KKR, Shareholder Theory, and Corporate Governance Conflicts

Introduction

Kohlberg Kravis Roberts (KKR) is an investment firm that acquires influence in a company by purchasing a controlling amount of shares, or a significant enough stake to pressure the company's board. KKR has made a number of large-scale investments and leveraged buyouts (LBOs) over the years, including its LBO of RJR Nabisco in the 1990s. In that instance, the firm anticipated a higher return on investment (ROI) than it ultimately received, and KKR went back on its promise to keep RJR Nabisco's assets intact, liquidating them in order to move on to other investment projects (Leveraged Buyouts, n.d.). By using its capital to influence how a company is managed, KKR has been able to shape outcomes for various firms in which it heavily invests.

Like any other activist investor — from Nelson Peltz, who famously battled the board of P&G for control after taking a significant stake through purchases of public shares, to Bill Ackman and Carl Icahn — KKR seeks to influence the companies in which it invests so that it can reap a large ROI (Brunsman, 2019; Huddleston, 2014). The problem is that in some cases a conflict of interest can arise with respect to governance. The conflict between shareholder and stakeholder theory becomes evident, and one must ask whether it is within reasonable ethical guidelines for a company to manage another firm for the purpose of increasing shareholder value at the expense of stakeholder value.

Additionally, the issue of auditing comes into play. External auditors are awarded large contracts to audit a firm, but those firms often want a glowing review rather than one in which numerous red flags are identified. That, in fact, was the problem Arthur Andersen eventually ran into — a conflict that ultimately led to the fall of the most famous and respected auditing firm in America (Neuman, 2005). This paper analyzes the problem of conflicts of interest with respect to KKR and discusses how activist investors deal with this issue and how they manage — or fail — to make the right call.

How KKR Influences a Firm's Board

KKR is able to influence a firm's board by buying a controlling stake in the company, or by holding enough of a stake that it can demand a seat on the board — much the way Peltz did with P&G. Peltz went on to advocate for certain changes in the company's direction, which contributed to a substantial rise in the company's stock price. KKR typically seeks to do the same thing. If it does not hold a controlling stake, it operates much like BlackRock, which holds massive stakes in many of the world's top companies. Whenever an investment firm like KKR or BlackRock holds such a large stake, it can influence the board by making demands that must be met — lest the investment firm choose to punish the company by dumping its stock into a weak market and causing the share price to crash. Because many board members and executives receive shares as compensation, they have a strong interest in maintaining a high share price, and they therefore tend to give in to the demands of firms like KKR.

KKR is then able to reshape the corporate culture of a firm by orienting its governance toward increasing shareholder value. Shareholder theory holds that a company's primary duty is to increase the value of its shares so that investors see a good ROI. One of the ways that companies today implement shareholder theory is by authorizing share buybacks on the open market. Companies will often take on cheap debt — that is, debt at low interest rates — and use it to repurchase shares. By creating demand for shares, the price rises, benefiting shareholders (Light, 2019).

This creates a problem because, as Zhao (2010) puts it, "the essence of corporate governance in U.S. public corporations lies in the separation of ownership and control" (p. 495). When the owners of shares end up in control of the firm, the idea of corporate governance becomes conflicted. However, the situation is actually much more complicated than a single investor buying up stock, as KKR does, because U.S. corporate governance results from the integration of various entities and parties — from executives to shareholders to institutional investors to agencies like the Securities and Exchange Commission to consulting firms to the stock exchanges themselves (Ewmi, 2005). Nevertheless, when a shareholder is large enough, that shareholder can wield significant influence over the board, just as KKR often does in its investments and just as Ackman did with JC Penney in his attempt to alter that firm's direction (Guinto, 2013).

Conflict of Interest in Corporate Governance

When a shareholder is effectively calling the shots at a company, the idea of corporate governance becomes muddied. The board should be concerned with transparency, accountability, and security. But when an activist investor like KKR influences the board, the question of accountability becomes fraught: to whom is the board now accountable — this single powerful shareholder, or other shareholders and stakeholders alike? Corporate governance is supposed to focus on the long-term success of the company. Yet, as KKR demonstrated with RJR Nabisco, the firm was really interested only in a short-term positive ROI, and it exited the investment when that ROI failed to materialize.

Large investors like KKR want returns that are both big and fast, and they are more interested in that outcome than in the long-term health of the company. They can therefore influence the board to engage in self-serving activities such as share buybacks: borrowing billions of dollars at low interest rates and using those funds to purchase the company's own shares, thereby creating artificial demand in the marketplace. This has nothing to do with corporate strategy, production, or research and development. Instead, it is about creating an illusion of demand by acting as a buyer of its own shares. Other investors observe the buybacks, the share price rises, and KKR benefits — as do board members, who typically hold large options contracts tied to share price performance. BlackRock represents another example of a potential activist investor that can leverage its shareholding to influence board decisions regarding firm direction and policy. Peltz did the same with P&G: activist investors can criticize a board's corporate governance strategy until the board conforms to the investor's will, and that will is driven primarily by ROI.

The board is supposed to be accountable to all shareholders, and, according to stakeholder theory, it should be accountable to all stakeholders as well. By reshaping corporate governance to serve those who benefit most from higher share prices, the board demonstrates a clear conflict of interest. There are, however, mechanisms a firm can use to address this conflict — and Chinese Walls represent one such approach.

Conclusion

Activist investors like KKR pose a significant ethical risk to corporate governance. They represent a shareholder-first mentality that not only flies in the face of stakeholder theory but also undermines shareholder theory itself when viewed from a long-term perspective. The pressure that KKR and similar activists place on boards to authorize debt-financed share buybacks — inflating stock prices at the cost of long-term financial health — is compelling evidence that a serious conflict of interest exists.

The U.S. corporate governance system imposes few strict regulations on this type of activity. On the contrary, it has encouraged it since 1982, when share buybacks — once illegal — were permitted, and public companies were effectively allowed to manipulate the market in this way. Until regulatory frameworks are updated to better account for the outsized influence of activist investors, the tension between short-term shareholder returns and the long-term interests of all stakeholders is likely to persist.

References

Brunsman, B. (2019). P&G CEO Taylor, activist investor Peltz laugh off proxy battle as stock soars. Retrieved from https://www.bizjournals.com/cincinnati/news/2019/09/20/p-g-ceo-taylor-activist-investor-peltz-laugh-off.html

Ewmi, P. F. (2005). Three models of corporate governance from developed capital markets. Lectures on Corporate Governance, December, 1–14.

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Huddleston, T. (2014). A look at how some of the top investors and hedge funds spent the second quarter. Retrieved from https://fortune.com/2014/08/14/hedge-funds-quarterly-disclosure/

Leveraged Buyouts. (n.d.). RJR Nabisco — Case Study.

Light, L. (2019). More than half of all stock buybacks are now financed by debt. Here's why that's a problem. Retrieved from https://fortune.com/2019/08/20/stock-buybacks-debt-financed/

Neuman, E. J. (2005). The impact of the Enron accounting scandal on impressions of managerial control. Academy of Management Annual Meeting Proceedings, S1–S6.

Seyhun, H. N. (2008). Insider trading and the effectiveness of Chinese Walls in securities firms. JL Econ. & Pol'y, 4, 369.

Zhao, J. (2010). Comparative study of US and German corporate governance: Suggestions on the relationship between independent directors and the supervisory board of listed companies in China. Michigan State International Law Review, 18(3), 9.