict can be defined as the issuer versus the shareholders. But the issuer also happens to be in charge of controlling the vote up to a point, after which control cedes to an administrator, who is paid by the issuing company. This fundamental bias present in a proxy election means that the odds are, by default, positioned in the issuer’s favor, especially because abstaining votes (or those that never arrive in the first place) generally count in the existing board’s favor.

But none of these obstacles would matter were it not for the fundamental flaw in the proxy-voting system that Rock views as the chief impediment to legitimate elections: the lack of transparency in the process as a whole. “In any election, you want to establish an end-to-end audit trail so that you can show the vote was fair and accurate,” says Rock, “but the current proxy-voting system is too complex to allow that to happen.” Very few votes are contested, and regulators such as the Securities and Exchange Commission rarely probe into specific proxy contests. Critics charge that there are insufficient checks on the process to ensure that voting moves smoothly and in accordance with proper conduct. It is this lack of transparency that leaves shareholders, company personnel, and regulators in the dark.

In the Yahoo case, this lack of transparency has been a source of frustration for certain shareholders. “No one from Yahoo or Broadridge has provided an answer to where the extra votes went…it doesn’t give you confidence that they went back and analyzed the votes. It’s more like they just wanted a quick fix,” says Jackson.

Chuck Callan, Broadridge’s senior vice president of regulatory affairs, called the error “an isolated incident brought about by a confluence of factors,” and claimed a review of past votes found that no such error had occurred previously.

A Voting Monopoly

With its “lion’s share” control of the U.S. proxy-services market, Broadridge has a kind of monopoly that most companies dream of. Since Broadridge (then called ADP) began offering proxy-voting services in 1989, it has come to define the industry. In its first year, it administered voting for 31 client custodians; today, Broadridge annually processes around 818 billion votes in 14,000 elections.

Broadridge cites a variety of internal and external checks to ensure the integrity of its system, including annual reviews with both the SEC and NYSE. It also reports that its voting system—which constantly moves towards electronic recording and away from paper ballots—saved clients almost $500 million in the recent proxy-voting season. Broadridge’s services are “unparalleled in the public market,” Callan says.

But critics like Rock continue to cite transparency as being essential to an accurate and trustworthy voting system. “If the public had access to the vote, we could be confident in Broadridge’s ability to effectively administer the proxy,” he says, “but without that transparency, we can’t trust that this huge and complex process is going through without a hitch.”

A Better Way?

Identifying a problem is easy, but how to revamp a system as complex and far-reaching as proxy voting? An end-to-end audit trail that would allow a given proxy-election’s results to be verified by a third-party would require regulators such as the SEC to increase oversight and develop new methods to probe a given vote.

“Investors would feel better assured that their best interests were being looked out for if there was more oversight by the SEC,” says Patrick McGurn, special counsel at RiskMetrics. “Shareholders need to know that their vote counts, and that means more oversight on more levels. If there were more independent inspectors, voters would have better faith in the system.”

In their paper, Rock and co-author Marcel Kahan propose an outright “redesigning of the architecture” in which the complexities of the custodial ownership system of share-voting are discarded in favor of the “Spanish” model. Spain’s public companies distribute shares to investors through a centralized bookkeeping system in which the company registers its stock sales through a depository known as IBERCLEAR. Through this method, third-party intermediaries such as investment banks and stock brokers are not involved in the voting process; when a proxy vote occurs, the third-party vote administrator just has to contact IBERCLEAR to determine who should receive proxy materials.

The proof of the efficacy of this system is the fact that voter rolls are taken a mere five days before the shareholder meeting, not the 10-to-60-day window offered in the United States. One vote for one share, and one regulatory system to keep the numbers in line. “I’m not sure how easy it would be to implement,” says McGurn, “but the more streamlining, the better.”

We May Never Know

Several months after the Yahoo share-holder meeting, the controversy surrounding the alleged missing votes has for the most part faded from the public eye. Yahoo’s board remains whole—Carl Icahn’s negotiated additions notwithstanding.

Eric Jackson’s disappointment in what he now refers to as the “scandal” also remains. “I’m frustrated with how the voting scandal played out,” he says. “Yahoo’s strategy was ‘put your head down and hope it goes away,’ and that’s exactly what happened. It may have just been a mistake on Broadridge’s part, but Yahoo cooperated with it, and so we’ll probably never know just what happened with the vote.”

For Jackson, frustration with the outcome of the Yahoo vote gave rise to a brief flurry of media attention, but ultimately led to no changes in the makeup of the Yahoo board. However, this brief time in the limelight was perhaps not in vain, as it exposed deficiencies of proxy voting as a whole.

As companies and regulators consider the possibility of improving the proxy-voting process, expect more complaints like Jackson’s. Expect, too, that the conversation will likely emerge in the forefront of regulatory discussion.

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