Discussion Mikhail Fridman and Dominic Barton discuss L1s experience
Discussion: Mikhail Fridman, Chairman of L1 Group and Dominic Barton, Global Managing Director of McKinsey & Company, discuss L1’s experience as long-term international investors who work actively with companies to deliver sustained growth.
Mikhail: Dominic, you have proposed a great topic for discussion – focusing capital on the long term. For me this is very interesting, because in a way we are “newcomers to capitalism”.
For many who graduate with MBAs in Europe and so on, the rules of Western capitalism are so well-known as to be almost undiscussable; it’s like the air that you breathe. But for us, from the beginnings of our time in business, this was very much a new world – and that, I think, gives us a fresh perspective.
We entered a corporate world where there were pretty well-established practices – what we should do, what we shouldn’t do, especially for the public because the public companies were regulated extremely tightly and carefully.
Some things work well but we’ve also seen a lot of contradiction and imperfection that surprises us. Frankly, I wonder why people believe this corporate model is so firm and beyond challenge. Evolving how it works, could have a profound effect on a company’s longevity, and economy’s stability and growth.
We’ve seen a number of big corporates effectively, in a very short period of time, get into very difficult positions because of changes in the market. It looks like they were not prepared at all for the market changes, which happen especially now – very fast, with the internet.
I believe that if companies had long-term investors, with pretty sizeable shareholdings, who are active investors with a long term perspective, with an owner mentality, companies would be less prone to fail.
Dominic: Let’s talk a bit more about the long-term perspective. Is your view that if more people follow this model of ownership, of real Board level engagement, that will lower volatility in the world?
Mikhail: Yes that’s right – at the moment it’s a game. People are buying shares, making arbitrary speculations, the whole thing is so short-term.
If you go to minority shareholders in public companies and say “what this company is doing is wrong”, so often the response is “We don’t care what management is doing, we just care about stock price… We can always sell.” That is a very common approach. So management effectively, without pressure or control, are doing what they want.
Also, for the management it’s quite difficult to make major, long-term structural changes – changes that are necessary – because it will inevitably impact current price. You have your bonus system, you have your stock price motivation system, you’re so afraid to even touch anything that requires serious, fundamental, tectonic changes, because immediately the share price of the company will go down.
But often companies really need to make these kind of big, fundamental changes of direction in order to survive long-term. Especially when it comes to technology. Financially, you’ll suffer for a couple of quarters, but you’ll go far.
I think much of this strategic and governance deficit in companies is due broadly to an inappropriate balance between management and the Board functioning. This imbalance is the core issue in my opinion – it’s pretty wrong.
Dominic: That’s interesting because you come at it from a clean sheet, what strikes you as “out of balance” at Board level?
Mikhail: Today’s corporate governance model effectively hands all power to the executive management. The Board meets once per quarter, a meeting of 1 to 3 days max, they make some comments and say: “the show must go on.”
If you look at the “input” of the whole management of any big company, I would say, for the executive management it’s 90%. The other 10% is from the Board, who are responsible to the shareholders for delivering value.
So often, until the price of shares go down, the Board don’t seem to intervene too hard at all, to argue about management, the business plan, the budget, appointments, and so on and so forth. Their level of deep knowledge about the company is pretty weak.
Dominic: As you say, in these widely held, publicly traded companies – like many of the Fortune 500 – there can be no one who has the accountability to act like a true owner. That’s what I think is interesting about your view and “the owner mindset.”
Mikhail: Generally I think the modus operandi of the Board’s in today’s corporate world is wrong. Executive management tries to implement strategy just to satisfy the last minute demands of the quarterly earnings, rising of shares immediately, just to have compensation – that’s completely different for the company with long-term investors who are available and active. Let me make a comparison to the political system: the government and the parliament.
Parliament is a permanent working body – working every day, pushing for change every day. The people in the parliament can really argue with the government, challenge them all the time, criticize them and have competence which is completely comparable to the government. Why doesn’t that happen with the Board to the management?
By the way, to add to the comparison with the political system, for instance in the UK you have a Queen who is really a long-term investor. She’s looking for what is going on in 10, 100 years because of her dynasty.
Dominic: That’s a good analogy. And if you compare a private equity Board to a publicly traded Board – the private equity Board spends three times more time.
Mikhail: Yes, in a company the first priority needs to be “do you have those people who know something.” and this more than just the Board members’ time, I believe that you should have a group of people who are permanently working within the company as an extension of the Board.
This is how we do it in L1. There are Board teams or shareholder teams who sit in the company, collect all the information on an everyday basis, who really understand deeply what is going on inside.
It’s not just about the financials of the company, which in my opinion just show the surface – but rather looking more deeply at the corporate spirit of the company; all those things that are difficult to measure if you’re meeting once a quarter and spending one day and that’s it.
Dominic: I agree with you. But if you were to suggest Board members going deeper into the life of the company, the classic MBA approach would be “whoa, hang on a second. Management will get upset that you’re peering at them.” How do you balance that?
Mikhail: I think actually the areas the Board focus on should be very concentrated and management should be free to focus on day to day execution.
I seem to remember Thomas Jefferson mentioned a good expression about the function of the Senate. In American policy-making, the Senate has fewer members, is more deliberative and there is a more extended debate; its members are more seasoned and experienced…As one of the founders of the constitution said the senate proceeds with coolness, with more system and with more wisdom.
So my suggestion is that the Board is the same: focuses on just a few issues, no rush, but deliberating everything very carefully.
And from my point of view that should be three main areas: first, the long-term strategy – that is, the business plan for the next year or three years. Second, personnel decisions about the top 10, top 15 people depending on the size of the company. Third, strategic deals, mergers and acquisitions. That’s it.
Dominic: That’s very interesting. That’s radically different. I like the idea of Board’s spending way more time over decisions. To me, private equity is a good model in this respect. What you’re saying, in terms of annual time commitment for a Board, is 50 days, 55 days. The thing I wonder too is: if Board members have to spend much more time overseeing the company, shouldn’t they be paid more?
Mikhail: That’s exactly right – because in this system they create value and are accountable.
All the time we hear that appropriate corporate governance demands the Board members will not compensate with certain bonuses or whatever – they should have a fixed compensation, very moderate…
Dominic: It’s often cash not stock in the company…
Mikhail: That’s it, which from my point of view is just 100% wrong. One more topic which is also interesting is the LTIP compensation of the management.
Here’s another rule that we ‘newcomers’ see and find strange: rewarding management with stock options. To me, this is a very strange system.
The whole idea behind this is to reward people for good performance, right? But let’s put that to the test.
Look at the oil business right now. The price of a barrel has been cut in half. It’s inevitable that companies share prices will be damaged. Apart from some variation here or there, this is an industry-wide problem. But stock option rewards mean that all managers suffer more or less the same results – whether they behave effectively or frankly stupidly.
Wouldn’t it be better to assess how well a company has performed against its peers on longer term operational measures independent of total shareholder return?
It is easy to get information about their performance. So if one of them is doing better than their competitors, that’s probably a good reason to pay management a bonus – even if the share price has declined two times, because of events beyond their control.
Dominic: So you take out the industry shifts that are going on…
Mikhail: Absolutely. I think that the system of the management compensation should be somehow modernized, based on the competitiveness of the peers rather than share price, which depends on many things.
Dominic: Back to your point about financials and surface area. I think many publicly traded companies focus only on financial performance, not the underlying health of the business. I think it’s about looking at innovation; talent; trust; what this management team’s relationship is like with regulators, with the community, with people they’re trying to hire over time. You have a very interesting set of companies: you’ve got technology, oil. How do you think about health? You can see the surface financial performance, but how do you check the health of your companies?
Mikhail: It’s difficult to find objective indicators for corporate spirit – is it in good shape or bad shape? It’s about how people feel – are we proud of our company? Do we like working at the company? That is an important function of the Board, to measure those temperatures. If the temperature is not good, you are in trouble.
Dominic: And that’s clearly where the right people come in. Let’s talk about leadership. One thing I’ve been wondering about is whether in business schools we focus too much on what people do and not enough time on who people are: will this person panic when crazy stuff happens? How will they work with the Board? How do they handle the unforeseen stuff? I think the HR role is way underappreciated in companies – way under.
Mikhail: I fully agree. The people and the leadership are everything. The Board is the cornerstone of the whole building, the whole construction. So you first build the Board, and then the Board build the executive management and so on.
And as you say, it is not so much about the technical, sector-specific knowledge but what you might call the human qualities, how they respond to events, how willing they are to embrace change. I’ve seen a lot of examples of transfer of successful CEOs from one industry into another. Because it’s not about industrial knowledge, it’s about leadership. You can always find the deputies to have the technical knowledge.
Dominic: To pick up on technology, there is a book called No Ordinary Disruption which makes your point about the world moving faster and faster; we think that the next 15-20 years will be some of the most historic in the last 300 years. Technology, the shift in economic power to Asia and Africa, older populations – all these changes. I’m optimistic, I think it is an opportunity, but what we’re finding is the average age of a company is shrinking dramatically. In 1935 if you were on the S&P 500 list, the average time was 90 years. Today it’s 18 years. For any company, if we don’t change, if we aren’t thinking about the trends, the bold moves, we’re gone and we deserve to be gone.
Take Facebook. When they did their IPO, Mark Zuckerberg said “Oh my God, everything is going from PCs to mobile, so we have to switch.” So he said “we’re doing a platform shift,” and people said “You can’t do that, you’ve just done your IPO.” Guess what? The stock price went down. And he said “I don’t care, we have to do this.” But if he had been public someone would have taken him out, and not let him do it. And in a world where things are changing like this, governance – traditional governance – will destroy companies.
Mikhail: Yes, I recognize that. Another good example is Warren Buffet, Berkshire Hathaway. Effectively, it’s a public company because of his personal influence and brand. It’s effectively acting as a private company because he’s the guy who’s really heavily involved in making a lot of decisions for the companies they’re investing in, very active in participating in all major issues inside each company. It’s a very deep play. And it works.
So we follow that kind of thinking. We get involved with businesses where we can have an impact, and effectively act as a kind of owner of that business. We don’t buy 2% or 3% – we always buy big.
Dominic: Everything you’ve spoken about today – the importance of Boards, leadership, the right compensation – it’s fascinating, because it’s a very different model from what people teach. And it works. You have results over time.
Mikhail: These are just my humble opinions – I’m not actually a professional… no Harvard Business School graduate! It’s just based on our own experience. Our own operations.
Dominic: You’re very modest. Thank you for talking today.
Mikhail: Thank you.