The recent publicity surrounding the hostile takeover bid for CommonWealth REIT makes for interesting reading for fans of corporate intrigue. What is even more interesting to compliance wonks like us at Laven is the number of corporate governance issues that are in play. A review of these issues can provide great lessons for investors looking at any Private Equity, Hedge Fund, or other asset management firms.
Background:
CommonWealth REIT is a Boston-based commercial mortgage real estate investment trust (REIT) founded in 1986. They have a reported AUM of about US$7.8 Billion, primarily in office in major metropolitan markets in the US.
Unlike most REITS today, CommonWealth is managed by a third party management company, REIT Management and Research. This manager is run entirely by Barry M. Portnoy, CommonWealth’s founder, and his son Adam. Both father and son serve on the Board of CommonWealth and their management company is paid an advisory fee based on the size of AUM, as is typical in the industry. This arrangement has netted the Portnoy’s management firm a reported US$77.3Million last year alone.
The problem is that while CommonWealth has been growing its AUM through issuance of additional stock, its overall performance on a per share basis has been sub-par. So while the management company continues to increase its aggregate income, investors are left with an unimpressive yield from an underperforming set of commercial real estate assets.
Enter Corvex Management, a hedge fund, and Related Companies, a large NY-based commercial real estate firm. Together, Corvex and Related have purchased a 9.8% interest in CommonWealth. They have tried to remove the Portnoys from the Board and fire their management company. In turn, CommonWealth has mounted a vigorous defense, including adoption of aggressive poison pill provisions, lobbying at the Maryland State legislature for changes to certain corporate governance laws, and other tactics all designed to maintain the status quo.
Lessons for Investors:
What is interesting for all potential investors are the lessons that can be learned from a review of the corporate governance structure of CommonWealth and how that structure is now hampering investor efforts to right this ship. Here are some of the red flags that have been reported:
1. CommonWealth’s managers own little equity stake in the REIT. The management company’s executives and trustees on the board own a reported 0.33 percent of CommonWealth equity. This provides no alignment of incentives. In fact, the management agreement, when combined with a market that allows CommonWealth to easily grow AUM through the issuance of new equity, has created a disincentive for the manager to buy assets at a proper price. Because new equity is relatively cheap and has been used to increase AUM, and that equity needs to be put to work, there has been an opposite incentive for CommonWealth to buy as many commercial real estate assets as they can as quickly as they can, regardless of price. For smaller funds, a typical 2%/20% fee structure is still the norm and deemed adequate since the 2% fee on AUM is what is typically seen as allowing the manager to sustain operations, while the 20% promote is seen as the true incentive for managers to perform. But when a fund has almost $8Billion in AUM, it is pretty obvious that those fees are doing more than just sustaining infrastructure.
2. CommonWealth maintains “poison pill” protections. This kicks in when any investor purchases 10% or more of the company. Investors need to look very closely at the existence of poison pill provisions and wonder why any fund or management company would need that protection given the fee structures involved. Again, alignment of interests is what is needed.
3. CommonWealth maintains a number of provisions designed to keep the current board in power. These include staggered board terms, a provision requiring at least two members of the board to be employed by its management company or involved in the day-to-day operations of the company, a provision requiring any shareholder seeking to remove a board member to have held its equity for a minimum 3-year period, and a provision allowing board members to be removed for cause only by a vote of two-thirds of the shares outstanding. These are all highly aggressive provisions, each designed to maintain the status quo and prevent disruptions of existing management structures.
4. CommonWealth has an unusual provision requiring all shareholder disputes to be resolved by arbitration. The U.S. Securities and Exchange Commission discourages these provisions. But nonetheless, Commonwealth’s board held fast and includes in its by-laws a requirement that all shareholder disputes must be arbitrated. Note that Corvex and Related have not only filed suit in Maryland seeking to overturn most of CommonWealth’s board protections, but also began the arbitration process in the event the arbitration requirement is upheld. CommonWealtht hen selected a friend and occasional business partner as their arbitration panel member, effectively insuring that the arbitration gets held up for years.
The lesson for investors is, of course, to look for corporate governance provisions that serve no purpose other than to make it difficult to remove board members. This will give investors a view into management’s thinking and help determine whether interests are truly aligned.
