5 Things I Wish I Knew About Corporate Boards When I Was An Institutional Investor

The best part of undertaking more than 80 speaking engagements in the last few years around the world has been the incredibly smart, diverse, fascinating people I’ve met; investors, academics, students, world leaders, scientists, visionary business leaders, social activists, amazingly helpful event planners, and a 12 year-old playing Jimi Hendrix covers on a Chicago street corner who made all the plane trips worthwhile.

Throughout all of those experiences, I’ve been asked a few questions that I continue to think about months, sometimes years, later.  One of those questions was: “what have you learned from advising scores of pre-IPO boards and small public companies that you wish you knew when you were co-managing a small-cap special situation hedge fund?”  Such a great question.  Here are my top five answers.

1. ROI. BlackRock, CalSTRS, and CalPERS et al. spend millions and millions of dollars a year analyzing the corporate governance efficacy of their largest portfolio positions for the same reason that Jamie Dimon and Warren Buffett, among others, published this: because better governed companies make more money.  If the folks who manage trillions of dollars and run the largest companies know that better governed companies make more money, how on earth does that not apply equally to small public companies?  If you’re one of those people who still don’t buy it, I have two more words for you: Darden Restaurants.
2. Follow the numbers. Forget what you hear on CNBC and read in the WSJ, shareholder activism is not a large-cap phenomenon.  Roughly 7 out of every 10 shareholder activist campaigns are actually in small-cap companies (and smaller).  Heck, in October 2016, according to Activist Insight, 40% of activist overtures were in companies with market caps below just $50 million.  Moreover, approximately 60-70% of activist “asks” are corporate governance related.  Put it all together and you get this: better governed companies make more money, but most small public companies are poorly governed.
3. You’re holding the wrong people accountable. When I was a fund manager, it was my opinion that two things predominantly cause small public companies to underperform: getting strategy wrong, and misallocating capital.  Like many small-cap fund managers I’ve met over the years, I was 100% convinced that both of those shortcomings were management issues.  I couldn’t have been more wrong.  Strategy and capital allocation failures aren’t management issues – they are board issues.  Active, objective, appropriately comprised boards head off strategy and capital allocation problems long before they cause substantive diminution in shareholder value.
4. Objective vs. independent. Director independence requirements iterated by the exchanges are important, but of limited value.  Companies can comply with the “letter” of those regulations, yet simultaneously have boards exclusively comprised of the CEO and their friends.  Put differently, objectivity is what’s most important.  It’s pretty hard to effectively oversee management on behalf of shareholders (a board’s central role), when the person you’re principally governing is a friend who gave you the job.  It’s even more unlikely when all of the directors are also friends/acquaintances.  The best-case scenario for any given company in your portfolio is that most/all board members lack preexisting relationships with the CEO (or each other), and were predominantly recruited by the chair of the nominating/governance committee.  When CEO’s handpick boards, the likeliest outcome is “oversight lite.”
5. Speak directly to board members. In the not too distant past, corporate lawyers advised directors not to speak directly with investors.  But today, in large public companies, those conversations happen every business day.  Take it from someone who regularly assesses boards from a buy-side perspective, those conversations should take place in small public companies every day as well.  Here’s what to ask a director if you were limited to just one question: “how does the board benchmark whether key strategic initiatives are failing or succeeding?” Board members who don’t have cogent answers to that question are either: (a) disengaged; (b) largely dependent on whatever management tells the board; (c) inexperienced; or (d) lack the right background to be on that board.  In the absence of CEOs like Jobs or Zuckerberg, companies that are comprised of board members (a) through (d) are much more likely to either fail or underperform.

Here is Adam Epstein’s presentation at our MicroCap Leadership Summit:

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