The ongoing proxy battle between P&G and Nelson Peltz is coming to an end. Although it may appear to be another fight between a management and an activist investor, I see it as a more important event. This proxy battle has some critical implications for the future of American exceptionalism.
T. Boone Pickens Goes to Japan
Back in the 1980s, Pickens found an opportunity to invest in an underperforming Japanese company, Koito Manufacturing. This was similar to how Peltz recently found P&G as a turnaround opportunity.
Pickens bought the largest stake in Koito and demanded a board seat on the firm. Only after his investment and conversations with the management, did he realize the massive challenges of the Japanese corporate governance system!
Recently, David Taylor of P&G made several direct attacks against Peltz; I analyzed the nature of those attacks and their underlying argument in an earlier post. Pickens had a similar experience back then. Koito’s management said that Pickens was an oil investor and did not have a manufacturing background. As a result, they did not view him as a qualified manager.
But in the end, Pickens couldn’t do much at all. He didn’t get a board seat and had to sell his stake and give up any hopes of turning around Koito.
Japanese Vs. American Corporate Governance Systems
That incident demonstrated a well-known fact – The Japanese corporate governance system is a different world from the American system. While the American corporate governance system is a shareholder capitalism system, the Japanese system is a stakeholder capitalism paradigm.
In the American system, the interest of the owners of a company (shareholders) is paramount. Here, efficiency and performance are critical because they help maximize shareholder returns. But in the Japanese system, several stakeholders are essential. Shareholder returns are not the most important criteria for success of a company there. Therefore, a sub-par performance in the Japanese context is acceptable if most stakeholders are kept happy.
The Keiretsu Complication
Furthermore, companies in Japan are usually a part of a keiretsu wherein a significant number of firms have cross-holdings with each other. The buyer-supplier relationships are further reinforced with cross-holdings. And when a company underperforms significantly, it is the Keiretsu partners (and not the banks) that step in to help. Keeping your partners happy is often as important or maybe even more critical than financial return.
Pickens saw a lower shareholder returns and excess cash with Koito as an opportunity. He thought that a board seat would help him eliminate the inefficiencies at Koito. But the Keiretsu partners and the management didn’t allow Pickens to get a seat.
Shareholder Capitalism and Capital Deployment
The difference between shareholder and stakeholder capitalism systems has more profound implications for capital deployment in each economy.
In stakeholder capitalism, the capital does not necessarily get deployed most efficiently. Such a system focuses on reducing the counterparty risk through long-term relationships. Those relationships become more important than return on capital.
But the American system of corporate governance leads to a very different type of capital deployment. The system is geared toward capital efficiency and forces capital to reach the best avenues.
In the American system, the management works on behalf of shareholders, who own the company. The Board of directors has a fiduciary responsibility to do what is in the best interest of the shareholders. They are the representatives of owners of the company to provide oversight.
Both Japanese and American companies have had a long history of success. This shows that each system works and can produce successful companies. But what is not apparent is that due to the capital allocation implications, the nature of industries in which each system works is different.
The Japanese system is geared towards a long-term investment horizon where short-term performance erosion can be forgiven. It produces certainty for an investment over a longer period. But that is not the case in the American system. It does not excuse sub-par performance for too long. If the total shareholder return declines too much, checks and balances result in the management being booted out. Whether it is due to board action or from the market for corporate control (mergers and acquisitions), sub-par performance does not last too long.
The Meaning of P&G Vs Peltz
In fact, Nelson Peltz’s proxy battle with P&G management is a shining example of how well the American corporate governance system works. The fact that a shareholder can force a proxy vote and has a chance of bringing about change is a testament to this great system of governance. It is due to this system that American corporations have ruled the world since the Second World War. The system has worked across a very large number of industries.
Koito manufacturing never benefited from the skills and financial acumen of Pickens. It could continue to survive at a less than optimal performance because of the Keiretsu partners. Favorable terms of the contract to Keiretsu partners offset the lower shareholder return to the same partners (due to cross-holdings). But for a shareholder of a single company, it was not a great deal. When viewed from the overall logic of stakeholder capitalism, that may not have been a bad outcome for the Keiretsu.
But a similar outcome in the American system would be concerning within the institutional logic of shareholder capitalism.
P&G, Peltz, and the Future of American Exceptionalism
The current proxy battle between Nelson Peltz and P&G raises some critical questions for the future of American capitalism. It is not that our system of corporate governance has changed. But it may point to a significant erosion of the strength of our system. The outcome of this proxy battle will tell you a lot about how this system of corporate governance is working today.
Ideally, the board of directors steps in and demand changes from the management if the management underperforms for too long. In my earlier post, I showed how P&G has been underperforming for a decade.
The comments from David Taylor tell us that P&G wants to have an amiable board of directors. A board that the CEO picks and can count on for support. But the board’s job is not to support the CEO; it is to perform a fiduciary duty towards the shareholders. So when a CEO says no to an investor like Peltz with the subtext that we are not sure how amiable Peltz will be, it raises significant concerns in my mind.
But what about the second level checks and balances. What about shareholders voting directly? That is where my second concern lies. In the last three decades, the ownership of American corporations has passed from individual shareholders to intermediaries like Vanguard, Fidelity and State Street. Most Americans still own P&G stock, but they are not even aware of it.
When you search for the largest shareholders of P&G in Morning Star, the top five includes three Vanguard index funds, one S&P 500 index (SPDR) and one 529 plan. These mutual funds and pension funds own P&G on behalf of individual investors. But most of them cannot have a significant concentration of investment in a single firm. It is in line with the broader goals of these intermediaries.
But this change has a massive impact on American shareholder capitalism. How do these investors vote? There is some evidence that the passive funds vote with management in an overwhelming majority of cases.
The Core Problem for American System of Corporate Governance Today
Between an amiable board and passive intermediaries, what is the future of the American exceptionalism? If there is no one monitoring corporate management, can we hope to remain the most innovative and high performing country in the world? Can we expect to give birth to exceptionally successful companies in America in the future? This is an 18 trillion dollar question.
There is some good news here. Recently, the tide seems to have been turning. A recent vote at Exxon Mobil showed Vanguard and BlackRock vote against the management. Maybe, the index investors will not remain passive in their voting. Maybe they will start to use their clout to provide the voice that individual investors need. At least this vote provides some promise in this direction.
But one swallow doesn’t make a summer. That’s why you need to watch how the institutional investors vote in this week’s proxy battle between Nelson Peltz and P&G. This contest is critical for a majority of Americans who own P&G stock. But it is even more critical for all because it will tell us the future of our corporate governance system.