“A culture of greed and self-dealing has run amok.”
—J. CARLO CANNELL, 2005
“Without having the candor to admit it, the opposition is saying ‘no’ to growth and proposing immediate, drastic cuts to compensation that, if enacted, will inevitably drive away key personnel and diminish the value of our existing business.”
—JOHN A. LEVIN, 2005
THE MOST NOTORIOUS CASE within the canon of failed shareholder activism is Bill Ackman’s “Think Big” campaign at JCPenney. Mention the letters J-C-P to money managers and you’ll usually get a response that combines rage and schadenfreude. Ackman runs a hedge fund called Pershing Square Capital Management, which has been very successful employing an ultraconcentrated value investing strategy. It now manages more than $15 billion.1 Once most hedge funds get to this size, they start to tone down their investing style in favor of a more conservative, index-tracking approach. Ackman, to his credit, has stayed true to his roots. A recent SEC quarterly holdings report shows $13 billion spread over just seven stocks.2 Because he makes relatively few moves, and many of those have been huge home runs, Ackman is closely watched by the whole of Wall Street.
Bill Ackman is known for his silky-smooth delivery of incredibly detailed and lengthy presentations. A 52-page whopper on Burger King, 78 pages on McDonald’s, 101 pages on General Growth Properties, and, why not, a 342-page presentation on Herbalife. His 63 pages of thinking big about JCPenney outlined an ambitious vision for the company’s future but the investment thesis was simple. JCPenney owned 49% of its real estate and leased the rest at below-market rates. The company had some economies of scale with $17 billion in annual sales and a $1 billion marketing budget.3 Although even a modest turnaround in its operations would generate good returns for shareholders, Ackman aimed higher. He saw JCPenney as a blank canvas for the right retailing visionary.4 He found his artist in Apple’s Ron Johnson.
But at JCPenney, Johnson failed to re-create the success he had at Target and Apple. His effort to wean JCPenney’s customers off of big-discount promotions instead drove them away. Same-store sales plummeted 25% and what was once a very low cash-flow business turned into a very high cash-burning one. The board aborted Johnson’s effort to turn around JCPenney, after just seventeen months. Even Ackman had harsh words, saying Johnson and his team had made “big mistakes” and the company’s execution had been “very close to a disaster.”5 Within five months Ackman would sell his entire stake in JCPenney, reportedly for a loss of more than $450 million.6
Despite the crushing result for shareholders, I’m not convinced JCPenney belongs in the bad-activism canon. When the company’s board unanimously hired Johnson away from Apple, investors were giddy with excitement. Bill Ackman and the rest of JCPenney’s board of directors took a calculated risk on behalf of shareholders by going with Johnson, and it was a sensible move despite the outcome. That JCPenney has become synonymous with bad activism shows us the difficulty of post facto analysis in a results-oriented business.
Judging activism purely based on stock performance can be tricky and superficial. For example, many interventions result in a sale of the company that generates positive stock returns. The actual impact of a sale on long-term shareholders, however, is not so clear-cut. When it forcibly separates an underperforming, entrenched management team from a valuable business, shareholders usually benefit. But when a buyout premium does not fairly compensate shareholders for likely future gains, then holders have been hurt, even though the stock has gone up. Recent academic research defending shareholder activism treats buyouts at a premium as unequivocal positives.7 They definitely are not. When fund managers talk about their most frustrating experiences as investors, many of them involve low-priced buyouts.
To properly evaluate an activist situation, we need to look beyond the stock price performance and understand what really happened to the business and why. We should also consider what would have transpired had the activists never gotten involved. With this in mind, let’s examine the pitiful situation at BKF Capital Group, where an activist campaign in 2005 resulted in total value destruction for shareholders. But for the celebrity status of Bill Ackman, BKF would be the poster child for activism gone awry.
TIMBER I’M FALLING
Baker, Fentress & Company traced its roots back to the 1890s, when it was a Chicago investment bank specializing in the timber business. Starting in the early 1940s, it liquidated its ownership interests in dozens of lumber and logging companies and invested the proceeds in public equities.8 By 1995, Baker, Fentress was a closed-end fund managing $500 million in passive investments, and a controlling interest in Consolidated-Tomoka Land Company, one of its legacy timber holdings. But the company was a dinosaur. Its portfolio had drastically underperformed the S&P 500 since 1987, when James Fentress, who had run the company for almost twenty years, passed away.9 Baker, Fentress traded at a steep discount to its assets, so it could not raise capital without diluting existing shareholders. Chairman James Gorter believed that the best way to grow the company was to start managing outside money, but recent underperformance made it hard to attract clients.
In June 1996, Baker, Fentress bought John A. Levin & Company, a money manager that specialized in large-cap value investing. The firm managed over $5 billion, up 40% from the previous year, and had generated strong investment returns since its inception in 1982. John A. Levin’s eponymous founder had been director of research at Loeb, Rhoades before leaving in 1976 to become a partner at hedge fund Steinhardt Partners. Levin’s own firm started out managing long-only investments for high-net-worth individuals. By the time Baker, Fentress bought it, Levin’s institutional clients made up more than 80% of his asset base. He had also recently launched a few hedge fund strategies. The deal gave Levin’s firm access to a large, permanent capital base from which it could seed new fund strategies.10 As part of the deal, John Levin became Baker, Fentress’s largest shareholder and CEO.
Levin’s company, renamed Levin Management, continued to grow under Baker, Fentress. By the end of 1998 it managed $8.3 billion and was producing healthy growth in its hedge fund assets. The firm’s largest hedge fund was its event-driven strategy, co-managed by John’s son, Henry. Hedge funds were a valuable growth opportunity for Levin in part because of their aggressive fee structures.11 In 2000, Levin Management’s fee revenue from its traditional long-only assets was $41 million. The hedge funds, which accounted for only about 10% of the firm’s total assets, generated $34 million. That year, Henry’s fund crossed $1 billion in assets.12
Despite Levin Management’s growth, Baker, Fentress continued to trade at a large discount to the value of its assets. Closed-end equity funds were out of favor as it was, and Baker, Fentress was a particularly odd duck with stakes in Levin and Consolidated-Tomoka. In 1999, the company decided to deregister as an investment company, liquidate its portfolio, and distribute cash and shares of Consolidated-Tomoka to shareholders. This was an excellent outcome for shareholders, who finally received fair value for Baker, Fentress’s equity portfolio. The remaining entity was renamed BKF Capital Group and consisted solely of the Levin business. “I thought that was an incredibly shareholder friendly event,” John Levin recently told me.13 But it also overhauled the stockholder base in a way that opened the door for activist investors.
AFTER MORE THAN a hundred years in existence, Baker, Fentress was about to disappear. Investors who held the dividend-paying, closed-end fund would end up with a small operating business focused on investment management. As Glenn Aigen, BKF’s CFO, remembers, “Once we deregistered as a closed-end fund . . . the shareholder base completely changed from a mutual fund and high-net-worth individual base to a more institutional base, being specifically hedge funds.”14 Big structural turnover in a company’s shareholder base often results in the stock getting quite cheap, and Baker, Fentress attracted a lot of value investors. Mario Gabelli acquired a large stake. Even Warren Buffett bought shares for his personal account right before the company distributed its assets.15
In the early 2000s, BKF Capital Group became a trendy stock pick for value-oriented hedge fund managers.16 The long thesis was straightforward. Most analysts value money managers at a percentage of assets under management. BKF looked very cheap in this regard—its enterprise value as a percentage of managed funds was lower than other public asset management companies. Adding to the enticement, unlike most of its peers, BKF had a rapidly growing hedge fund business. There were very few public companies with direct exposure to hedge funds. As all the hedge fund managers buying BKF in the early 2000s understood, the industry was experiencing explosive growth.
At the end of 2003, BKF Capital had $13 billion in assets under management. The event-driven hedge fund topped $2 billion and generated $51 million in fees for the year. But despite BKF’s rapid growth and its $97 million in fee revenue, its stock was lagging. For most of the year the company was valued at less than $150 million by the market. At one point the market value fell under $115 million, well below what Baker, Fentress paid for John A. Levin in 1996, when it managed significantly less capital. Shareholders began to lose their patience.
When you value a business based on its revenues rather than its cash flows, you are making implicit—and often optimistic—assumptions about its cost structure. But BKF’s costs, especially employee compensation, were very high, and there was no indication that John Levin had any interest in moderating them. Many of BKF’s investors eagerly awaited the day that the company’s hedge funds really took off. But when it finally came, it exposed the flaw in the investment thesis: When BKF’s hedge funds earned a large incentive allocation, most of it went to compensate employees rather than shareholders. This highlighted a deeper, structural problem with the company. BKF’s employees did not own many shares. John Levin himself only owned about 10%. Their incentives did not line up perfectly with shareholders’.
Levin initially believed that he and his son were so important to the business that nobody would want to make a hostile attack on the company.17 He also had a star-studded, independent board of directors including James Tisch, Burton Malkiel, Dean Takahashi from the Yale endowment, and investment bankers Anson Beard and Peter J. Solomon. But in 2001, shortly after entities controlled by Mario Gabelli crossed 9% ownership, BKF installed a poison pill with a relatively low 10% threshold. A month later, Gabelli said it would submit a proposal at the upcoming annual meeting that BKF redeem its poison pill unless approved by shareholders.18
Stockholder proposals to redeem the poison pill received overwhelming support at BKF’s 2002 and 2003 annual meetings. But the proposals were not binding, and the board chose to ignore the recommendations. In September 2003, James McKee, Gabelli’s general counsel, sent BKF a spirited letter about the poison pill. He wrote, “It is time to hold companies accountable for their actions and restore the checks and balances in corporate boardrooms and executive suites. This is not the time for companies to build moats around themselves with poison pills and ignore the voice of their shareholders.”19
Two months later, Phillip Goldstein, a former civil engineer for New York City who embarked on a successful second career investing in undervalued closed-end funds, filed a 13D and submitted a shareholder proposal that BKF sell itself. In his supporting statement he wrote, “BKF’s ratio of market capitalization (market price of equity plus debt) to assets under management is just 1.3%. That is significantly lower than the ratio for other investment management companies. For example, Franklin Resources (‘BEN’) shares trade at a ratio of 4.4%, Janus Capital (‘JNS’) at 2.9% and Waddell and Reed (‘WDR’) at 7%. We think the primary reason for BKF’s low multiple is its excessive expenses. In 2002, compensation expenses consumed approximately 69% of BKF’s revenues vs. 25% for BEN, 30% for JNS and 13% for WDR. . . . In short, we think the surest way to enhance stockholder value is to immediately engage an investment banking firm to evaluate alternatives to maximize shareholder value including a sale of the Company.”20
Beyond shareholder proposals, McKee’s letter on behalf of Gabelli threatened the nomination of directors for the 2004 annual meeting. But the meeting came and went without a proxy fight—just another bid to repeal the poison pill that would be ignored by the board. Despite several years of palpable shareholder discontent at BKF, nobody had been willing to put up a fight for board representation. This was about to change. In April 2004, Steel Partners filed a 13D showing a 6.5% stake.
READY FOR A FIGHT
Steel Partners was founded by Warren Lichtenstein in 1990. It was one of the first firms to utilize an activist investing strategy within a hedge fund structure. Lichtenstein’s aggressive style was modeled on Carl Icahn’s. Like Icahn, Lichtenstein operated with an urgency to generate immediate results. Many hedge fund activists will fill their proxy materials with nods to long-term value and long-term shareholders. Lichtenstein cut right to the chase: In a letter he wrote to the CEO of SL Industries in 2001, he explained that his slate of directors “will take all necessary action in order to create short-term value for the SL shareholders.”21
Steel Partners came to BKF with a fourteen-year history of running activist campaigns against small public companies. With Steel involved, there was a certain inevitability to fundamental change at BKF. The company had alienated its investors for three years with high employee compensation and refusal to redeem the poison pill. Steel Partners was a willing fighter, so either the two sides would negotiate a settlement that restructured the board, or Steel would wage a proxy fight and win. The only plausible alternative outcome was the immediate sale of the company. The market responded enthusiastically. Between Steel Partners’ 13D in April and its first public letter to the company in December, BKF’s stock appreciated 24%.22
On December 16, 2004, Steel Partners demanded that BKF immediately add three shareholder representatives to the company’s board of directors. Warren Lichtenstein’s accompanying letter to the board outlined his case: “Although we believe that John A. Levin & Co. has and continues to serve its clients well, BKF has failed to deliver value to its owners. Frankly, we do not understand how a money management company that manages approximately $13 billion of assets and has over $100 million of revenues can lose money.”23 He continued, “[W]e believe that BKF must adopt compensation arrangements that reward its key employees for performance and align their interests directly with BKF’s clients and stockholders. Based on our observation of the long term performance of BKF, we are concerned that BKF’s Board runs the Company as if it were a private company that is not accountable to its stockholders. . . . To be clear, our goal is simple and straightforward—to promptly and immediately increase value for ALL of BKF’s stockholders.”24
When John Levin and the rest of the BKF board did not meet Lichtenstein’s demand to immediately add new directors, Steel Partners nominated its own slate for election at the upcoming annual meeting. Because of BKF’s staggered board, there were only three board members up for election: John Levin, Burton Malkiel, and private equity investor Bart Goodwin. Steel Partners nominated Lichtenstein, investor Ron LaBow, and Kurt Schacht, who had operating experience at several large money managers.
The proxy fight was concentrated into about three weeks, from mid-May until early June 2005. Steel’s message strayed little from the charges in its first public letter. It focused on BKF’s high employee compensation and low operating margins, as well as entrenchment devices like the poison pill, the staggered board, and anti-takeover provisions in the charter and bylaws. Steel also targeted related-party transactions, including Henry Levin’s $9 million in compensation in 2004, and $175,000 in consulting fees paid to John Levin’s daughter.
BKF’s board argued in its defense that the company’s long-term strategy to grow assets necessarily compressed near-term margins. The company’s May 18 proxy filing stated, “[W]e feel that our decision to seek to pay compensation competitive with that offered by larger or private investment management firms will provide us with the opportunity to retain and attract the personnel required to bring the firm to a scale at which it can produce higher profits. . . . While we understand that our margins are lower than competitors who are much larger than we are, we do not believe that measures designed solely to improve margins in the short term, or a focus solely on maximizing margins, rather than on absolute profits, in the longer term, will ultimately maximize shareholder value.”25
The two sides exchanged blows for several weeks. Steel pounded BKF on its corporate governance practices and won support from proxy advisors Institutional Shareholder Services (ISS) and Glass, Lewis. BKF responded by pointing out related-party transactions at companies where Steel served on the board. A May 26 letter from BKF’s board said, “On the corporate governance front, Steel Partners has hardly been a role model. . . . Mr. Lichtenstein’s hypocrisy in campaigning on a corporate governance platform is breathtaking.”26 BKF highlighted the good performance of its stock, even though much of the rally came after Steel publicly disclosed its stake. Steel called for higher dividends or a share repurchase.
BKF also asserted that Steel Partners might have ulterior motives in investing in a competing money management firm. The board wrote that Steel might move in on BKF’s assets to try to generate fees for itself.27 BKF’s board concluded, “Please do not be fooled—Steel Partners is not primarily interested in corporate governance or in representing the interests of all stockholders. It is in this contest to further Mr. Lichtenstein’s personal interests.”28 Lichtenstein scoffed at the idea he was interested in pilfering BKF’s assets for Steel’s benefit. He wrote that Steel’s reputation depended on protecting value for all shareholders, and he pointed out that BKF’s other angry investors were all in the money management business. He added, “Any inference that we may have ulterior motives has no merit and is a smoke screen to cloud the real issues in this election.”29
The BKF Capital Group proxy fight was pretty standard fare through the end of May 2005. Steel Partners was having success using its time-tested proxy fight formula. It repeatedly stressed its core argument—that BKF’s financial performance was depressed because of excessive employee compensation—while piling on with whatever else it could think of, including corporate governance initiatives, calls for higher dividends, and accusations of insider dealing. BKF Capital was trying its best to deflect Steel Partners’ attacks in order to keep shareholders focused on the director election, and the company’s success growing assets under management. Then, just eight days before the shareholders’ meeting, a hedge fund manager named J. Carlo Cannell surfaced with a 13D letter that distilled all the BKF shareholder discontent into a stinging rebuke of John Levin and the rest of the directors. Levin and his board of luminaries were personally offended, and the embattled chairman responded with his own impassioned plea to shareholders.30
A DYNAMIC FORCE
In 1992, J. Carlo Cannell launched his hedge fund with only $600,000 in assets. Ten years later, he managed just under a billion dollars and was one of the industry’s rising stars. According to Institutional Investor, Cannell was the thirteenth-highest-earning hedge fund manager in 2002, with a $56 million haul.31 This ranked him ahead of big shots like George Soros, David Tepper, Eddie Lampert, and Stephen Feinberg.
Carlo Cannell ran a long-short value strategy focused on obscure, smaller capitalization companies. As he said in an interview in Value Investor Insight, “[We] spend our time trying to uncover the promising turnarounds, dullards and assorted investment misfits in the market’s underbrush that are largely neglected by the investment community.”32 While many of the fund managers on Institutional Investor’s list of top earners built large, multistrategy firms, Cannell kept his organization lean and stuck to his core investing approach. To keep his fund from growing too large, he actually returned $250 million to his investors. “The great disadvantage of our investment approach is that it’s not very scalable,” he explained.33 A lot of hedge fund managers would have kept that revelation to themselves and retained the capital (and collected the consequent fees).
Despite reaching the upper echelons of the rapidly maturing hedge fund industry, Carlo Cannell remained something of an oddity. He prided himself on being a loner in the investment world, and he rarely worked alongside other funds. At an investment conference where managers were told to pitch specific stocks, he gave a presentation on the extinction of Hydrodamalis gigas, aka Steller’s sea cow.34 In 2004, after several years of returning capital to his investors, Cannell stepped away from his thriving business altogether to sample retirement. “When Cannell Capital was in diapers, I regretted neglecting my family,” he announced at the time. “Now that my son is in diapers and the business is not, I have decided to take some time off to be with them.”35
After six months, Cannell missed the search for investment misfits and dullards. He came back with a renewed focus and found BKF Capital, which he saw as a growing company whose earnings were depressed because of bad management. Given the unhappy shareholder base and the presence of capable activist investors, BKF’s problems didn’t seem like they would be too hard to fix. Cannell disclosed a 5% stake on February 14, 2005, the same day as Dan Loeb’s Valentine’s Day massacre at Star Gas. He upped his holdings in BKF to almost 9% as the proxy fight heated up.36
While Steel Partners founded its business around activism, Cannell embraced it as a necessary weapon to protect his investors. Years of investing in small public companies hardened him in the same way it had hardened Dan Loeb. Cannell had a strong sense of right and wrong, and felt compelled to act when businessmen with bad intentions harmed his investors. “When I see clearly that people are stealing from my limited partners, it’s a breach of duty to do nothing,” he told me.37 In the case of BKF, Cannell objected to Levin’s unwillingness to produce profits for his public investors out of the firm’s $120 million in fee revenue. “All he needed to do was be self-aware of the structural issues that were inappropriate,” said Cannell. “The egregiousness was fairly blatant. It wasn’t debatable . . . it wasn’t subjective.”38
Though J. Carlo Cannell is an unconventional money manager, he comes from a storied line of financiers. He’s the grandson of investment banker Ferdinand Eberstadt, who had brilliant careers on Wall Street and in Washington, where he was a frequent advisor to the U.S. government. Among Eberstadt’s business accomplishments, he founded Chemical Fund, the first mutual fund to reach a billion dollars in assets under management.39 Carlo’s father, Peter B. Cannell, started his career as a copywriter for BBDO, a large advertising agency. Peter’s father-in-law pressured him to come to Wall Street, where he later became president of Chemical Fund. Peter started his own firm, Peter B. Cannell, in 1973. It generated 16% annualized returns through his retirement at the end of 2004.40 Peter’s colorful letters to investors, in which he channeled his inner David Ogilvy, were passed around Wall Street much the way Howard Marks’s memos are today. Like his son Carlo, Peter Cannell was critical of Wall Street management teams and had a fondness for sharply written copy—he wrote a letter in 2000 titled “Dumb.com” about how Internet companies were wasting shareholder money on terrible ad campaigns.41
But Peter Cannell didn’t use his poison pen directly on his target companies. As one of his coworkers said in an interview in 1997, “We are plain vanilla investors. We shy away from controversy. If a holding becomes controversial, we sell it.”42 Carlo shares his father’s facility with words, but when it comes to underperforming companies he resembles his grandfather, who was described in one book as “the embodiment of dynamic force.”43 His letter to BKF Capital Group on June 1, 2005 (page 236) is proof. It opens:
“When, O Catiline, do you mean to cease abusing our patience? How long is that madness of yours still to mock us? When is there to be an end of that unbridled audacity of yours, swaggering about as it does now?”
Thus, in 63 B.C., did Marcus Tullius Cicero expose corruption and vice in the Roman Senate in his First Oration Against Lucius Catilina. His words are relevant today as we study the record of BKF Capital Group.
Cannell begins by targeting BKF’s low profit margins and high employee compensation: “Costs are exorbitant. . . . Incremental revenues are sucked up by inflated salaries; as a result, BKF continues to lose money, even as assets and revenues have grown 18% and 64%, respectively, over the last five years.” He then writes about the rich compensation of Henry Levin and the other senior managers of the event-driven hedge fund: “None of the Managers’ compensation is in the form of BKF equity. None of their compensation is in the form of long-term incentives, which would encourage retention. How are these arrangements supposed to align the interests of the Managers with the well-being of your stockholders? All this excess would be dandy in a private company, but BKF is public.”
Regarding BKF’s expenses, Cannell complains,
The callous conflagration of shareholder assets by BKF galls us as it would gall Cicero. When we visit companies, we stay at $39.95 motels, not fancy hotels with fruit at the “reception” desk. . . . My visit to your offices on May 26, 2005 left me astounded that such an unprofitable company would house itself in some of the most expensive office space in America. Your 56,000 square foot office in Rockefeller Center immolates cash at the expense of BKF’s shareholders. . . . I appreciate the lavish spending of casinos as they lure “whales” to their tables, but this acceptance is predicated upon such adornments being accretive to earnings, to bringing in profitable bacon. Your Rockefeller Center pork just stinks.
While Cannell touched on many of the same issues raised by Steel Partners, he did so in a much more provocative fashion. He singled out board members Barton Biggs, Burt Malkiel, and Anson Beard, stating, “One would expect such deportment from scalawags, but not you noble nabobs of Wall Street.” Cannell then urged the board to “(i) take BKF private and squander privately; (ii) appoint an investment banker to conduct an auction of the company, as Opportunity Partner’s Phillip Goldstein first suggested in his November 17, 2003 13d filing; or (iii) stand down and pass the baton to a shareholder-friendly board.” Cannell concludes the letter, “Cicero ultimately vanquished Catiline despite the latter’s attempt to form a rebel force with other rich and corrupt men. . . . You still have time to flee. Go forth, Catiline.”
VOTE THE WHITE CARD
As the June 9 meeting approached, momentum was clearly on the activists’ side. BKF’s previous attempts to curry favor with shareholders, including a 92.5 cents special dividend and a new policy to distribute 70% of free cash flow, didn’t have a big impact.44 Steel Partners’ calls for governance reforms, on the other hand, resonated with investors. BKF took drastic action. The company postponed the shareholder meeting for two weeks and caved on all of the corporate governance items. BKF agreed to redeem the poison pill, de-stagger the board, and amend its bylaws to allow shareholders to call special meetings. Lichtenstein scoffed at BKF’s too-little, too-late actions in a letter to shareholders:
Due to your support for our nominees and the corporate governance initiatives that we are advocating, BKF’s Board has been dragged kicking and screaming, against their will, into the modern world of corporate governance reform. . . . The fact that BKF has belatedly adopted many of our proposals and positions that we advocated much earlier we believe demonstrates that our advocacy is already yielding benefits for BKF’s stockholders. THERE IS STILL MORE TO BE ACCOMPLISHED. BKF’S BOARD STILL DOES NOT UNDERSTAND THAT THE MAIN ISSUES IN THIS ELECTION CONTEST ARE IMPROVING OPERATING PERFORMANCE AND ALIGNING COMPENSATION WITH STOCKHOLDER INTERESTS!45
To this point in the proxy contest, John Levin had kept a relatively low profile. He had not publicly responded to the personal attacks against him, and the company’s previous three proxy letters were signed “The Board of Directors.”46 On June 16, Levin decided to address the shareholders personally. He wrote a powerful rebuttal to Cannell and Steel Partners that implored shareholders to reelect Burt Malkiel and Bart Goodwin. Like William White in the 1954 New York Central proxy fight, John Levin took it upon himself to stand up to “gunpoint capitalism” in the face of near-certain defeat.47
Levin opens his letter (page 243) by explaining the decision to rescind the poison pill and de-stagger the board: “The Board of Directors of BKF recently took dramatic action to take off the table for the annual meeting all issues except the central one: which slate of candidates will produce the best board to foster the growth and success of the company.” He points out that while Steel Partners and Cannell made a lot of mean-spirited noise about reducing expenses, they offered no concrete plan to do so. Levin then argues that BKF needs to invest in its employee base so it can properly grow the business to create the most long-term value for shareholders:
So while we are comprised of experienced professionals, we are also a young public company that is seeking to develop a diversified series of investment strategies that have the capacity to grow. AT THIS STAGE OF OUR DEVELOPMENT, STOCKHOLDERS HAVE THE POWER TO DETERMINE IF WE WILL GROW OR FAIL.
After defending BKF’s spending policies, Levin then addresses accusations of self-dealing.
The attack on Barton Biggs, a universally recognized expert on the asset management industry, for paying us rent for a limited period of time for space inside our offices we weren’t utilizing and couldn’t sublet was always a joke, which people understand when we discuss it. We are being attacked for paying a relatively low amount of fees to Peter Solomon’s investment banking organization while these same attackers simultaneously criticize us for not pursuing strategic alternative to realize shareholder value.
Perhaps the most compelling passage in Levin’s rebuttal comes when he discusses his children’s compensation:
With respect to the attacks on my children, I must say they reveal much about the nature of the opposition but disclose absolutely nothing improper. Much has been said about the compensation paid to my son Henry, but I just ask that stockholders evaluate him as one of two senior portfolio managers for event-driven strategies that have generated a very significant portion of our firm’s revenues and free cash flow over the years. . . . He is paid on the basis of the profitability to the firm of the strategies he manages, which is exactly how our hedge fund manager critics pay themselves. . . . I don’t understand why being rewarded based on the profitability of the accounts he manages is no longer a valid way of looking at things. . . . My daughter, Jennifer Levin Carter, has a distinguished academic record, having become a member of Phi Beta Kappa in her junior year at Yale, and having graduated from there with distinction in molecular biophysics and biochemistry, from Harvard Medical School and from the Harvard School of Public Health. She has provided valuable research to our investment professionals on biotech and other companies within her area of expertise, and is viewed as a substantive plus by all who interact with her.
Levin accuses Steel Partners and Cannell of misleading investors by characterizing BKF as a money-losing business, when the company’s accounting losses since 2000 stem from $91 million in noncash amortization expenses. He then closes with a last entreaty:
One is supposed to conclude with a wonderful inspirational message of hope, but let me tell you the grim reality. I don’t know what any shareholder or group of shareholders is going to say or do next. It is up to the unaligned shareholders of this company to decide what the future is. There is no middle ground. Our slate is composed of outstanding individuals. Burt Malkiel is just the kind of director shareholders should want. He is a former member of the Council of Economic Advisors, a long-standing full professor of Economics at Princeton and a trustee of various Vanguard funds. Bart Goodwin is a quality investor in private equity companies. Both of these gentlemen were directors of BKF before our money management firm merged into it in 1996. They are as independent as directors can be. Vote the white card.
ON JUNE 23, BKF Capital Group shareholders elected Steel Partners’ slate of directors by a two-to-one margin.48 Chairman John A. Levin was voted out, although he was immediately invited back by the new board. When Levin and Lichtenstein took their seats in the same boardroom, however, they did not agree on a plan to move the company forward together. Barton Biggs quit the board on July 12. The company announced Levin’s resignation on August 23, though he would keep a “chairman emeritus” title. At the end of September, BKF’s assets under management were $9.6 billion, down 29% from the beginning of the year.
The bad news kept coming. On October 18, BKF announced the departure of Henry Levin and the rest of the senior managers of the event-driven team. Their hedge fund would be permanently shut down. On December 20, CFO Glenn Aigen left to go work for Levin’s new firm. The company ended the year with only $4.5 billion under management. Anson Beard and James Tisch left the board on January 10 and 11. On April 3, BKF announced that it couldn’t come to terms with two managers of $615 million of hedge fund assets. Two weeks later, one more hedge fund manager walked, forcing the liquidation of another $133 million. BKF ended June 2006 with only $1.9 billion in assets. The quarter’s revenue was just over $1 million, down 96% from the $30 million it collected a year earlier. In July, the death blow came. BKF lost its long-only manager and announced it would liquidate its remaining assets. By the end of September 2006, fifteen months after the proxy fight, BKF Capital Group had no operating business or assets.49 The stock price had fallen 90% from the day shareholders voted in the dissident slate of directors.50
A PRIVATE BUSINESS IN A PUBLIC COMPANY
If activist investors had never meddled with BKF Capital Group, there’s no doubt that shareholders would have fared better. Even if John A. Levin had continued paying 80% of revenues to employees until the end of time, the market would have valued the company higher than it valued BKF’s empty shell at the end of 2006. But BKF Capital is more than a cautionary tale about failed activism. It raises fundamental questions about the nature of public companies.
John Levin was very clear to shareholders that he was investing in BKF’s employee base to prime the company for growth. But shareholders didn’t really believe him. They were worried about Levin’s sub-10% ownership stake, and they knew there was not a strong incentive for him to tightly manage costs for the benefit of investors. Without perfectly aligned incentives, corporate governance becomes a matter of trust. But in the business world, relying on trust often backfires. BKF’s shareholders simply did not trust Levin to look out for their interests versus his employees’. BKF’s track record on corporate governance, besmirched by the poison pill and the staggered board, undermined Levin’s credibility. In the end, shareholders decided en masse to put three new members on the board of directors. Steel Partners may have been the catalyst, but there was a groundswell of shareholder discontent.
But was the shareholders’ mistrust of Levin justified? BKF did utilize anti-takeover devices and Levin did pay millions of dollars to his son, but was he mismanaging the company and abusing shareholders? The first place to look to evaluate charges of self-dealing would be Levin’s own salary. He averaged $4 million in total compensation per year for the five years leading up to the proxy fight.51 That’s certainly a lot of money, but it’s not even close to out of line for the CEO and portfolio manager of an investment company managing over $10 billion. In 1997, Levin kept about 7% of the business’s revenues for his compensation, accounting for 14% of the employees’ take. By 2004, his personal compensation was well under 3% of revenues, and accounted for just over 3% of total employee pay. It’s hard to argue John Levin was grossly overpaying himself.
Henry Levin’s pay attracted a lot of attention from the activists. He earned almost $8 million in 2003 and just under $9 million in 2004. These are big numbers that Steel Partners used to highlight BKF’s “lack of accountability.”52 But Levin was one of two senior hedge fund portfolio managers who generated $51 million of fees in 2003 and almost $60 million the following year. The hedge fund industry is famous for its “eat what you kill” compensation structures. Henry’s pay for managing a $2.5 billion hedge fund was almost certainly lower than that of most of his industry peers. (Recall that Institutional Investor estimated that J. Carlo Cannell made $56 million in 2002.)
BKF let its event-driven team keep two-thirds of its earnings.53 In the hedge fund world, this was actually a generous deal for BKF. Most hedge fund seed arrangements take a smaller 25% cut, and these deals almost invariably get negotiated down if the fund is successful—it’s almost a rite of passage to cram down your seed investor once your hedge fund is established. BKF’s activists wanted the company to restructure its compensation arrangements with its hedge fund managers, but carving out more than 33% would have been difficult.54
IN THE VERY first Steel Partners proxy in December 2004, Warren Lichtenstein wrote, “Perhaps what is most startling is when one compares BKF’s financial metrics to those of other publicly-traded money managers. Even a cursory glance at these figures demonstrates that changes are needed to deliver reasonable value to the Company’s stockholders.”55 But what happens when a cursory glance is misleading? Comparing BKF to companies like Eaton Vance or Waddell & Reed doesn’t make a lot of sense. Those were larger, diversified institutions with established brand names. It would have been impossible for Levin to achieve their level of efficiency without hurting BKF’s growth prospects.
Carlo Cannell is a very good investor. But it’s hard to overlook how a nonconformist like Cannell, who prospered under the hedge fund pay-for-performance structure, didn’t appreciate how BKF was fundamentally different from its industry peers. The great irony of BKF Capital is that the shareholders who pushed the company to reduce its compensation were highly paid hedge fund managers who should have known better. They saw a quick path to increasing earnings by cutting employee compensation, but they ended up driving away the talent. John Levin told me, “We grew from $4 billion to $15 billion. We created $50 million of cash. We distributed $680 million to shareholders, and the whole thing was destroyed by activism.”56
On the whole, I believe shareholder activism has been very good for the American economy and its public companies. I think that record profit margins achieved by public corporations since the financial crisis are at least partly due to the pervasive threat of activism. But the rise of the shareholder also promotes a bias to conformity among industry peers. Icahn’s quote about getting your stock price up before someone does it for you could be rewritten for today’s market as “Get your operating margin up to the industry norm or someone will try to do it for you.” Many of today’s shareholder activists focus their efforts on maximizing operating margins. To a fault, they don’t give much credit to uncertain growth prospects, while viewing trailing earnings as future money in the bank. This is a very different kind of activism than Benjamin Graham’s, which centered on capital allocation.
IT’S TELLING THAT almost every participant in the BKF proxy fight acknowledged different standards for public and private companies. Phil Goldstein, Steel Partners, and Carlo Cannell all asserted that BKF was being run like a private company. “I’m not judging the greed,” Cannell told me. “But that type of structure is best practiced privately.”57 Director Anson Beard, who briefly succeeded Levin as chairman of the board, told Joe Nocera of the New York Times, “It shouldn’t have been a public company in the first place.”58 Even John Levin alluded to the divide when he wrote about his son Henry, “I understand that being part of a public company must necessarily reduce the cash compensation he can earn. . . .”
Today, John Levin deeply regrets that he did not push for supervoting shares when Baker, Fentress restructured. “I made a horrendous mistake,” he said. “This sounds ridiculous, but we thought we had such a great victory in distributing $680 million to shareholders that it would be fine.”59 If Levin had secured voting control of BKF through a dual-class share structure, he would have never been voted off the board for being too generous with his employees. This highlights an interesting bifurcation occurring in the stock market today. On the one side, almost every public company with a one-share, one-vote structure is subject to shareholder activism. On the other side, a large number of companies have opted out of corporate democracy altogether by granting their founders special controlling shares. As a result, large technology companies like Google are completely immune to activism while they sit on huge cash hoards and toss billion-dollar investments into companies like SpaceX.
Google’s AdWords is literally one of the best businesses ever to exist, and shareholders have chosen to cede their oversight rights in order to participate in its growth. Google’s relationship with its shareholders is thus a matter of trust and not much else. So far, investors have been richly rewarded. Shareholders raised their eyebrows at acquisitions like Android and YouTube, but they have been huge triumphs. Still, it will be fascinating to watch how these benevolent dictatorships work out over time. Google already betrayed its original agreement with shareholders by concentrating ownership back into its founders after generous employee stock and options grants diluted their voting stakes. How long will shareholders continue to trust the company? How long can you really trust anybody that says they aren’t evil?
WHEN BKF CAPITAL blew up, John A. Levin landed on his feet. He took $2 billion in client assets to his new company and has grown it to $9 billion, mostly through new relationships. Well over half of the firm’s employees worked with Levin at BKF. “We had and have the philosophy of compensating our people very, very well,” says Levin. “One of the unique features of our present firm is that more than twenty-five people in operations, investment, and trading have stuck together, which is pretty unusual in this business. That whole culture was effectively destroyed and then transplanted.” Levin credits part of his success to not being “challenged by the problems of being public.”60
Still, one can’t help but wonder what would have happened with the business if Steel Partners and John Levin had come to any kind of compromise to work together. Several of BKF’s offshoot hedge funds, such as distressed fund Onex, went on to do very well. And Levin’s long-only business clearly thrived, with $7 billion of new capital. Cannell attributes BKF’s shareholder value destruction to an irrational scorched-earth policy by Levin. “I don’t have anything against John Levin, but what he did was stupid,” says Cannell. “It hurt him more than anyone else.”61 For his part, Levin believes the company’s demise wasn’t due to his departure. “I had a reputation, but the real talent was younger. They didn’t make any deal with the talent. The big mistake here was, I think they could have hired a lot of people, but they didn’t hire anybody.”62
BKF Capital Group is a catastrophic example of shareholder activism destroying huge amounts of value. But the market doesn’t keep track of your mistakes, and Carlo Cannell, John Levin, and Warren Lichtenstein survived to fight another day. They all walked away a little bit wiser, though also a little bit poorer. As for the remnants of BKF, the once-proud Chicago institution with more than a century of history? In 2006, it was reduced to being a shell company with a small cash balance and a large tax-loss carryforward. As you can imagine, a new pack of activist investors began circling.