OLD ARTICLE – Originally posted on January 9, 2020
More than any other directive, human beings act in line with their individual incentives.
In the natural world and bleeding into modern-day addictions to drugs, social media and pornography, human beings are predominantly incentivized by dopamines.
In business, though, human beings are typically incentivized with money. The ability to earn it as salaries, bonuses and–more importantly for owners of stocks–via dividends and capital growth.
The Agency Dilemma of investing, though, is that investors typically do not run (or even materially influence) the companies in which they are invested. Rather, investors have to rely on the management of the company to manage day-to-day and execute on longer-term strategies to generate growth, dividends and, ultimately, returns.
Hence, traditional wisdom seeks to align management interests with that of investors via a large shareholder (failing that, some form of share incentive scheme). In theory, this alignment makes management similar to an investor and–following on the theory of incentives noted above–should lead to better outcomes for all investors as management seek to maximise their own gains.
Broadly, I completely agree with the above and think that the absence of skin-in-the-game and the misalignment of interests are crucial red-flags to look out for when analysing a stock as an investment.
That said, the converse is not always true and management being anchor shareholders in their own businesses is not always an indication that it will be a great investment.
Let me unpack two examples (I have decided to exclude company names so this does not get personal):
Company A: Asymmetrical decisions
I sometimes help listed small cap companies unlock their value (call it “free” corporate finance work or “soft” shareholder activism). In this instance, I lined up a large and willing buyer of the entirety of Company A. The buyer was offering nearly a 100% premium to the share price.
Company A was tightly controlled by a director who–along with his consortium–controlled the majority of the votes. As he was an empowered shareholder, the offer was angled to give him shares in a larger group (a share swap) and, thus, carry his empowerment into the larger group. The rest of the shareholders would get a plain cash offer.
This director (and his Board) blocked the transaction for what I believe are two reasons:
- Valuation: Despite the offer being nearly double their money, they–as most management teams do–believed their share was worth even more than that!
- Script Aversion: The anchor shareholder did not want shares for his investment, but cash.
The first reason has subsequently been proven wrong as the share price has halved, and the second reason is asymmetrical as it only affects the anchor shareholder and not minorities (minorities were always getting cash).
Unfortunately, due to both reasons, the value-unlocking deal never saw the light of day and neatly illustrates one of the sharp-edges of an anchor shareholder: asymmetrical decision-making by an anchor shareholder who blocks an entire deal or vote.
Company B: Businesses still fail but these have fewer options
Company B’s management team controlled it and, collectively, are the largest shareholders in its stock. They run the business and appear very involved down to a granular level.
Here the lesson is much shorter: sometimes things go wrong.
Company B was hit with macro-tailwinds, legislative tailwinds, a cyclical downturn in its industries/country and it even proceeded to make a bad acquisition or two that blew a reasoanble-sized hole in its balance sheet.
The acquisitions may be self-inflicted, but many of the other negatives were largely out of management’s control, irrespective of how incentivized they were.
And, herein lies the first half of the lesson: while skin-in-the-game is better than the absence of it, it is also far from a guarantee that the business will succeed.
The second half of this lesson is that if a management change is needed to reinvigorate this business and drive its turnaround, well, minorities do not have the voting power to do this while management will undoubtedly never vote against themselves.
Hence, a stalemate in a business where everyone stands to potentially lose out.
Conclusion: Skin-in-the-Game is better than nothing, but it is no guarantee
While I still firmly believe that the best alignment of interest for a management team is a large portion of their personal wealth invested directly into the same share-class as me, the outside investor, I now have a more nuanced view of this detail.
Beware ego’s and be cautious of Boards that predominantly serve the anchor shareholder at the expense of minorities. Also, skin-in-the-game may be a great incentive, but a management team also needs to have the ability to influence outcomes for it to matter.
And, despite all of this, things may still not work out.
Any day of the week, I would rather have aligned-interests with management, but beware the two-edged blade that can be a large anchor shareholder.