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Dr. Travis Dirks has provided a guest post with important implications for activist and special situations investors. Travis is the Founder and CEO of Rotary Gallop, a company pioneering the application of Nobel-prize winning mathematics to the problem of acquiring, keeping and exercising corporate control. You can reach him at T@RotaryGallop.com

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To Fellow Greenbackd Readers:

Activists:

The advice you receive on proxy strategy is medieval. I mean that literally. It is a pocket of our world, which like baseball before Billy Bean and Moneyball, has not experienced the scientific revolution. That backwardness leads to serious strategic errors and the following post is a small example of how much better one can do.

Special Situations Investors:

We can calculate the exact odds that an activist will succeed in a proxy campaign. That makes certain activist campaigns a reliable uncorrelated class of special situations that can really boost you portfolio and help uncouple it from the market. Activist campaigns have all three legs of the special-situations stool: a clear deadline for the battle, a clear idea of the value of the company with/without their changes in place (if the activist has done his job), and the odds of success (now possible with Rotary Gallop’s tools). You can’t ask for a more textbook-perfect special situation than that!

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A current case beautifully highlights a fact we observe in engagement after engagement: going from qualitative fuzzy adjectives (traditional proxy strategy advice) to quantitative hard numbers can be a gamechanger! Even when the situation appears blatantly obvious, cold hard numbers give a new perspective like no other. Case in point: ModusLink Global Solutions, Inc (NasdaqGS: MLNK ) featuring Peerless Systems Corp. (PRLS) and Steel Partners.

For the second year in a row, ModusLink is having an eventful proxy season. For a great summary, check out the October 28th edition of the always useful Catalyst Equity Research Report . This year, management faces Peerless Systems’ seasoned activist Timothy Brog. He is backed by an amalgam of varied and vocal supporters, totaling roughly 11% ownership. This is significant activist power. Peerless is seeking to replace two directors up for election this year.

As far as we’ve been able to determine, Steel Partners, the 800-pound gorilla in the room and largest shareholder by far with nearly 12% ownership, has not publicly announced allegiance to either side. One might rightly assume the obvious: that Steel Partners is a huge prize in the contest and that they may have significant negotiating power with both management and Peerless Systems.

However, as a decision executive at one of the involved parties, how do I use this information? What do I do with an adjective like “significant” or “huge”? How do I weigh “significant” against the actual costs and changes that Steel Partners might like to see in order to support me? And what does “significant” really mean, coming from an advisor who may have a different gut-calibration than myself? Answer: It is a big fat ambiguous term that in turn results in a big fat clumsy strategy.

We can do better. Rotary Gallop’s Control Measurement  techniques crush fuzzy adjectives and presents tangible numbers. Numbers that you can touch and feel, weigh and measure, and then use to think. Numbers that exactly measure the power and influence of each shareholder. In the case of ModusLink, at Rotary Gallop we take “significant” and give you:

Steel partners has a voting power of 53%. In the upcoming proxy battle this January,  there is a 53% chance that Steel Partners will cast the deciding vote.

Take a moment to appreciate what just happened. We’ve gone from an adjective like “significant”, to knowing the odds that Steel Partners will be the deciding factor in the election. Now that is a giant leap forward! And the beauty of numbers is that we can make the connection between Steel Partners and the fate of the opposing campaigns even more direct.

Presenting Exhibit 1: Management and Peerless’s Risk of loss

We have directly measured the “significance” of Steel Partners’ decision to Peerless and ModusLink. Look at the middle gray columns in the graph below. With Steel Partners remaining undecided, ModusLink has a 65% chance of losing, while Peerless has a 35% percent chance of losing. That is a fairly wide-open race, with management winning 7 out of 20 times.

Exhibit 1:  Measuring the Risk of Steel Partners’ decision to ModusLink and Peerless

If Steel Partners sides with ModusLink (blue columns) the tables turn but the race still remains quite wide open. Peerless has a 61% chance of loss while ModusLink now has only a 39% percent chance of loss. (ModusLink now wins 12 out of 20 times). If, on the other hand, Steel Partners sides with Peerless (red columns) we have a much more drastic change in the character of the race, with ModusLink’s risk of loss shooting all the way up to 92% percent and Peerless’s dropping to only 8%!

Using an adjective, like significant, to communicate the importance of Steel Partners completely misses the key observation that their value is asymmetric. In siding with ModusLink, Steel Partners does not change the character of the race – it still remains essentially open. However, in siding with Peerless, Steel Partners makes a proxy win nearly impossible for ModusLink’s and the game changes from a contest to one of negotiations. Thus, from Peerless’s point of view, Steel Partners represents a primarily offensive opportunity (a game winning strategy), while ModusLink should see them as primarily defensive (a stay-in-the-game strategy).

Now Peerless, ModusLink, and Steel Partners all know just how valuable Steel Partner’s decision is to each party and they will all be able to make much more intelligent decisions about what concessions are and aren’t worth Steel Partners’ support. Having at least this part of the competitive landscape in sharp focus will help the decision makers at Peerless and ModusLink as they head towards the election in January. And for other decision makers and advisers our there: You don’t have to put together your strategy while viewing the battle field through a dirty coke bottle. We have satellite images!

As I sign out, I’ll note that we can go another step further and put a monetary value on Steel Partners’ Vote for both Peerless and ModusLink, but that’s a post for another day. Let me know what you think!

-Travis

Greenbackd Disclosure: No position.

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Travis Dirks has provided a guest post on the voting power of differently sized shareholdings, which has important implications for activist investors seeking to impose their influence on a management. Travis is an expert in Nanotechnology, and received his Ph.D. from the world’s leading institution for the study of condensed matter physics, University of Illinois at Urabana-Champaign. Travis has also taught informal workshops on sustainable competitive advantage, business valuation, and the wider applications of behavioral finance and prospect theory, in addition to running a concentrated deep value/special-situations equity portfolio, which has returned 69.53% since inception in June 2006 relative to the S&P 500’s -6.08%. An entrepreneur at heart, Travis has co-founded one successful local business and one technology startup. He is currently working on a book – Voting Power in Business. Travis can be reached at TravisDirks@gmail.com.

(I would greatly appreciate feedback on whether the information below is new and/or useful to you)

Process over outcome. The watch words of all great investors. By thinking probabilistically in terms of relevant long-term averages, such investors gain control over a field swayed by random events. Yet, it appears that this method of thought has not yet been thoroughly applied to shareholders’ only means of control: the shareholder vote. When probabilistic thinking is applied to the proxy battle the activist investor, and those of us who rely on him to catalyze our deep value investments, gain a counterintuitive and valuable edge! Here, I outline the strategic value of voting power – a measure of a shareholder’s true influence – via two examples: a simplified hypothetical and a real world company.

How does ownership differ from power?

Pop quiz: 1) Does 10% ownership of a company imply 10% influence on the vote? 2) Does buying 1% more of the company imply proportionally more power? 3) Is your influence on the vote impervious to other shareholder’s buying or selling?

Answers: No, no and NO!

Voting power is not related to ownership in a straightforward way – it is a function of the entire ownership structure of the company, i.e., how much everyone else owns. Voting power measures the percentage of all outcomes where a voter gets to decide the result of the vote. In fact, you can gain more or less power depending on who you buy from! The counterintuitive nature of these answers hints at an opportunity for the enterprising investor.

A simple example of voting power analysis

Alice and Bob each owned 50% of a successful rapidly growing small business. Like so many before them, they lost sight of cash flow and needed money fast. With no bank to turn to, they decided to sell 2% of their business to uncle Charlie. So the ownership structure looks like this: Alice –> 49%, Bob –> 49%, Charlie –> 2%. Does Charlie, with only 2% ownership, really have any influence on the company? The astounding fact is that Charlie now has just as much power over the business as Alice and Bob. When matters come to a vote, Alice, Bob, and Charlie are in exactly the same situation: to win the vote they each have to convince one of the other two to agree with them and it doesn’t matter which one.

Not everyone is as fortunate as Charlie – a voter can have drastically less control than his ownership would indicate. In fact, he may even have no control at all!

Let’s rejoin the story a few years later. Charlie now owns a third of the company, as do Alice and Bob. They’d like to raise more capital to buy out a weak competitor so, at Charlie’s suggestion, they do something clever: they sell Dan 20% of the business (new ownership structure: Alice –> 26.66%, Bob –> 26.66%, Charlie –> 26.66%, Dan –> 20%).  Interestingly, though Dan paid for 20% of the business, he received zero voting power! The reason is that there is no possible voting outcome in which Dan could change the result by changing his vote. All possible voting outcomes have a winning majority even without Dan’s vote! Effectively, Dan is wasted conference space. Thus:

Rule 1 of voting power analysis: a voter can have drastically more or less voting power than his ownership would indicate.

Driving strategy via voting power analysis: Breitburn Energy Partners

What strategically valuable information can such statistical analysis reveal for a large public company?  Consider such a company from my (and Seth Klarman’s) portfolio: BreitBurn Energy Partners L.P. (NYSE: BBEP)

BBEP’s is a beautifully intricate story in which the oil crash, the market crash, an angry majority shareholder, a convenient bank loan covenant, 5 years of hedged production, and the fleeing of dividend-loving stock holders combined to create the easiest purchasing decision I’ve ever made! Voting power analysis sheds new light on one part of this story – a dispute between the majority shareholder and the company over voting rights.

In June 2008 the board decided to give the limited partners the right to vote on who would sit on the board of directors—with one caveat. No one share holder could vote more than 20% of the company’s shares. In the event that a shareholder owned more than 20% of the outstanding shares, the final vote would be counted as if the rest of the shareholder’s votes did not exist. This understandably upset Quicksilver Resources Inc., who held 40% of the outstanding shares. Strategically, how should Quicksilver and The Baupost Group (the other large shareholder) react to these unique voting rules?[i]


Figure 1: Percentage ownership (blue), and voting power under two schemes –  standard (red) and BBEP’s 20% cap (green) for Quicksilver Resources Inc. and The Baupost Group, the two largest stakeholders of Breitburn Energy Partners.

In Figure 1 the blue bars show Quicksilver’s and Baupost’s percentage ownership of BBEP as of March 2010. The red bars show each company’s voting power under a standard voting scheme. Notice that under a standard voting scheme  Quicksilver has drastically more voting power than their ownership indicates and Baupost has drastically less. This disparity, with some shareholders having more power and some less, is closer to the rule, than the exception. Under the 20% cap rule (green bars), however, Quicksilver’s voting power is cut in half and Baupost’s tripled, but both have influence that is more in proportion with their ownership – a powerful insight that could have been used in BBEP’s defense in the inevitable lawsuit that followed.

The lawsuit was settled and a voting system in which Quicksilver got to vote all its shares (but others who crossed the 20% threshold did not) was agreed on. The resulting power distribution is now exactly the same as under a standard voting scheme (red bars). Therefore, in the event of a disagreement between Quicksilver and Baupost, Baupost’s chances of success are much worse than their ownership percentage would suggest.

How to use voting power analysis to minimize influence loss?

The settlement also seemed to indicate that Quicksilver would be selling down its majority position. It has already sold nearly a quarter of its holdings, most of which went to a new share holder, M.R.Y. Oil Co. Now, assuming Quicksilver would like to retain some ownership, what strategic insight can voting power analysis lead to? Because voting power is a function of both individual ownership and the overall ownership structure, it is actually possible to minimize your lost voting power (on a per share basis) by strategically selecting low-impact buyers.[ii]

Consider two options open to Quicksilver to drop below the 20% ownership threshold: selling a third of its holdings (10% of the company) to the second largest stakeholder, Baupost, or selling it to small shareholders on the open market.[iii]

Figure 2: The current voting power structure at Breitburn Energy Partners (blue: ownership, red: voting power), as of July 2010, and two hypotheticals in which Quicksilver Resource Inc. sells another 10% of the company. In the first scenario, the shares are distributed among the smallest shareholders (orange bars). In the second, the shares are sold in a lump sum directly to The Baupost Group (pink bars). The inset shows the percentage change in power from the current situation for each hypothetical.

Figure 2 shows each company’s ownership stake (in blue), as of July 2010, along with the associated voting power (in red). First, note that Baupost’s voting power has improved significantly from March (see Figure 1) without buying any shares because the ownership structure has changed. Second, Quicksilver’s voting power changes depending on whether it sells its shares to the smallest shareholders (in orange) or to Baupost (in pink). When Quicksilver sells to the masses, Baupost’s power again increases substantially, even though they have not increased their holdings by a single share! (The same is true for M.R.Y. Oil Co.) Thus:

Rule 2 of voting power analysis:  voting power can be increased by influencing others to buy or sell!

In the inset in Figure 2 we can see that if Quicksilver sells its shares to Baupost, Quicksilver loses nearly 50% of their voting power. Whereas, if they sell to smaller shareholders they lose only 37% of their voting power. Thus, even a simple application of voting power analysis has profound implications – given the choice, Quicksilver can buffer its loss of influence by a whopping 13% by distributing its shares to smaller shareholders, rather than selling a lump sum to Baupost.

Voting power analysis: what else is it good for?

Stakeholders can use voting power (and related) analysis to help guide key strategic decisions like:

  • Who to buy from and who not to buy from to maximize their purchased control
  • Who to sell to and who not to sell to minimize any lost influence
  • When to be greedy by identifying situations where the purchase of a few more shares will result in a large increase in influence
  • When not to be greedy by identifying situations when the sale of just a few shares will result in a large decrease in influence
  • How to increase their influence without buying any more ownership
  • How much of a company can be sold, while giving up ZERO voting power

and more…

In conclusion, control isn’t worth much – until it is. When trying to change the course of a business in crisis, voting power analysis might prove essential. As voters form coalitions, the effective sizes of the voting blocs grow and so can the disparity between voting power and percentage ownership. It is here in the crucible where, I believe, voting power analysis plus intelligence about key voters’ stances can provide a real edge to investors trying to decide whether the proxy battle is worth the expense and, if so, how best to win it.

Again, I would really appreciate feedback – especially on whether such voting power analyses are commonly applied either in the boardroom or by activist investors.

Travis Dirks, Ph.D. (TravisDirks@gmail.com)

I’d like to thank my co-authors, Radhika Rangarajan and Guy Tal for their insightful conversations that both inspired and fleshed out these ideas as well as for their heroic efforts in helping me to (hopefully) make this tricky subject understandable!


[i] I have made two main assumptions for ease of calculation. The first is that all shareholders vote their shares. The second is that the shares held by groups and individuals with small enough position to not file a 13d are held in equally sized small pieces. While a more realistic assumption, such as a power law distribution in shareholder size, will change the values of voting power, it will not change the main results: percentage ownership alone does not equal voting power, allowing for full optimization of voting power. Also, a Shapley-Shubik index is used to measure voting power.

[ii] It is also possible to optimize in other ways. For instance we can  buy shares to maximize our voting power gain or even our voting power gain plus competitors’ voting power loss.

[iii] Here I’ve assumed that Baupost would get to vote all 25% of its shares, as it would in most other companies, after its own lawsuit. Interestingly, if Baupost were to suffer the 20% cap, selling to Baupost or the masses becomes nearly equivalent options for Quicksilver (Q = 28% , B = 22% , M = 7% ).

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Michael R. Levin, who runs The Activist Investor website, has produced a white paper, Effective Activism, on the Cheap that identifies 36 undervalued companies that fit his profile for “effective activism, on the cheap.” Michael likens the list to the companies generated in an Endangered Species / Darwin’s Darlings strategy.

Says Michael of the target companies in his white paper:

  • These companies conceal significant potential value relative to their current market cap, with a potential to increase the average investment by about 75%.
  • They have a concentrated investor base (ten largest investors own at least half of the outstanding shares), which allows an activist to influence management in creative and low-cost ways.
  • They are also hardly micro- or small-cap investments, with an average market cap of $375 million (the highest at $1.8 billion), which should provide ample liquidity.

How cheap is “cheap”?

We estimate that an investor that confines its activism to companies with highly concentrated holdings can spend a tenth of the cost of a full proxy contest, and avoid the proxy solicitors, public relations firms, and legions of attorneys. For a fund manager that earns income in the form of fees (management and performance), this savings can make an activist strategy feasible, and even attractive.

Click here for more information on and to obtain a copy of the report.

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The New York Times has a fantastic profile on Carl Icahn called Does Icahn Still Make Them Tremble?

He is one of Wall Street’s most colorful, controversial and complicated characters.

Wearing slightly rumpled khakis and waving his eyeglasses to punctuate key points, Mr. Icahn is constantly jumping from one topic to another in an endless stream of dialogue. In that respect, he more closely resembles an absent-minded professor than a master of the universe.

Corporate executives visiting his offices walk through hallways adorned with paintings of battle scenes and sculptures of cowboys on bucking broncos. One large painting in the conference room features a lion gazing at the bones of an animal in a desert.

Yet he bristles at being labeled a “raider,” despite the fact that he is widely viewed as a founding member of the clan that roamed Wall Street in the 1980s, occasionally pursuing hostile takeovers with ruthless abandon.

He prefers to paint his role in those years with the same “activist investor” brush he holds today, arguing that he has created tens of billions of dollars of value for shareholders in companies in which he invested. (In conversations, he declares that he has created $30 billion, $40 billion and even $50 billion worth of value for shareholders. What is a few billion among friends?)

This is Icahn’s thesis for his investments in the biotechnology sector:

“The biotechs have been his big winners recently,” particularly investments in ImClone Systems and MedImmune, said Mr. Young at Institutional Shareholder Services. “His thesis, which is no secret, is that biotech firms should be purchased by Big Pharma, which is always in need of new products. In his mind, that’s a match made in heaven.”

I love this story:

Mr. Icahn does not seem to let anything, including a very close friendship, get in the way of protecting his and his investors’ profits. Late in 2008, through his hedge fund, he sued Realogy, a real estate company controlled by Leon Black, the head of the private equity firm Apollo Management. Mr. Black was trying to reduce Realogy’s hefty debt load by offering to exchange some of the debt with bondholders.

Mr. Icahn, a bondholder who has known and been friends with Mr. Black for decades — the two have been longtime tennis partners — objected to some terms of the exchange and sued.

“Carl and I have been good friends for over 25 years,” Mr. Black said in an e-mail message. “Occasionally we skirmish as couples are wont to do, but I believe we both feel that when the chips are down that the friendship is paramount.”

How, exactly, does one sue and still be good friends with someone on Wall Street? Mr. Icahn smiles sagely over his cup of coffee: “The two of us have a saying that we always use whenever there is friction in our business dealings. We always say, ‘there’s only one Maltese Falcon.’ ”

At one point in that classic 1941 film, a character chasing a valuable figurine says to a close associate, “You’ve been like a son to me,” Mr. Icahn explains, paraphrasing from the movie.

Then, lowering his voice with mock intensity, Mr. Icahn adds that the character says that if you lose a son, it’s possible to get another — “but there’s only one Maltese Falcon.’ ”

Click here to see the rest of the article.

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