For activist investors, real change can be elusive

In early summer 2017, activist investor Richard T. "Mick" McGuire III won a proxy contest at Buffalo Wild Wings and gained seats on the company's board.

It's still not easy to know really what the point was.

The restaurants are still operating, of course, just by franchisees or as part of a big restaurant company created by private-equity firm Roark Capital Group. Wild Wings had already been in contact with Roark before McGuire's victory at the decisive shareholder meeting, and it's important to know that Roark made the first call.

McGuire shut his fund-management business last month, a symbolic end to the senseless Wild Wings saga.

This wasn't the first time our corporate community has been visited by the likes of McGuire. His old boss Bill Ackman, an early backer of McGuire's ran his own pointless campaign here, trying to remake Target Corp.

Ackman, of Pershing Square Capital Management, is a business celebrity, his name is one that anyone in business might recognize. With Target now thriving and employing thousands of Minnesotans, it's a very good thing he failed.

Activist investor is a whole category of hedge-fund manager. Even though they had a better year in 2019, average returns as a group lagged the S&P 500 for the first 11 months of the year. For the high net-worth individuals and institutions that have put money in these things, an index fund would have been a better choice.

The argument McGuire made at Buffalo Wild Wings was that the company needed to get out of the capital-intensive business of owning and operating restaurants and become much more of a franchiser and marketing company. Let the franchisees come up with the dough to build restaurants.

Ackman made a very similar argument about the use of capital at Target, that the company had far too much money tied up in land and buildings. His ideas included spinning off those real estate assets into a real estate investment trust, or maybe doing that and then raising money from the public market in the REIT.

There's a downside, though, to taking capital out of a business. Financial capital provides a cushion for the ups and downs of the business cycle. Physical capital — the buildings, restaurants and equipment — provides a lot of control to companies and might be cheaper than leasing or outsourcing.

The bigger point is that what really matters is whether the management team generates a return on the capital that exceeds what it costs to get the money in the first place. Target doesn't always get that right, of course, but it's had a disciplined approach to this task for decades. It routinely reminds its investors how it's doing at investing the shareholders' money.

Ackman's campaign failed for a number of reasons. One of the simplest ways to characterize it came from an investment analyst quoted in a Forbes article, who pointed out that Ackman couldn't cut up one pie into different pieces and expect a different value.

Another of Ackman's problems was timing, arguing about the merits of a real estate spinoff and financing in the same season that investment bank Lehman Brothers tipped over and the capital markets all but seized up.

One of Ackman's funds slipped nearly 90% that year, which Ackman himself later characterized as a disaster. In early 2009 he wrote a letter to his investors about this and then followed up with a second letter within a week, having neglected in his first letter to apologize.

It's hard to get a 90% loss investing in a blue chipper like Target, but that's if you just buy and sell shares. The tool kit for funds like those run by Ackman and McGuire includes options and other derivatives.

Options can be used to reduce risk, of course, but also to speculate. Buying a slug of call options, the right to buy stock at a fixed price, will only work out if the underlying stock price doesn't sink.

If the stock price declines enough, all the options can expire worthless. The only thing left to do for the fund manager then is write a letter of apology.

The liberal use of options is one of the reasons activists can't seem to escape their reputation as short-termers uninterested in helping build a business. Mutual-fund managers who vote for board members know that any investors talking about the long term can't be taken seriously if they just own options that expire in 60 days.

One research paper from last year described activists as "more or less impotent," that for all their bluster and campaigning they are mostly unable to affect real change at the companies they target. There has been little evidence they have been able to turn around companies that are not doing well or turn good companies into better ones.

One of the points made here is that the activists have no special insights. Why would anyone think a hedge-fund manager on the outside would have any great ideas of how to improve corporate performance that somehow haven't already occurred to the managers who run the business?

What the activists do seem to have a knack for is forcing a company to seek a buyer, which might be good for shareholders in the short term if the company finds a buyer willing to pay a premium price.

And that, of course, brings us back to Buffalo Wild Wings and Mick McGuire. In Marcato's last full presentation before the 2017 shareholder vote at Buffalo Wild Wings, the fund manager confidently said that its plan of turning restaurants over to franchisees would double if not triple the stock price. In that presentation, Marcato reported that the shares were trading at $155 each.

And McGuire even won a board seat for himself. At the same time, longtime CEO Sally Smith said she would retire. By then, though, discussions to sell the company were already underway with the principals of Roark Capital.

The eventual sale, to Roark affiliate Arby's Restaurant Group, took out the public shareholders at $157 per share.

If a $2 move in the stock price constitutes winning, it's no wonder Marcato had to close.