The London Business School/ECGI Paper: Returns to Shareholder Activism & 2007 Global Issues

Presentation byPeter R ButlerFounding Partner & Chief ExecutiveGovernance for Owners LLPwww.g4owners.com

Governance for Owners

Company Directors Conference 2007

Australian Institute of DirectorsShanghai – May 2007

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What is ‘relational’ investing’?

• Investing in underperforming public companies where value can be added through exercising share owners’ rights

• Engaging with the executive and non-executive teams of investee companies on strategic and structural governance issues

• Consulting with other investors and share owners on ownership issues

• Engagement by informed, responsible owners providing the catalyst for change that can unlock value in underperforming companies

• Created by Bob Monks when he launched the LENS fund in the US in 1992

• The ultimate active investment strategy – but it requires a rare mix of skills and experience

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Relational Investing - Matters on which to engage

• Board composition• Strategy• Capital structure

• Internal controls• Executive remuneration• Corporate responsibility

But owners must not micro-manage

Strategic governance

Structural governance

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Is relational investing simply activism?

• No. Some overlap but significant distinctions

• Responsible share owning, not shareholder agitation

• Relationship with companies – we look to work with boards and management

• Applies private equity techniques to public equity investments

• Timeframe – we expect each engagement process to take 2-3 years

• Act with the long-term interests of all shareholders in mind

• Confidentiality – we prefer to work privately with companies

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Relational Investing requires a rare combination of skills and experience

• Skills mix: corporate, investment analysis, strategic analysis, M&A, regulation, corporate finance, institutional relations, corporate governance and press relations

• Diverse background: board experience, consultancy, investment banking, investment research, portfolio management, legal; with a range of nationalities

• Independence: enabling us to resist pressure from influential parties and avoid conflicts of interest

• Networking: broad-based contacts in business, finance and media on a global basis

• Alignment of financial interest: between fund executives and long term owners

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The LBS/EGCI Paper : Returns to Shareholder Activism (4th December 2006)

• A clinical study of the Hermes UK Focus Fund investment approach and results

• Undertaken by four distinguished business school academics

• Covers the period 1998 to 2004 when Peter Butler and Steve Brown set up and ran the Fund

• A rigorous and fiercely independent analysis of the Fund’s performance

• Paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection at: http://ssrn.com/abstract=934712

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Why is the paper so significant?

• Provides the first robust evidence that shareholder engagement can be effective

• Confirms it can have a substantial influence on corporate activities…

• … and that it can generate significant excess returns (alpha)

• Shows that collaborative engagements are no less effective than hostile episodes, and are a lot swifter to execute

• Suggests that the engagements studied had a lasting positive effect on corporate performance

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Background

• There has been only a limited amount of activism observed in the past Why? - Fund managers historically have not undertaken extensive

engagement due to ‘free ride’ effect and conflicts of interests- The US legal and regulatory frameworks make it difficult to

influence Board behaviour

• Majority voting and relative ease of calling EGMs in the UK make it a more fruitful environment

• Institutional investors in the UK are well organised and practised in collaboration (e.g. ABI, NAPF)

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The Hermes UK Focus Fund

• Created by Peter Butler and Steve Brown with help and support of Bob Monks and launched in 1998

• The Fund bought additional stakes in underperforming UK companies already held by Hermes’ indexed fund (which typical held 1% of each UK stock)

• Engagement with the boards and management teams was then undertaken to bring about change and eventual share price re-rating

• The Fund outperformed the FTSE All Share index by 4.9% per annum net of fees over the 6 year period 1998-2004

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What factors did the study analyse?

• The study estimates that 90% of the Fund’s out-performance came from the engagement activities

• Documented the team’s stated objectives of the engagements - board changes- financial goals- capital expenditure- payouts to shareholder- capital structure changes

• Categorised style of engagement (which was driven by companies’ reactions to the engagement)- collaborative- confrontational- mixed

• 41 investments, 30 engagements

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What were the objectives of the engagements?

• 28 out of the 30 involved restructuring of diversified conglomerates

• In more than half of cases a change of Chairman or CEO was sought

• Also in more than half, increased cash payouts were sought, often related to specific divestments

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More detail on the engagements undertaken

• 41 investments; 3 not in the Fund long enough to measure; 8 sold swiftly due to out-performance caused by exogenous events

• Differing reactions led to three styles of engagement: - confrontational: disagreement about the Fund’s objectives from

the outset; often led to changes of chairman/CEO- collaborative: target agreed with objectives and implemented

changes in co-operation with the team- mixed: attitude was neither collaborative nor wholly

confrontational

• Engagement with other shareholders also important – largest three shareholders averaged nearly 20% of the equity, highest in confrontational episodes

• Confrontational engagements took, on average, nearly 3 times as long to complete as collaborative

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Some interesting observations

• Exceptional high number of meetings with companies – average over 9 times in each engagement, highest 48

• Contacted other shareholders in 80% of cases; corporate brokers in 70% and headhunters in 26% of cases

• In only one case was a question or agenda item raised at an AGM

• In only two cases were votes against management solicited

• Three EGMs were planned but none actually requisitioned

• Only one US style class action, but the Fund chose not to take part

• Two rights issues were blocked

• Of seven press campaigns, only 2 were initiated by the Fund

• Of four takeovers seen, none were induced or facilitated by the Fund

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“Event studies” on outcomes

• Detailed studies on individual events to identify whether the Fund’s engagements were value enhancing

• Identified detailed objectives that led to specific announcements

• 98 individual events identified across the 30 engagements

• Event windows around the announcements used to measure the abnormal returns

• Event windows varied from 3 to 11 day periods

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Results of the event studies

• Mean cumulative abnormal returns (CARs) ranged from 3 to 4%

• When events containing other corporate news were excluded, the mean CAR was higher at 5.3%

• The largest CARs (6%+) were associated with restructurings, asset or division sales and changes of CEO and chairman

• Mixed and collaborative engagements produced events with higher CARs than confrontational engagements

• Limited evidence suggests that company performance (measured by ROA) was better one year after engagements than before

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Smith & Nephew - a case study

• 1998 – a healthcare conglomerate with five disparate divisions

• October 1998 – stake bought; action plan to reduce conglomerate discount identified in advance

• December 1998 – meeting with new CEO revealed similarity of views on actions required; letter sent outlining concerns about Chairman succession and excess free-cash flow

• 1999 – several non-core businesses disposed of; Chairman retired and replaced by outsider

• 2000 – further significant disposals and return of £415 million to shareholders followed by a letter from Fund to congratulate

• August 2001 – letter confirming sale of stake by the Fund

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Linking out-performance to engagement

• Detailed attribution regressions used to disaggregate results

• Results support view that performance was associated largely with the reversal of previous corporate under-performance

• Aggregating the returns from each event indicates that 92% of the Fund’s out-performance was derived from the effects of the events ie from the engagements

• 14.4% of the out-performance came from collaborative engagements; 30.5% from confrontational and 55.1% from mixed engagements

• But collaborative engagements were on average much quicker to execute

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Conclusions

• The paper concludes: “In contrast to much of the previous literature, this paper has reported substantial effects and benefits associated with shareholder activism in the form of private engagements by an activist fund”

• The study provides robust evidence that our style of engagement changes companies’ behaviours and delivers exceptional investment returns

• Bulk of the out-performance comes from engagement – meaning the results are largely uncorrelated with other investment styles and therefore a great source of diversification

• This approach has now progressed at GO and is being successfully applied by the same senior team to pan-European companies where the opportunities are huge

• We also expect the approach to be successful over time in Asia. A brief case study on the recent ISETAN (Singapore) engagement follows

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Isetan Singapore – event-driven strategic engagement

• Isetan Singapore – retailer women’s apparel - 61% owned by Isetan Japan• Minority shareholder concerns spanning several years and raised at AGMs

– No indication as to how or if the S$60m tax credit would be used– ‘Independent’ directors had ‘adopted an increasingly partisan management

attitude’– 2 independent directors brothers, on the board since 1981 and family ties to

Isetan• Group of 43 minority shareholders request an EGM which board calls for Jan 10• Resolutions to remove the incumbent independents and replace them with

shareholder nominated directors (Tan Lye Huat, Eng Guan Siah, Soh Suwe) =>Tan Lye Huat is GO’s partner on governance and engagement in S.E. Asia

• Resolutions voted down (unsurprisingly) but company committed to address special dividend/tax credit issue (in cooperation with controlling shareholder)

• Feb 7 Isetan’s announcement that it was working with advisors on a solution => +3% in share price at a time when the wider Singapore market going down

• Feb 27 Isetan proposed S$1.50 special and final dividend but no rights issue• Several other Singaporean companies subsequently made similar commitments• Isetan share price rose 41%, from S$4.72 to S$6.65 over period of engagement

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Isetan comment and share price performance

“I feel it's important to be part of the process that promotes greater shareholder activism in Singapore, which will eventually lead to improved standards of corporate governance.

…minorities can influence outcomes if they act in the right spirit and intentions.”

Tan Lye Huat, Business Times Singapore, 29 Dec 06

“Mr Tan, who is a well respected expert in the field of corporate governance, deserves special commendation for being willing to stand up for the minority shareholders although he was himself

not a shareholder of the company. Isetan also deserves kudos as they showed a willingness to engage and compromise with the minority shareholder community.”

Ang Hao Yao, Business Times Singapore, 6 Mar 07

Isetan Singapore share price vs Straits Times Index Oct 06 – Mar 07

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Team of experienced investors and engagement specialists…

Paola Perotti,Managing Director

13 years as an investment banker, engagement specialist for 3 years

Peter Butler, CEO

20 years corporate experience, 10 years as anengagement specialist

Steve Brown,CIO

Over 20 years as a fund manager, broad experience of UK and European markets. 14 years in engagement

Diverse backgrounds working on investment and engagement

Robert Machell, Investment Director

Fund manager for over 12 years, extensive knowledge of European equities

Robin Hindle Fisher,Managing Director

Over 23 years investment management experience with extensive engagement involvement

Michelle Edkins, Managing Director

Over 9 years experience in corporate governance, institutional relations and engagement

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Issues for discussion 2007

• Proxy Voting

• One Share One Vote

• Long term v short term

• Development of Principles for Responsible Investment (UN initiative)

• Bribery and corruption in Europe

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For more information contact

• Robin Hindle FisherManaging DirectorTel: +44 20 7614 4773Email: r.hindle_fisher@g4owners.com

• Hattie BurgessMarketing ManagerTel: +44 20 7614 4759Email: h.burgess@g4owners.com

Governance for Owners 26 Throgmorton StreetLondon EC2N 2ANTel: +44 20 7614 4750

• Or visit Governance for Owners’ website: www.g4owners.com• Or contact our regional advisor Tan Lye Huat, HIM Governance Pte Ltd

E-mail: lyehuat.tan@himgovernance.com