Shamrock Holdings was founded in 1978 by Stanley Gold to invest the assets of certain Disney family members, including Walt Disney’s nephew Roy E. Disney. It mostly kept below the radar until a couple of years ago, when Gold and Disney waged their highly public campaign to oust Michael Eisner as head of Walt Disney Co. and change the corporate governance practices in general.

Today, it has over $1 billion under management in several funds, including an "Activist Value Fund" and a corporate governance fund. To understand how activist and hedge funds are targeting companies, making investment decisions, and tying governance to performance, we talked with managing director Michael McConnell.

What is Shamrock’s investment style?

It depends. Our activist fund takes a deep value approach. Private equity investments, both domestic or in Israel, can be a mix of growth and value. Real

estate is real estate. We take no developer risk.

What is your activist fund’s strategy?

We focus on small caps, defined as $1.5 billion or smaller. There are inherent inefficiencies in those stocks that are greater. And our ability to be effective shareholders is greater in a small company. We can accumulate 5, 10, 15 percent of a company. Also, in a deep value situation, either the asset value or the cash flow is available to the owner’s equity.

Why?

We never lost money in a deal. This is important to us and our clients. Protecting the downside is a big part of our focus.

How do you protect the downside?

By the price we pay going in. This also gives us a variety of levers where we can influence a company. A couple of "our ideas for change together" with sweat

equity go a long way to protecting "our" equity "value," and that's (the ideas and engagement) where value is created.

What do you look for in a company in general?

Fundamental value. We look for companies with strong market share positions. We currently have four positions, and they are clearly number one [in their respective markets]. Also, we look for strong free cash flow—The cap expenditures that is required to maintain the business is significantly less than the depreciation associated with the property, plant and equipment. We also like a company to have a variable cost structure—besides property, plant and equipment. This allows the management team to change its cost structure based on market conditions. We also tend to like companies with sticky customer bases. Enterprise customers-business customers—tend to value [a company] more than just price. Then layer on top of

that other types of elements, such as where we see areas where we can suggest changes.

Like what?

The opportunity to change capital management. For example, if there is too much cash or not enough debt on the balance sheet. We find some companies that are

holding too much cash to maintain or grow their business. The second thing we look for are operating strategies that have become unfocused. This may start

in one market—geographic or distribution chain. The company may see growth as unconditionally good and try to expand into areas where the dynamics are different

or the skill sets required are not the same. So, there is not much value creation and in some cases, value destruction. Look for companies to focus on what they do well.

You said you currently have four positions. Is that typical of your holdings?

We are highly concentrated. Once we are fully invested, we will have 9 to 15 positions.

How long do you anticipate holding these positions?

18 to 30 months.

One of those four companies is Intrado. Why did you single out this one?

It has monopoly on back office provisioning of 911 services. They have almost a 100 percent market position on the wire line. When you call 911, it goes through their database or software. [Given this market position] they should have higher free cash flow. So, we are working with the board to focus on improving return on capital. We are also focusing on the overall compensation system to assure it is structured

appropriately and properly.

What does that mean?

In terms of being appropriate, a good plan has three things—base salary, short term incentives with bonus hurdles, and long-term incentives. We want to see [in general] more employees compensation tied to the LT. We want the compensation dollar divided up 50 percent long-term incentive, 25 percent base salary and 25 percent short-term.

Why do you want it this way?

We think it is more appropriate if they have a lower base, and more at risk. But they can then earn above the industry average if the performance is above average.

Do you prefer the long-term incentives to be in the form of stock or options?

As long as the company understands the potential value of what they are giving, whether it is options or stock is not as important. That’s why option expensing is important. We know how much we gave them. But, you have to detach yourself from comparative economics, to the person [executive at a similar company] down the road. It’s a slippery slope.

Are you compensated this way?

You betcha. Also, we must put up our own money in the fund. Our salary is not popper’s wages. We are reasonably well paid. We have hurdles. We must meet a

preferred return like private equity funds, such as 4 or 5 percent [before we get a bonus.] Also, it is relative to the performance of the Russell 2000, plus

200 basis points.

Do you have a high water mark?

I don’t know if it is called that. But, 30 percent of what we earn in incentive fees is held back subject to continued out-performance. Also, if we don’t hit that 4 percent return, we must achieve that on a cumulative basis next year. We think our compensation is very fair.

How much of a role do corporate governance practices play in your investment strategy?

Let’s be careful how you define governance. On the tactical side, we spend a lot of time understanding who the directors are, who owns the stock, do we know them, will they support our activist agenda, how concentrated is the shareholder base? If we have 30 percent support, we can win a proxy contest.

How do you know that?

That comes from our 20 years of experience. We need 50 percent of those voting to win, and some shareholders don’t vote. Ideally, for us the top three shareholders each have 10 percent of the stock if they believe the ideas we are putting forward make sense. Then we buy 5-10 percent and take the lead.

Do you ever team up with others?

Sure. We look to put forward a bunch of ideas, and if fellow investors think they are good ideas, we look to be supported. It’s in their interests to do so. It’s not about Shamrock. It’s about getting boards to implement ideas.

What about individual governance practices?

We have a long governance check list with 35 items—Poison pills, classified boards, technical aspects of governance. We ask law firms what is best practices. We then try to get companies to adopt each and every one of them.

Does this really impact stock prices?

Not one of them will add a dollar to the share price. I don’t think governance in or of itself will add cash to a company’s coffers, but it gets a board to have a tone and culture in a way where they feel they are first and foremost the representatives of the shareholders. They won’t make a company operate more efficiently. If you have a board whose shareholder base has confidence in the representatives, it will have confidence the board will negotiate appropriate compensation and not merge companies [if it doesn’t make sense]. They will be better stewards of capital, as if it is their own money.

Can this be quantified?

I’m not sure if you can ever academically show high "R" squares here. My experience is when shareholders have confidence in management they pay a higher price for their business.

Do any governance changes make a difference?

Compensation practices and policies have enormous impact on performance and share price. I consider it a matter of board governance. Also, the level of disclosure and transparency governing owners’ facts.

What are other key governance factors?

Capital management, or how the board monitors how management invests and/or returns excess free cash flow to investors. Also, how they communicate their process for answering that question is very important. Another thing is how the board hires, fires and evaluates senior management. If it’s a robust process, it will engender confidence in shareholders. Besides paying for performance, it’s important how they evaluate performance. How much time do they give the management team and they don’t do the job, is the board willing to make a hard decision and fire the senior team? How do they go about hiring a new team? Conducting a CEO search is a time consuming, difficult and important job. Also, the board ought to have a rigorous evaluation of itself. Every few years, it ought to rotate 30 percent of the board and bring in fresh blood. This keeps everyone on their toes. I'm getting off a board after four years because their business conditions have changed and my ability to add value in this new environment is limited.

In what way?

Every few years, it ought to rotate 30 percent of the board and bring in fresh blood. This keeps everyone on their toes. I’m getting off a board after four years because their business conditions have changed.

Which company?

Ansell, an Australian listed company. It’s a manufacturer of latex-based products—surgeons’ gloves and condoms. Half of the company is in occupational hand protection products for the industrial marketplace.

Is sitting on a board one of your goals as an activist?

No. The only reason I have to end up on a board is if I don’t have trust and confidence in the existing board. So I have to be there minding my investment.

What’s your take on the SEC’s Proxy Access proposal?

I have very strong views. It’s unfortunate that those rules, even in a watered down fashion, were not adopted by the SEC. In our civic life, we have a true democracy. Local, state or federal, you have a right to go to the ballot box and cast your vote. There is a system, and a standard to get your name on the ballot. It’s not an overwhelming standard. We have a right to choose who represents us. This is not what happens in Corporate America. I don’t think most people appreciate how stacked the deck is. The existing board members are the only ones who can put forward people for election. Someone can run a proxy contest. But, it is a critically costly thing to do. So, the ability for owners to put forward or vote for someone who

isn’t put forward by the incumbent board is costly. Then in the election you have two choices—vote for or withhold. You just need one vote to get elected. This doesn’t sound democratic. It’s a far cry from the level of democracy in civic life. The way proxy access was designed is similar to the way it is run in New Zealand, Australia and the UK—Someone who owns 5 percent, can force board to have meeting at company’s expense and decide who represents them.

The Business Roundtable’s complaint is, what if unions want someone on the board?

If everyone likes them, why not?

Even special interests?

The current group doesn’t have special interests or special agendas? What’s wrong with allowing owners to decide who they like representing them? I don’t see why they can’t have that say.

You like majority voting policies?

It’s better than what we have, but cold comfort. Shareholders are not getting much of a voice through majority voting. All power still funnels through the board at their discretion. There is not much teeth. If say this or nothing, half loaf is better than nothing. In this case, it is 1/20th.

The Council of Institutional Investors advocates that institutional investors, "Adopt proxy voting guidelines that follow or improve upon a recognized corporate governance framework." Has Shamrock done that?

It’s embodied in our best practices list of 35 items.

Have you ever been a CEO of a company?

No. I haven’t

Have you ever been a senior executive?

Not at a public company. I’ve been a director.

If you were a CEO, is Shamrock your worst nightmare?

Not at all. It would be my best ally. I would treat them with the respect due as an owner of the business. Circling back, we understand what it is like to be an agent for a principal [Disney]. If you are honest and communicate openly and debate ideas in every aspect as a partner. A CEO needs to know how to be a capital partner. That’s what CEO needs to do.

One of the big criticisms of some activist investors is that they are too short-term-oriented.

If you look at our track record, we on average invest in a company for three or four years. We actually take great comfort and pride that we left [each] company in better shape. In small cap companies, you can’t be trading due to liquidity. Over

time, we will appropriately sell to someone with a lower cost of capital. We are looking to get 25 percent [returns on our investment]. So, you have to be about creating for companies what is best for the long time. In order to be effective with the board and management, you must show you are committed to what they are doing for the short- and long-term. Otherwise, they can put a black hat on us. And we won’t allow that. You are only as good as how effective you can be with the board and management.

Thanks, Michael.

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