How One Hedge Fund’s Operational Approach Spawns Turnarounds

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Jeffrey Smith, CEO at Starboard Value, explains how his firm's operational activism turns firms around.

The idea of activist investors is not new, but today they are running strong. New York-based hedge fund Starboard Value considers itself an “operational activist” that invests in undervalued companies and works with management to unlock value for shareholders. Jeffrey Smith, CEO and chief investment officer at Starboard, talked with Knowledge@Wharton about his firm’s approach on the Knowledge@Wharton show, which airs on SiriusXM channel 111. Smith helped transform Darden Restaurants (The Olive Garden and Red Lobster, among others) by completely changing the makeup of the board. The interview took place at the recent Wharton Global Forum in New York City.

An edited transcript of the conversation follows.

Knowledge@Wharton: Why do you think activism is drawing what seems like more attention than ever before?

Jeffrey Smith: It’s grown up. It’s turned into something where it’s not just about being an activist investor and influencing companies but also getting involved in corporate America. From our standpoint at Starboard, we’re highly operational. We get involved in these companies.

I think what’s so intriguing — not just for shareholders but also for the general population — and why it’s so interesting in the media is because it’s relatable. We’re investing in whole companies and looking at those businesses and saying, “What can we do with that company to make it better? To make it worth more? To make it more profitable than it has been?” The question we ask ourselves all the time is, “If we owned the whole company, what would we do? What would we do that would be different? What would we do that would be more valuable?”

I think the general population, or at least the business-viewing population, is really interested in that. They’re really interested in looking at companies and seeing how they can be run better. What we’ve been able to achieve as operational activists is the respect and the credibility in the community, that when we get involved those businesses are going to run better. That’s intriguing because you can see transformation happening at companies.

“From our standpoint at Starboard, we’re highly operational. We get involved in these companies.”

Knowledge@Wharton: You’re coming from a perspective that the traditional investor may not be able to come from. You are kind of the big brother looking out for the smaller brothers.

Smith: That’s exactly right. Again, these are the companies that aren’t performing well. There’s a great population of businesses out there that are performing well, that have great management, that have great boards, that are doing a really good job. But for the companies that are not performing well, the companies that are struggling, the companies that have lost their way where the shareholder base is frustrated and the board isn’t doing a great job of representing the best interest of shareholders, it’s our job, it’s our responsibility, to step in the shoes of all of the shareholders and advocate for the change that the shareholder base wants from that company.

It’s that idea that we are truly looking out for the best interest of all the other shareholders. Our interests are more aligned with those shareholders than any other constituent in the company because we own shares.

Knowledge@Wharton: How frequently do you feel tension coming back from the company because of the approach that you are taking?

Smith: We’ve been now doing this for 16 years, and we’ve seen different cycles. When we initially started, there was a lot more feedback from companies, a lot more resistance. Now, there is somewhat reluctant acceptance. I think that companies realize that they’re not performing well. It’s easy to tell, right? The stock price is lower. They’re missing their numbers. So, this isn’t a surprise to them that shareholders are frustrated and that somebody comes forward.

“We haven’t gotten nearly as much resistance as we used to.”

If it’s us that comes forward, what those management team members or board members very quickly hear is, “Oh, it’s Starboard that came forward.” They ask around. They ask other shareholders, they ask other board members, they ask their advisers, they ask their proxy solicitors, they ask their attorneys about us. What they hear back is, “Starboard really does care about the company and making it better. They have good ideas. They’re very responsible. They will listen to others when they’re involved in the boardroom. They just want the best idea.” If it’s a carrot and stick, on the carrot side, they say, “You might as well work with them, because they add value.” On the stick side, they also say, “They’re willing to run a proxy contest. They’re probably going to win, so you might as well work with them.”

We haven’t gotten nearly as much resistance as we used to. Companies are really looking to work with us when we come forward. That doesn’t mean we’re not willing to run a proxy contest if we have to. But since we’re willing to, and since they understand that we add value, they’re more willing to work with us than ever before. Oftentimes, after we’ve fixed the company, we get the feedback that they don’t want us to leave. Which is a nice problem to have, right?

Knowledge@Wharton: You were chairman at Darden Restaurants. When you were in that role, how much did you have to deal with what you’re now doing on the other side?

Smith: Darden is a very well-known case. Darden was struggling, and we did something that’s never been done before and hasn’t been done since. We ran a proxy contest all the way to the end, through a vote, and replaced the entire board of directors. Then the hard work began, which is that we actually had to go in and fix the company. We were fortunate in that there was a president inside of Darden named Gene Lee. We elevated Gene to interim CEO at first, then to CEO. I became the chairman. Gene and I worked very closely together to revamp the strategy at Darden. He’s an extremely talented executive and really transformed that business.

“We have to make sure we’re listening to what the shareholders are saying. You can’t close your ears.”

Darden went from a company that was struggling to now being considered the bellwether. Whenever you talk about any other restaurant company, everyone says, “Why can’t you be like Darden?” The transformation has been incredible. We were also successful at being able to spin off a real estate business in Four Corners Property Trust, creating a lot of value for shareholders.

But yes, we did have to work with the other shareholders. The shareholders are our constituents, and they’re on the other side. I’m the chairman of Advanced Auto Parts now, too. It’s the same thing. When we’re inside the company, we have to make sure we’re listening to what the shareholders are saying. You can’t close your ears. You’re representatives of the shareholders. Fortunately, if you’re creating value, then you’re hearing mostly positive feedback. But usually there are some good ideas from shareholders, and you want to listen, and you have to be open.

Knowledge@Wharton: Do you see more companies owning their own real estate in the future?

Smith: I think you’ve seen some of that already, and I think it will continue. When companies are looking at their owned real estate, they need to analyze whether that’s the best use of their capital. The question that really resonates for a manager is when you ask them in the inverse: When you build a new store or a new restaurant, depending on what it is, do you buy the real estate today? Overwhelmingly, the answer is no. This is what we hear. They say, “No, of course not. That’s a bad use of our capital. We wouldn’t do that.”

Well, then the inverse is also true. “For your existing stores, why does it make sense for you to continue to have all of that capital invested in that real estate?” It’s the same thing. You’re buying it every day. If you can release that capital and use it for good purposes, whether it’s reinvesting in the business or returning it to shareholders to create value, that’s great.

That should be looked at only if you can make sure that that’s a good store. That’s the key. The last thing you want to do is to sell the real estate and put a lease on that store and have a struggling store that you can’t operate. But if you know it’s a good store, and you believe the store’s going to continue to be a good store through the lease term, then unlocking that capital can create a lot of value.

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