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26
Journal of Business Studies Quarterly
2013, Volume 4, Number 4 ISSN 2152-1034
Hermitage Fund: Shareholder Activism and Corporate Governance
Amir Manzoor
Hamdard Institute of Management Sciences, Hamdard University, Pakistan
Abstract
In countries with weak judicial systems that can easily be hijacked by influential, investing and
safeguarding the interests of investors is not easy. One such example is Russia. This case focused
on application of shareholder activism and corporate governance besides traditional strategies
of stock picking and timing maximize the returns and safeguard investors. This case is about
Hermitage Fund, an investment fund focused on investing in Russia. The case begins by
describing the Hermitage Fund, the country background of Russia, followed by the corporate
governance crisis in Russia and Hermitage Fund response to this crisis. The last part of the case
discusses the use of activist strategy in response to the corporate governance crisis. The strategy
worked in part by impacting Russian companies' reputation abroad and in part by forcing
regulators into action. However, continuation of such strategy required a rethinking about the
long-term sustainability of the activist strategy.
Keywords: Activism, Shareholders, Corporate governance.
The Hermitage Fund
Hermitage fund was founded in April 1996 as an investment fund focused on investing in
Russia. The Fund was started by William Browder in partnership with Edmond Safra, Chairman
of National Republic Bank. Browder had an MBA from Stanford and prior experience as
management consultant for BCG1 and investment banker for Salomon
2. He was the master mind
behind Hermitage strategy. Browder had distinct advantages over other fund manager operating
in Russia. He had proprietary knowledge about the oil companies operating in Russia which no
else knew. He was one of the very few people who had knowledge about how to invest in Russia.
Browder’s compensation was tightly linked with fund’s success. Hermitage focused on equity
market of Russia and did not engage in other investment services such as investment banking.
The fund had always concentrated on oil and gas sector (see Exhibit 11)
1 Boston Consulting Group. A diverse and global business consulting firm in USA. 2 A global investment banker in USA.
©JBSQ 2013 27
Country Background
Russia went through a wave of economic reforms during 1990’s. Initial focus of reforms
was to decentralize economic power and decision making. Macroeconomic reforms were
followed by microeconomic reforms with a privatization policy (See Exhibit 2). Voucher scheme
received little public attention.3 Loans-for-Share scheme dramatically increased importance of
so-called financial industrial groups.4 Privatization did provide financial supporters for Russian
government in the elections and broke the power of bureaucracy which could have thwarted the
reforms. Privatization was expected to increase efficiency and stimulate financial sector
development. Scholars emphasize that country with deeper financial sector witness high growth
rate of nation. With more developed financial systems, firms dependent on external finance see
high growth.5
Corporate Governance Crisis
But concerns mounted about the decline of government effectiveness and rampant
corruption (See Exhibit 1). A significant source of this concern was the lack of functioning
corporate governance system and institutions. These institutions, such as company laws,
accounting principles, securities regulations, and financial intermediaries (e.g. audit firm and
equity analysts) are present in developed markets to address conflicts between insiders of the
firms and investors. But these institutions either didn’t work as intended or developed slowly in
Russia (See Exhibit 3). Laws and their enforcement proved to be weak. Insiders in the firms e.g.
managers who achieved control through voucher scheme or oligarchs who achieved control
through loan-for-shares scheme took advantage of the situation and used their powers to enrich
themselves. This situation contributed to weakening of other corporate governance mechanisms
(e.g. company charter, company board) because insiders often had the power to change charters
and dominate the corporate boards. Abuse of rules became common practice by insiders of firm.
They manipulated judges to order in their favor or ignored entirely the legal rulings against them.
The toothless Scurrilities and Exchange Commission was unable to enforce compliance with
their rulings and relied upon Russian courts which often ignored or threw out these rulings.
Though litigation in Russian courts was inexpensive but had little prospects for success. Courts
were easily corruptible and, as a result, corporate governance violations were extreme, very
common, and very visible. 6 There was political involvement in corporate cases where
government officials likely took actions against interests of minority shareholders as to support
insiders of firms. The weaknesses in economic and political environment, together with
institutional weaknesses produced a challenging environment for Russian firms. GDP fell and
poverty increased (See Exhibit 12). The situation demanded immediate response from Hermitage
as the largest public equity fund in Russia and for its strong returns in spite of these problems
(See Exhibit 11).
3 Hilary Appel, 1997, “Voucher Privatization in Russia: Structural Consequences and Mass Response in the Second
Period of Reform”, Journal of Europe-Asia Studies, Vol. 49, No. 8, 12, pp. 1433-1449 4 “Political Environment for Global Business - Course Guide- Chapter 5: Privatization in Russia, Poland”
http://www.mega.nu:8080/ampp/PEGB/chap05.htm 5 Ross Levine, 1997 “Financial Development and Economic Growth: Views and Agenda” Journal of Economic
Literature, Vol. 35, No. 2, 6, pp. 688-726 6 Alexander Dyck et al., 2006, "The Corporate Governance Role of the Media: Evidence from Russia"
28
Hermitage Response
Hermitage had early success by following a traditional investment approach of choosing
stock. In Browder’s words:
“In these early years, my investment strategy was relatively straightforward and my main
skill was picking stocks. I put together a list of the most important companies as a percent
of GDP and a list of the most important companies on the stock market. When a company
was on the GDP list but not on the market list I saw an opportunity because I believed an
important economic player would eventually become an important stock market player.
The companies that weren’t important stock market players often traded at massive
discounts to Russian companies that were well researched by the brokers.” 7
But the current Russian crisis diminished these returns. Hermitage changed its strategy to activist
strategy (See Exhibit 7). Browder provided some perspectives on activist strategy.
“We take large long-term positions in companies, which are highly undervalued on a
fundamental basis, but often have corporate governance problems. Instead of waiting for
the world to change, we launch our own corporate governance initiatives to unlock their
intrinsic value.” 8 “We use two strategies. If the company acts in blatant violation of
shareholder rights, we embark on a media campaign exposing the problem. We also
conduct thorough research to see if the company is diverting money. These are often
complex questions, but when we relate them we will provide an easy-to-understand
presentation of the facts. We have the expertise and resources to conduct research that
would be beyond most people’s budget. We also have money at stake, and so it makes
sense for us to perform this research.” 9
Hermitage also contacted leading western financial newspapers such as Financial Times and
Wall Street Journal. Hermitage often combined its legal campaign with high-profile lawsuits,
designed to maintain the high profile of the issue in the press as to redress shareholder rights
abuses in the courts. With this new strategy, Hermitage again gained significant increases in its
share price (see Exhibit 11).
The Rise of Activist Strategy
In pursuit of its activist strategy, Hermitage launched campaigns against several
companies in which it had invested. UES (Unified Energy System) announced a restructuring
plan whose primary hidden goal was to sell assets of the company at lower value in a series of
non-transparent auctions. Hermitage launched a public campaign to draw the attention of the
Russian government to potential losses which both the government and minority shareholders
would incur should the initial plan go through. As a result, the Russian government established a
special commission to prepare a new restructuring plan. Hermitage was become member of this
commission (See Exhibit 9).
7 “Media and Corporate Governance in Russia” HBS Case # N2-703-010 8 Media and Corporate Governance in Russia” HBS Case # N2-703-010 9 “Russian Activism and the Press: Is There a ‘Hermitage Effect?’”
http://hermitagefund.com/index.pl/news/download/891/hedgeworld%20june%202007.pdf
©JBSQ 2013 29
In 2001, Sberbank (The Savings Bank of the Russian Federation) management decided to
proceed with a new share issue without granting pre-emptive rights to existing shareholders.
Hermitage together with other minority shareholders initiated a campaign to stop dilution. In the
end, the Russian parliament approved amendments to the Joint-Stock Company Law that
introduced the concept of pre-emptive rights to protect minority shareholders from dilutive share
issues (See Exhibit 8).
The case of Gazprom was the latest. Gazprom was accused of massive asset stripping.
Gazprom largest shareholder was Russian government. Hermitage, together with other minority
shareholders, launched a campaign to address governance problems at Gazprom (See Exhibit 10).
Hermitage also sought a court ruling to invalidate the PricewaterhouseCoopers‘(Gazprom
auditor) audit reports in order to pave the way for a new forensic audit at Gazprom by an
independent auditor.
The Future Direction
The activist strategy was unusual for an institutional investor. In the words of Robert
Chappell, chair and CEO of Penn Mutual Life Insurance Co.:
“Once we lose faith in the management or the trajectory of that company, we sell it. We
are strictly passive. We don’t feel so much engaged or wedded to (a stock) that we’re
going to spend time trying to change its behavior … Is that the right thing to do? It’s a
debate.” 10
Hermitage strategy gained some appreciation. At the same time this strategy was criticized as
well. Not everyone was convinced that this strategy was good for Hermitage investors or for
other minority shareholders. Among the criticisms Browder encountered were concerns about
showboating for his own personal interest, using the media campaigns as advertisement for his
funds, and that returns could be higher without this using this strategy. Alternatives to activist
managers emerged soon. The Russia's Investors Protection Association (IPA) was founded in
April 2000. IPA had support of many fund managers including Hermitage. It was dedicated to
minority shareholders' interests against the predations of Russia's business oligarchs. Headed by
former head of the Russian Securities Commission, IPA had its own members to take up seats in
corporate boards. 11
In the aftermath of Gazprom case Browder needed to rethink his approach.
While Hermitage returns had increased significantly after Gazprom case settlement his strategy
was showing some weaknesses. Browder failed to win seat at Gazprom board. Russian courts
dismissed lawsuits against PricewaterhouseCoopers. There were daily stories of corporate
scandals in USA. It was becoming increasingly difficult to make these Russian corporate
governance issues newsworthy in western media and this could cause decline in his leverage.
Should he continue his activist strategy? If yes, what policies should he follow, and would it
continue to work? Time was running out and he had to quickly come up with the answers to
these questions.
10 “Institutional Investors as a Force for Change” Knowledge@Wharton;
http://knowledge.wharton.upenn.edu/article.cfm?articleid=655 11 RUSSIA - Profile - Igor Kostikov; http://www.allbusiness.com/mining/oil-gas-extraction-crude-petroleum-
natural/617610-1.html , Accessed 15 August, 2007.
30
Exhibit 1: Corruption and Government Response in Russia
Source12
12 Hermitage Capital Management (HCML)
©JBSQ 2013 31
Exhibit 2: Summary of Russian Economic Reforms
Year Event Outcome
1992 Price
Stabilization
Reforms
Price stabilization took longer. Inflation was finally under control by
1995. Government increased reliance on debt to cover its
expenditures. Government’s inability to collect tax revenue led to
budget imbalance, default on domestic debt and massive devaluation
of ruble.
1992-
1994
Privatization-
Stage I
15,000 firms employing more that 60% of industrial workforce were
privatized using voucher method. Later, government sold through
cash sales to domestic and foreign investors as well.
1995 Privatization-
Stage II
Strategic industries e.g. oil and gas were privatized through loans-
for-share scheme. Shares of strategic industries were transferred to
investors as government did not make its loan repayments.
1996 Privatization-
Stage III
A new privatization law was passed. More emphasis was placed on
competition in privatization.
Source 13
Exhibit 3: Development of Corporate Governance Institutions
Year Event
1993 Bankruptcy law was passed
1995 Securities law was passed
1995-
1996
Securities and Exchange Commission(FSRC) was established.
A civil law was passed.
Source 14
13 Privatization in Russia: Scope, Methods and Impact available at http://www.bbk.ac.uk/polsoc/staff/academic/bill-
tompson/privatisation-in-russia1992-2002 14 A Survey of Corporate Governance in Russia; http://www.cefir.ru/download.php?id=988
32
Exhibit 4: Hermitage Strategy and its Impact on Corporate Governance
Source15
Exhibit 5: Russian Macroeconomic Indicators
15 Hermitage Capital Management (HCML)
©JBSQ 2013 33
34
Source16
Exhibit 6: Russian Firms Microeconomic Indicators
16 Hermitage Capital Management (HCML)
©JBSQ 2013 35
36
©JBSQ 2013 37
Source: Hermitage Capital Management (HCML)
Exhibit 7: Hermitage Investment Approach
Source
17
Exhibit 8: Sberbank Initiative and Outcome
17 : Hermitage Capital Management (HCML)
38
©JBSQ 2013 39
Source18
Exhibit 9: UES initiative and Outcome
18 Hermitage Capital Management (HCML)
40
©JBSQ 2013 41
Source19
Exhibit 10: Gazprom Initiative and Outcome
19 Hermitage Capital Management (HCML)
42
©JBSQ 2013 43
Source20
Exhibit 11: Hermitage Performance
20 Hermitage Capital Management (HCML)
44
©JBSQ 2013 45
Source21
21 Hermitage Capital Management (HCML)
46
Exhibit 12: Russian GDP by Expenditure 1990-1999
Source22
22 IMF Staff Country Report: Russian Federation, No. 00/150, Nov. 2000, page. 29.