Alternative Investment Analyst Review Editor's Letter: Stock Market Myths: High P/E Ratio, Volatility Tsunami & Share Buybacks Hossein Kazemi Investing Like the Harvard and Yale Endowment Funds Michael W. Azlen, CAIA and Ilan Zermati, Frontier Investment Management Offshore Property Investing: Thoughts on the Investment Process Tim Stringer, CAIA, Frontier Advisors Patience Premium Igor Yelnik, ADG Capital Management The Rise of Unicorn Funds: Examining the Supply of Private Growth Capital Rohit R. Kulkarni, SharesPost Investing in an Overvalued Market and Tail-Risk Hedging Michael Ning and Michael DePalma, PhaseCapital Should DC Plan Sponsors Add Private Equity to Target-Date-Funds? Andres Reibel, Pantheon Pershing Square, Ackman and CP Rail: A Case of Successful “Activism”? Yvan Allaire, and François Dauphin, Institute for Governance of Private and Public Organizations (IGOPP) The Merits and Methods of Multi-Factor Investing Andrew Innes, S&P Dow Jones Indices A Simple Approach to the Management of Endowments Hossein Kazemi, CAIA Association, and Kathryn Wilkens, CAIA, Pearl Quest The MSCI Global Intel Report Max Arkey, MSCI Real Estate Q3 2017, Volume 6, Issue 3 Chartered Alternative Investment Analyst Association® Pershing Square, Ackman and CP Rail: A Case of Successful "Activism"? Yvan Allaire Pershing Square, an activist hedge fund owned governance was no insurance policy against Institute for Governance of Public and managed by William Ackman, began shareholder discontent. and Private Organizations hostile maneuvers against the board of CP Rail Indeed, during the summer of 2011, a group in September 2011 and ended its association of 20 portfolio managers were gathered in a François Dauphin with CP in August 2016, having netted a profit New York City bistro to discuss opportunities Institute for Governance of Public of $2.6 billion for his fund. This Canadian saga, in the transportation sector. During pre- and Private Organizations in many ways, an archetype of what hedge fund diner cocktail, one of the investors spoke activism is all about, illustrates the dynamics critically about the governance of CP. “He was of these campaigns and the reasons why this exasperated that the company’s board had not particular intervention turned out to be a thrown out the chief executive, Fred Green.”2 spectacular success… thus far. That investor admitted that the previous winter Governance at CP Rail had been grueling for rail transportation, In 2009, the Chairman of the board of CP Rail but blaming the weather to justify CP’s poor asserted that the company had put in place the results was, according to him, just another best practices of corporate governance; that lame excuse made by Fred Green to avoid year, CP was awarded the Governance Gavel taking responsibility. His views were shared Award for Director Disclosure by the Canadian by many other portfolio managers who turned Coalition for Good Governance. Then, in belligerent about CP’s Board and wondered why 2011, CP ranked 4th out of some 250 Canadian no activist fund had yet spotted the opportunity companies in the Globe & Mail Corporate offered by CP. A phone call was made to Paul Governance Ranking1. Yet, this stellar corporate Hilal, an associate at Pershing Square Capital 57 Quarter 3 • 2017 Pershing Square, Ackman and CP Rail: A Case of Successful "Activism"? Management (Pershing Square), an activist hedge fund. That CP was to achieve an operating ratio of 65 for 2015 (down from phone call triggered the most highly mediatized proxy contests in 81.3 in 2011). Canada. Thou shalt never (henceforth?) underestimate the power The Board and Fred Green Respond to Ackman... and Harrison of discontented shareholders. The Board formally responded to the allegations of Ackman in its Ackman attacks Management Proxy Circular of March 22, 2012 and Fred Green Pershing Square began purchasing shares of CP on September used the occasion of an investor presentation, on March 27, 2012, 23, 2011. They filed a 13D form on October 28th showing a to make his case. stock holding of 12.2%; by December 12, 2011, their holding had The Board qualified Harrison’s (and Ackman’s) targets of reached 14.2% of CP voting shares, thus making PS the largest “shot in the dark,” showing a lack of research and a profound shareholder of the company. misunderstanding of CP’s reality. Green mentioned that Hunter A few weeks after Pershing Square disclosed its acquisition of CP Harrison was a wrong choice as a potential successor since shares, Ackman asked to meet the Chairman of the Board of CP, Harrison’s reputation precedes him in Canada and several of CP’s John Cleghorn. A meeting was scheduled on November 2, 2011 at customers have said they would consider moving their business the Montreal airport. Ackman reminisced: “Although I’d said we elsewhere if Mr. Harrison were appointed CEO8 of CP. wanted to talk about a management change, he and Fred Green Relying on an independent consultant report (Oliver Wyman were there. After three of us made a presentation, Mr. Cleghorn Group), Green mentioned that Harrison’s target for CP’s operating said, ‘I’ve spoken to the board and want to let you know we’re ratio was not achievable since CP’s network was characterized by 100 percent behind Fred.’ I couldn’t believe the board made its steeper grades and greater curvature thus adding close to 6.7% to decision before hearing our case."3 the operating ratio compared to its competitors.9 On December 15, 2011, CP issued a press release announcing The independent consultant’s report was used to buttress several the appointment (effective immediately) of Tony L. Ingram and arguments:10 Edmond L. Harris as directors on CP’s Board. "Both Tony and Ed have extensive and valuable railway experience. I am confident “In its report, Oliver Wyman concluded that the Multi-Year Plan that Canadian Pacific will benefit from their operational expertise (as of October 31, 2011) was both reasonable and achievable in and sound business knowledge.” said John Cleghorn.4 the overall context of expected market conditions, the competitive environment and the action plans supporting major productivity These appointments were a form of concession to Ackman.5 Tony initiatives. L. Ingram was the former COO of the CSX,6 while Edmond L. Harris held the same position at the CP for 11 months before Oliver Wyman also concluded that an operating ratio of 65 for retiring. The latter was well respected by the financial analysts 2015 was neither realistic nor achievable. This conclusion was and by the industry in general; his (surprise) departure from the based on industry experience with respect to the time needed by CP raised numerous questions at the time since he was closely the other five largest Class I railroads to achieve a 1300 basis point associated with the potential successful execution of the multi- operating improvement from a starting point of 78. year plan7 (CP’s strategic plan). These appointments were well […] In its assessment of the reasonableness of the assertion received by Ackman, who nonetheless judged them as being too that an operating ratio of 65 could be achieved for 2015, Oliver little, too late, and the proxy contest was officially launched. Wyman identified important inherent structural differences In the Chairman’s letter to shareholders from the 2011 annual between Canadian Pacific and CN franchises that support its report (signed on March 5, 2012), John Cleghorn wrote that: conclusions. Principal among these is the significant difference between main line grades and severity of curvature on comparable […] Even through a challenging operating environment routes. Canadian Pacific has a more limiting track structure as in 2011, CP has made great strides in the areas of a result of routes determined when Canadian Pacific and CN governance, management and operations. The Board were originally constructed. Oliver Wyman’s comprehensive and believes that Pershing Square’s demand for management in-depth review of track charts, timetables and traffic flows has change would put at severe risk the significant forward determined that Canadian Pacific must operate an additional 203 momentum the Company is making on the Multi-Year main line AC locomotives to compensate for its steeper grades Plan. and more severe degree of track curvature relative to CN. This requirement to operate with this greater number of locomotives On behalf of the Board, I would like to extend our results in higher expenses for fuel, equipment maintenance and appreciation to Fred Green and his management team depreciation.” for aggressively and successfully implementing our Multi-Year plan and creating superior value for our The Board also made the following claims:11 shareholders and customers. • “the Board has significant breadth and depth of Ackman responded by inviting all shareholders and other expertise and experience, including in the railroad interested parties to a public Town Hall Meeting (held on and complementary industries, with a recognized February 6, 2012) and, with Hunter S. Harrison (retired CEO of commitment to the highest standards of corporate CN and his candidate for CEO of CP, his side) made a fact-based governance; the Other Pershing Square Nominees have presentation about the shortcomings and failings of the CP board no evident railroad industry experience and add no and management. Harrison and Ackman stated that their goal for other complementary industry experience; 58 Pershing Square, Ackman and CP Rail: A Case of Successful "Activism"? • the Board has engaged with Mr. Ackman and maintains Again, Ackman reiterated that their goal was to achieve an an open invitation for him to join the Board, an operating ratio of 65 for 2015 (down from 81.3 in 2011). invitation which Mr. Ackman has so far declined. He lobbied investment funds to support his slate of nominees for Instead, Pershing Square has launched an unnecessary the board, as well as the hiring of Hunter S. Harrison (the recently and costly proxy contest; retired CEO of CN) as CEO for CP. • Pershing Square has disclosed no specific plan to achieve Ackman’s letter makes a forceful case for hiring Harrison: its stated operating ratio targets (the Board points out that Hunter Harrison, in an interview with Business “Hunter Harrison is a seasoned chief executive with a proven, News Network, when asked to provide a concrete unrivaled track record of operational and cultural transformation. example of how he would reduce CP’s operating ratio, he He is a change agent with deep railroad operating experience answered “Well, I think we would first of all, first of all and a thorough familiarity with all aspects of the Canadian we would build a team and a plan”); rail industry, including its customers, freight flows, terminal operators, unions (and union leaders), suppliers, regulations, • the only stated goal of Pershing Square is to install Mr. terrain, and weather patterns.” Harrison as President and CEO, who the Board believes is not the right leader for Canadian Pacific; Of course, in Ackman’s world (and apparently in Harrison’s too), no moral or ethical qualms are triggered by the hiring of a • Pershing Square proposal is ill-conceived and introduces recently retired executive from the direct competitor of CP, a man unwarranted risk to shareholder value. Pershing Square who had signed a binding non-compete agreement on leaving CN has demonstrated a lack of understanding of Canadian and who has been lavishly paid for his services at CN. Pacific’s business. Appendix II presents large excerpts from Ackman’s letter to The Board asserted that Pershing Square had, on numerous shareholders outlining his criticism of CP’s management and occasions, made fallacious statements to support its demand board as well as his proposed plan of action. that Fred Green be replaced by Hunter Harrison. For example, Pershing Square “claimed that Canadian Pacific’s mobile assets The parties were now on a path towards a full-blown (rail cars and locomotives) were poorly utilized and cited this as confrontation in the form of a proxy fight around nominees for a ‘big deficiency’ on the basis of comparative operating metrics the board of directors. from 2010”. In fact, according to CP’s Board, “Pershing Square Structural differences between CP and other railway companies ignored the marked improvements Canadian Pacific has achieved in 2011. Through February 2012, Canadian Pacific has achieved a Whether shareholders sided with one party or the other would level of rail car utilization surpassing that reported by CN for the hinge in part on the issue of structural impediments to the fourth quarter of 2011.”12 performance of CP. Clearly, as stated on multiple occasions, an unquestioned premise of the CP management was that significant To be fair to Fred Green, his actions as CEO as outlined in structural differences between the CP and the other railway Appendix I, do have merit even if eventually he failed to achieve companies imposed higher operating costs on CP. That premise the goals he targeted. was unquestioned and accepted as a fact by the CP management Ackman’s retort and its Board as well as by financial analysts and other members of the railroad industry. The magnitude of the operating These arguments did not sway or deter Ackman. On April 4th disadvantage that CP had to endure was estimated at some 6.7% 2012, he came out swinging in a scathing letter to CP shareholders by Green as well as by Oliver Wyman, the consulting firm hired disparaging CP’s Board of directors in general, and its CEO, by the Board of CP. This structural impact on costs was, it seems, Fred Green, in particular. According to M. Ackman, “under exacerbated in periods of extreme weather conditions. the direction of the Board and Mr. Green, CP’s total return to shareholders from the inception of Mr. Green’s CEO tenure to Harrison, the putative CEO for CP, would not have any of this, the day prior to Pershing Square’s investment was negative 18% made light of these “impediments” to CP’s performance. During while the other Class I North American railways delivered strong the Town Hall Meeting held by Pershing Square, Ackman asked positive total returns to shareholders of 22% to 93%.”13 Thus, Harrison to share his thoughts on the notorious structural according to him, “Fred Green’s and the Board’s poor decisions, differences at the CP16: ineffective leadership and inadequate stewardship have destroyed “I didn’t hear anything about structural differences when they shareholder value.”14 were on top [the CP]. The Rockies, they’ve always been there. Ackman demanded that the Board be restructured and the CEO They always will be there. I know it’s gonna be difficult to justify replaced by a leader able to “transform its ‘culture of excuses’ into a capital investment to get that grade down (laughs). It kind of one of performance and accountability.”15 depends on where you are. I remember coming to Montreal at first and kind of reading back in the files. Ackman’s letter contained some damning statistics on CP’s performance, particularly with respect to all important “operating I looked at the files after the IPO and one of the things that CN ratio,” showing that CP’s performance is the worst of the 6 largest was talking about then was the improvement they were gonna rail operators in North America (and CN the best by a wide make in their performance, in their operating performance, but margin). they cautioned everyone to ‘Please don’t think we gonna get to US types standards, it’s just not structurally possible, it’s not in the 59 Quarter 3 • 2017 Pershing Square, Ackman and CP Rail: A Case of Successful "Activism"? cards’. Now, as we went flying past, over the performance in the • Having failed to present to CP shareholders a balanced US, guess what the US carriers said? Don’t ever expect us to beat analysis of the opportunities and risks before the the Canadian standards; it’s just not in the cards. They get their Company, ISS puts forward spurious reasons to vote healthcare paid for. Our fringes are 40%, theirs are only 15 or against CP's directors, and 20%, so it’s kind of where you are. • The dissemination of the ISS report to the media prior Look, every railroad has structural… Every business has to receipt by the company and certain ISS subscribers structural issues. That’s what management’s paid to deal with. reflects poorly on ISS's professionalism and, by There’s no perfect franchise that I know of. So, you spend your extension, on the recommendation put forward by ISS.” time and energy fixing those things not making excuses about The Ontario Teachers’ Pension Plan also publicly confirmed them because guess what happens, you start believing your its intention to support Pershing Square’s proposed candidates excuses and then the team starts believing we can’t get that thing for the board. This public support from a large and respected done because we’ve got structural issues institutional fund was another strike against the CP. Then, So, look… It snows everywhere. It snows on CN, it snows on CP. a survey of institutional investors representing 45% of CP’s Some winters are rougher than others but, we need to be prepared outstanding shares showed that 94% of them would vote for the for them. So, I’m not a big believer in… that there are structural board nominees proposed by Ackman.19 hardships that this franchise cannot overcome.” Two other proxy advisory firms, Egan-Jones Proxy Services and As shown in Appendix III, the gap in operating ratio between Glass Lewis & Co., also endorsed Ackman’s position on Canadian CP and CN had not always been as wide. In fact, CP had a lower Pacific Railway.20 The perspective looked decidedly gloomy operating ratio than CN during a period of time in the 1990s for CP’s Board and CEO at the upcoming annual meeting of (Of course, CN was a Crown corporation at that time). The gap shareholders. eventually widened, reaching unprecedented levels during Fred Annual Meeting of Shareholders Held on May 17, 2012, and Green’s tenure (the last full year of operating ratios attributable to Changes to CP’s Board Green was in 2011). A few hours before the annual meeting, CP issued a press release A Proxy Advisor Invites Itself to the Debate in which it stated that Fred Green had resigned as CEO, and Just a few weeks before the annual meeting of shareholders that five other directors, including the Chairman of the Board, where the board candidates proposed by PS were challenging John Cleghorn, would not stand for re-election at the company’s the nominees of management, ISS (Institutional Shareholder shareholder meeting. Services) – the largest proxy advisory firm – published a report Pershing Square had won the proxy fight; all the nominees which strongly supported Pershing Square’s position “because the proposed by Ackman were elected. Quickly thereafter on June 28, dissidents have demonstrated a compelling case that poor board just a little more than a month after the shareholders’ meeting, oversight has allowed the company’s performance to drift further Hunter Harrison was appointed CEO. Meanwhile, two other and further below both its peers and its potential over at least half directors (member of the pre-Pershing CP’s Board) announced a decade, it seems clear that change on the board is needed.”17 The that they were stepping down. Only a few days after Harrison took CP now had to defend itself against a new and influential party. over as chief executive, Tony Ingram, another director appointed The company issued a press release to respond to ISS18: under the older management, also resigned on July 5. Thus, with • “ISS operates from a false premise and maintains a the addition of Hunter Harrison recently appointed to the Board double standard with respect to CP's Multi-Year Plan and the resignation of a third director, the Pershing group now and Pershing Square's failure to provide any strategic or had the majority on the board with 8 of the 14 board members. operational plan, Canadian Pacific Railway under E. Hunter Harrison • ISS fails to take into account the development and “Harrison has been making his way across Canada and the aggressive and successful execution of the Company's northern United States since taking on the job June 29, and he Multi-Year Plan, keeps asking: Why do we do this? What do we do with that? • ISS has failed to recognize the risk to shareholder value When he gets unsatisfactory answers, red tape gets cut, rules are and the delay to the continued execution of the Multi- changed, trains are operated differently, and the like.”21 Within Year Plan related to Pershing Square's proposal to replace just a few weeks, he made several changes that had an immediate CP's current CEO, Fred Green, with Hunter Harrison, impact on the operations. For example: • ISS attacks the Board's decision to commission the - A CP intermodal train changes crews 13 times Oliver Wyman report in response to Pershing Square's between Montreal and Vancouver. Harrison asked, ‘why CEO ultimatum and unrealistic OR target of 65 by 2015, are these supposed hotshots scheduled to dwell in places while overlooking the flaws in Pershing Square's thesis, like Ignace and Chapleau, Ont., for 20 minutes or longer when a step off-step on crew change takes more like five • ISS's flawed justifications for recommending the minutes?.’ So schedules are being tightened. Harrison Pershing Square nominees are based on incorrect and figures that limiting crew changes of intermodal trains incomplete information and reflect a lack of objectivity, to a brisk 5 minutes will take six hours out of the cross- • The ISS report contains a number of errors, country trip. 60 Pershing Square, Ackman and CP Rail: A Case of Successful "Activism"? - Harrison wondered why so many intermodal trains • 4,550 positions have been eliminated,26 thus decreasing are stopping along the way to pick up or set off just a the workforce by 27 percent.27 Most of these positions few containers at the smaller ramps in Calgary, Regina, were eliminated by attrition, and the majority of the and Winnipeg. Try doing this in winter and then timing reduction came from the operations, as Harrison would how long it takes to get a train’s air back up in -35 degree put it in its own style: “If you take 500 locomotives out Fahrenheit weather. The result was that Vancouver- and 10,000 cars out, obviously you don’t need as many Toronto trains 110-111 (train numbers assigned to a mechanics.”28 Part of the reduction also came from specific route) were abolished and in their places trains the customer service department in Winnipeg (about 100-101 were created with no work en route and high 75% of the 800 employees)29 – the new approach puts priority (green light during traffic controls, and other the responsibility of the customer service (keeping the trains on the tracks have to take the siding to let them customer happy) on the person actually delivering the pass in priority). The first 101 arrived in Vancouver 17 service. hours earlier than 111 would have gotten there under the old schedule. • Relocated CP’s corporate headquarters from downtown Calgary to new office space at CP-owned Ogden Yard, After some 18 months at the helm of CP, Harrison rationalized “a move that cut costs but also keeps Canadian Pacific’s the operations as well as resources, human and material. The focus on freight operations front and center for corporate newcomer CEO took a series of measures to transform CP22: employees.”30 Harrison says: 'It’s going to save us about • New executive leadership team, including a new Senior $17 million or $18 million annually, and I think over Operations lead team (also recruited from CN!) with time, it’s a better environment for the employees. […]It’s a mandate for centralized planning and decentralized a way to take those people out of headquarters and kind execution, to eliminate bureaucracy and have service of let them be out there and see what the business is all decisions made faster and closer to the customer; about. It’s not about downtown bank buildings and glass towers. It’s about railroading.”31 • Revamped intermodal and merchandise train service resulting in faster transit times for customers; • New longer sidings program to improve asset utilization and increase train length and velocity. A siding is a • Closure of hump-switching yards in Toronto, Winnipeg, low-speed track section distinct from a running line that Calgary and Chicago - producing significant cost may be used for marshalling, stabling, storing, loading savings and more efficient operating practices. A hump- and unloading vehicles. CP had short sidings (5,000- switching yard is an artificially elevated area within a 6,000 feet) and the new program foresees the building of classification yard where the force of gravity is used to 12,000-15,000 feet sidings to eliminate bottlenecks that move rail cars along a network of marshalling tracks. will allow the CP “to run longer trains more effectively Those humps were from the 1950s and 1960s; at that without adversely affecting speed and velocity.”32 time, 80 to 85% percent of the cars that the CP handled had to be sorted, classified or switched. Harrison Harrison communicates non-stop about the importance of his mentions that “the nature of our business has changed. Five Foundations to railroad success, which serves as a guide for Bulk and intermodal, which compromises over 70 the change he wishes to instill to CP: 1° provide service; 2° control percent of our business, is all handled in unit trains. We cost; 3° optimize assets; 4° operate safely and 5° develop people. certainly didn’t need classification yards. We’re going to a more flat switching mode of operation.”23 In the first edition of a new magazine for employees (now called Canadian Pacific Magazine, replacing the former publication • Closure of intermodal terminals in Milwaukee, Obico Momentum), Harrison observed “If you look at the recent history (Toronto), and Schiller Park (Chicago) - reducing of CP, it’s been an operating company run by marketing people. footprint and operating expenses while also facilitating There are a lot of good railroaders here, a lot of talent to build on. efficient operating practices and reduced end-to-end I’ve sensed some excitement, with people saying, ‘Oh, these guys transit times; want to railroad again.’ So we’re letting people know that we’re • Improved train service and network velocity resulting getting back to the basics.” in the need for 195 fewer locomotives and 3,200 fewer Unlike his predecessor, who was quite discreet in employee leased rail cars; this reduced company-controlled publications, Harrison uses this communication tool to impart his railcars and locomotives by 35 percent and 43 percent, vision and strategic orientations, to unveil upcoming major capital respectively.24 The reduction has been possible through expenditures, and to promulgate the results obtained since the gains in efficiency everywhere on the network. For leadership change (and give a positive connotation to the word example, by initiating change in the intermodal markets, “change”). The magazine is now targeting a readership of railroad the CP took a day out of service from Vancouver to people, with topics like the Spike-Driving Championships, Toronto, and Vancouver to Chicago, both ways (the interviews with employees working on railroad specialties sharing service is now offered in four days instead of five). By taking a day out of the transit time, “it reduces the their passion for what they do, and numerous photographs of overall requirements for locomotives on the system by locomotives and hump yards. The aim is to create and consolidate about 40 locomotives.”25 In some cases the transit time a winning culture through the sharing of accomplishments and was reduced by even more than a day. operational achievements. 61 Quarter 3 • 2017 Pershing Square, Ackman and CP Rail: A Case of Successful "Activism"? Exhibit 1: Operating ratio, compared to other Class 1 railroad companies According to Harrison, the rhythm of transformation deployed included and displays the major events and their impact on CP’s by the CP exceeds largely all expectations. All the targets set when stock price. he arrived have been attained and even exceeded. The decrease in CP’s saga became the epitome of how a hedge fund can create the work force and all the changes made were completed without value for shareholders by changing board members, management apparently harming customer service.33 When the CP unveiled its and thus strategies. 2013 results, everything seemed to indicate that Pershing Square was right to request the change. Ackman exits CP Under Harrison’s leadership, CP’s operating ratio improved During 2015, CP tried – unsuccessfully – to acquire Norfolk dramatically (see Figure 2), challenging CN for performance Southern Rail, a disappointing outcome. Yet, the drive for more leadership and shattering forever the “structural difference” efficiency at CP was relentless. By the end of 2015, CP was the argument. second best among Class I railroads in North America in terms of operational ratio, as shown in Figure 3. CP is now vying with CN Appendix IV presents other key performance indicators in the for first place. railroad industry and their evolution since 2010. Appendix V maps out the evolution of different ratios and indicators during Almost exactly five years after first buying shares of CP, Ackman Green and Harrison’s respective tenure (first years of Harrison’s confirmed in August 2016 that Pershing Square would sell tenure, showing the quick change), with some comparisons to the its remaining shares of CP, thus formally exiting the “target.” CN. Harrison was still CEO, and Keith Creel was officially named to succeed him starting on July 1, 2017. In his usual style, Harrison Despite the drastic measures undertaken by Harrison, revenues declared:34 “The board said, ‘Look, we’ve got the opportunity to increased by 7.7% in 2013. Most interestingly, all the key have two pretty good railroaders during a transition period and performance indicators, financial and operational (except for AT that’s not the worst thing in the world,'” The succession should who remained stable) swiveled in the opposite direction of the assure continuity in the way Harrison has led CP. enduring trend from the previous years as shown in Appendix Over those five years, CP has generated a compounded VI. annualized total shareholder return of 45.39% (between The financial markets did, of course, reward handsomely these September 21, 2011 and August 31, 2016), a performance well operating performances. As the shown in Exhibit 2, CP’s shares above the CN and the S&P/TSX 60 index (see Exhibit 2 and now trade at more than 4 times their price when Pershing Square Appendix VII). Pershing Square pocketed some $2.6 billion in first started buying shares of CP. In Appendix VII, this graph is profits for its venture into CP.35 62 Pershing Square, Ackman and CP Rail: A Case of Successful "Activism"? With massive reductions in the workforce, a transformation of the In the Canadian context, such behaviour is not quite gentlemanly. operations and a radical change of the CP’s organizational culture, Imagine the high performing CEO of the Royal Bank of Canada CP is undoubtedly a different company from what it was before who, soon after retirement, would join the Bank of Montreal as the proxy fight. In early September 2016, Bill Ackman resigned CEO. But both Ackman and Harrison are Americans who could from CP’s Board. not care less about the mores and values of the Canadian business world. Hunter Harrison’s declaration about Ackman’s resignation36 provides a fitting conclusion to this whole episode: “He [Ackman] Of course, recruiting Harrison came at a price, some $44M in saw an opportunity at CP, worked hard to bring me in to the fold, 2012. Harrison then turned around and recruited Keith Creel and delivered for shareholders and the board. Over the last four (then executive vice-president and chief operating officer at CN) years we have built a better CP and that model remains in place to follow him as CP’s President and Chief Operating Officer (and to continue to deliver not just for shareholders, but for customers most probably Harrison’s successor). and employees. We thank Bill for everything he has done and This sort of opportunity to recruit the recently retired CEO of wish him well in the future.” the company’s best performing competitor is rare in practice. Analysis: why was Pershing Square so successful in this case? Ackman has learned that lesson when as the largest shareholder of J.C. Penney (a chain of department stores), he pressured its Why was the CP intervention such an apparent success, when, board of directors to replace the CEO by Ackman’s choice: Ron in several other instances, Pershing’s brand of activism was far Johnson, at the time president of Apple retail. That turned out to less successful? Mr. Ackman’s forays into J.C. Penney, Target, and be a disastrous choice. Johnson was let go 17 months later to be Borders gave results ranging from mediocre to abysmal. replaced by the very CEO he had replaced. In an article published in the Financial Post, a number of critical So, an “activist” hedge fund unhappy with the performance of the features of this saga are singled out to explain the particular current CEO of a targeted company calls on the recently retired success of this intervention:37 CEO of a direct competitor who happens to be ready to jump ship 1. A rare case of perfectly transferable talent and hit the ground running. How rare is that? The recently retired CEO of Canadian National Railways (CN), 2. A simple, well-defined industry the best performing railroad company in North America, was The North American Railroad Industry is extremely well defined. soon to be freed from the legal (if not the ethical) constraints on The same companies have been serving this market for decades; his joining a direct competitor. This man, Hunter Harrison, is their networks are well-established. Performance measures are acknowledged as a highly skilled and innovative railroader… and standard across the industry, which makes for easy comparability he was ready and willing to take over as CEO of CP. across firms. Thus, it is a simple task for management, the board Exhibit 2: Evolution of CP’s stock price compared to CN and S&P/TSX 60 index (basis 100). 63 Quarter 3 • 2017 Pershing Square, Ackman and CP Rail: A Case of Successful "Activism"? of directors and investors to benchmark any company against 4. Massive support from institutional shareholders and other its peers. Unfortunately for CP, its score was substantially lower parties than its peer group and the gap was widening year after year. But, Yet, indifferent to these considerations, large Canadian it was widely accepted (including by financial analysts following institutional investors supported Pershing Square’s attack on the the industry) that there were structural factors which explained board of CP. Perhaps tired of CP’s stagnating stock price under a good part of this inferior performance. As for the part under the leadership of Green, they saw in the hedge fund a vehicle to the control of management, vigorous action plans were being channel their frustration. implemented to bring CP’s performance much closer to its peers within five years. That was certainly the firm conviction of the CP But many other parties also saw the need for change at CP. Indeed, board. the large proxy advisory firms, the largest Canadian pension funds, eminent and influential experts of the industry, and even 3. A prestigious and experienced Canadian board of directors the president of Teamsters Canada Rail Conference - Maintenance The board of CP had a nec plus ultra membership drawn from of Way Employees Division (union representing more than 10% the Canadian business elite, the “royalty of Canadian directors:” of CP’s employees), all supported Ackman in his quest. This is a former CEOs of the Royal Bank, Cargill, Ipsco, Shell Canada, and very rare case where an activist hedge fund enjoyed support that Corby Distilleries; current CEOs, scions of old families, a former extended beyond the short-term shareholders. minister in the Government of Canada. These people had a wealth These four features of the CP saga, taken together, are rather of business experience and were proud to serve on the board of unique. Yet, the proof is in the pudding! Under a new leadership, an iconic corporation whose history is enmeshed with the very CP has quickly and remarkably improved its performance. What history of Canada. did not seem achievable was achieved. Structural impediments to CP’s performance seem to have vanished. They surely did not lack confidence in their ability to govern the corporation. Indeed, their collective wisdom and governance How come the CP board at the time, presumably savvy and skills had been recognized repeatedly by various agencies making experienced, did not spot the mediocre performance of CP, a business of rating the governance of corporations. did not challenge the common assertion that structural factors explained CP’s poor results? How come no one seemed to notice Here comes an upstart “hedge fund” manager from New York that the CP performance had been deteriorating? Why were who has the gall to criticize their stewardship and to pretend they satisfied with the level and rate of progress proposed by he knows what CP should do to improve its performance. His management? Why did they not challenge management about the “bright” insight involves, first of all, the disgraceful suggestion reasons for CP trailing all other North American railroads. that the CP board chairman go and try to persuade the former CEO of a rival Canadian company to jump ship and join CP! After all, the critics formulated by Pershing Square were all based on publicly available data. Why could the CP board not see Here there is more than a whiff of cultural clash between what outsider Pershing Square could spot in a few weeks? The American and Canadian business practices. The differences initiatives that Harrison was able to implement swiftly after taking in values between Americans and Canadians have been well over as CEO constitute a damning indictment of the board (and documented,38 and the cultural clash between Ackman and CP’s management) of CP at the time. incumbent board offers yet another example. Indeed, the proposal to hire the former CEO of a competitor must have been viewed Conclusion as heretic and nonsensical to CP’s directors. Such underhand Costs and benefits maneuver is just not done in the Canadian business world in general and at CP in particular. CP’s culture has been shaped Let’s summarize the benefits and costs of this instance of hedge over a hundred years; it is based on the company nurturing its fund activism. The stock market just loved what was happening at executives, promoting them from within whenever possible. CP and rewarded the company with a booming stock price. Not only was Ackman arguing for CP to drop this policy of strict But it should be factored in that over 6,000 CP employees lost “promotion from within” but was urging CP to hire someone their job and the new management exerted unrelenting pressure from a direct competitor. Ackman was not inhibited by this on the remaining workers to increase productivity. The company Canadian culture (nor was Harrison, an American citizen); he just claims that it treated fairly those who lost their jobs, that most just saw an opportunity. took early retirement, etc. CP’s board could have hired Harrison and gotten all the benefits Still, it could be argued that the financial success of CP under without the pain of a proxy fight and the humiliation of being Ackman and Harrison was a sort of wealth transfer from workers rejected by shareholders; but it was, to them an unthinkable to shareholders. breach of the CP culture. In many ways, Pershing Square was Uniqueness of the CP case merely instrumental to the dramatic operational turnaround undertaken at the CP. The case identified four factors that are rarely present in other cases of activism, a fact which explains why few of these Of course, it is also plausible that a prestigious board, a board interventions achieve the level of success of the CP case. Indeed, made up of experienced former or current executives would be many interventions actually fail and others achieve only moderate more likely to reject out of hand any suggestion coming from a success. In fact, a study39 by Allaire and Dauphin analyzed “financial” sort of player. 259 firms targeted by activist hedge funds, and not a single 64 Pershing Square, Ackman and CP Rail: A Case of Successful "Activism"? case showed any similarity with the CP’s case and the perfect competitor (Canadian National Railway).” At the time, a source alignment of the four factors mentioned above. in the industry familiar with the decentralization plan mentioned that “Fred knows that a big part of the problem is nobody is really Lessons in corporate governance watching the shop close enough at the field operations level. […] In this day and age, the CP case teaches us that no matter its size If they pull up their socks, they can equal CN's performance.” or the nature of its business, a company is always at risk of being However, the operating ratio climbed gradually from 75.4% in challenged by dissident shareholders, and most particularly by 2006 to 78.6% in 2008. Blaming the economic downturn for this those funds which make a business of these sorts of operations, mediocre performance, Green launched in 2008 a new campaign the activist hedge funds. titled Execution Excellence for Efficiency (E3) featuring initiatives Of course, a widely held company with weak financial results and such as running longer trains and renegotiating fuel contracts a stagnating stock price will inevitably attract the attention of with freight customers. CP had also instituted a hiring freeze, these funds. trimmed staff travel budgets and restricted discretionary expenses as part of the campaign. But the puzzling question and it is an unresolved dilemma of corporate governance remains: how come the board did not know In 2009, the operating ratio stands at 79.1%. In a continuous effort earlier what became apparent very quickly after the Ackman/ to control costs, Green issued an internal memo to the roughly Harrison takeover? Why would the board not call on independent 3,000 non-union staff across Canada in which he was asking them experts to assess management’s claim that structural differences to burn off vacation days. He was also ending the system in place, made it impossible for CP to achieve a performance similar to which allowed up to 52 weeks of holiday time to be banked. This that of other railroads? How could the board have known that initiative was put in place to strengthen the balance sheet since performances far superior to those targeted by the CEO could be “unused vacation is a liability for which the company maintains swiftly achieved? an accrual.” Lurking behind these questions is the fundamental flaw of The initiatives put in place do have an impact, especially over corporate governance: the asymmetry of information, of the intermodal train lengths. On average, these trains went from knowledge and time invested between the governors and the 63 railcars in 2008 to 90 in 2010 . The CP also invested in new governed, between the board of directors and management. In technologies for railway optimization. CP’s case, the directors, as per the norms of “good” fiduciary Even if there was a few notable achievements in 2011, such as governance, relied on the information provided by management, the addition and extension of sidings (at the foundation of the believed the plans submitted by management to be adequate train lengthening strategy) that allowed the CP to establish a and challenging, and based the executives’ lavish compensation record year for train weight, the operating ratio went up to 81.3%. on the achievement of these plans. The Chairman, on behalf of The CP adopted a new multi-year plan, built around three key the Board, did “extend our appreciation to Fred Green and his initiatives: management team for aggressively and successfully implementing our Multi-Year plan and creating superior value for our 1. driving volume growth; shareholders and customers.”40 That form of governance is being 2. expanding network capacity to safely and efficiently challenged by activist investors of all stripes. support higher volumes and; Their claim, a demonstrable one in the case of CP, is that with the 3. cost control. massive amount of information now accessible about a publicly listed company and its competitors, it is possible for dedicated These initiatives were backed by the following multi-year shareholders to spot poor strategies and call for drastic changes. If programs: push comes to shove, these funds will make their case directly to • First Mile-Last Mile – this program drives improvements other shareholders via a proxy contest for board membership. in service, asset velocity and enables low-cost growth Corporate boards of the future will have to act as “activists” in by reducing railcars and creating additional terminal their quest for information and their ability to question strategies capacity. and performances. • Scheduled Bulk – we continue to schedule our bulk Appendix I train operations as part of our Integrated Operating Plan. In grain, our efforts involve leveraging our grain Fred Green’s initiatives to improve CP’s performance elevator footprint by scheduling all aspects of our grain shipments, including First Mile-Last Mile switching and Green, the CEO of CP from 2006 to 2012, could also argue that bulk unit operations, all centered around a simplified he had been a proactive driver of improvements at CP. A few network of origin grain hubs. months before officially becoming CP’s President and CEO, Fred Green had already started to set the table for important • Long Trains – this program is driving increased changes. In an internal memo titled “Organizational change for train lengths; improving service, safety, productivity greater success,” Green (then as President and COO) wrote in and efficiency. It includes targeted infrastructure 2006 that “The intent is to build fluidity into all aspects of our enhancements and the use of proprietary train business and, by doing so, to improve our operating and financial marshaling software, which maximizes the use of performance and narrow the operating ratio gap with our direct distributed locomotive power. 65 Quarter 3 • 2017 Pershing Square, Ackman and CP Rail: A Case of Successful "Activism"?