When an Activist Hedge Fund Thinks a Company’s Salaries Are Too High, Who’s Right?

The 359th richest man in the United States has decided that the workers with the highest salaries in Silicon Valley need to get by with less. At least, that’s one way of looking at Elliott Management’s campaign to shake things up at Juniper Networks. The hedge fund founded and run by billionaire Paul Singer just announced that it now owns 6.2% of the networking equipment maker and called out Juniper’s pay ranking as an indication the company’s costs are too high and its R&D spending “excessive.”

Couple this with the fact that Singer has in recent years been one of the biggest donors to the Republican Party, and you could, if you were so inclined, craft an outrage-inducing tale of a heartless right-wing financier sticking it to the workers and hollowing out America’s high-tech industry. Except that Singer isn’t all that right-wing, and if you look at Juniper’s performance over the past decade, it does seem like something has to give.

The company, founded in 1996 by an engineer from Xerox’s legendary Palo Alto Research Center, Pradeep Sindhu (who remains its chief technology officer and vice chairman), was one of the highest flyers of the fin de siècle tech stock boom. Its IPO in 1999 was a sensation; by autumn 2000 its market capitalization topped $65 billion and the ratio of its stock price to the next year’s projected earnings was a staggering 483. Its high-end Internet routers were gaining share on market-leader Cisco, and the sky was the limit.

It turned out to be a lower-than-anticipated sky. Juniper’s router market share topped out at around 30%, and both it and Cisco saw their share prices crash (in Juniper’s case from $243 in October 2000 to $4.43 two years later) to as it became clear that the ranks of potential customers weren’t going to keep growing exponentially as they had during the dot-com boom. That Juniper survived the collapse of its stock and grew into a substantial, profitable company is testament to the skills and commitment of its managers and employees. But lately it’s been looking a lot like a mature substantial, profitable company. Since bouncing back from the Great Recession, revenues have been rising slowly. Attempts to branch out into new product areas (security and enterprise switching) haven’t gone well. Neither have acquisitions.

As a result, Juniper’s stock price has been going nowhere. By Elliott Management’s reckoning, it has dramatically underperformed every conceivable peer group over one, three, five, and seven years. That helps explain why salaries are so high at Juniper — engineers sure aren’t going there for the stock options.

Mature companies are supposed to behave differently from hot growth prospects. They’re expected to return money to shareholders through dividends and buybacks and pay close heed to costs. Juniper has never paid a dividend, and while it’s been spending more than half a billion dollars a year buying back stock it still has tons of cash on hand. Its R&D budget, meanwhile, is almost twice the industry average as a percentage of revenue.

So Elliott Management is urging Juniper to focus on its core businesses, cut back on R&D outside those areas, increase its share buybacks and start paying a quarterly dividend. It wants the company to stop trying to be a growth stock and start acting like a value stock. There’s no rocket science here, no Ackmanesque (Ackmaniacal?) attempt to change the leadership and strategic direction of the company. In fact, all indications are that Juniper’s management already agrees that it should focus and cut costs (it tried to sell its security business in 2012, and announced a round of layoffs last fall); Singer just wants it to move faster. It’s the standard Wall Street playbook of stop messing around and give us more of your money.

The seminal argument for this approach was made in HBR’s pages by Michael Jensen 25 years ago: In “cash-rich, low-growth or declining sectors,” he wrote, “the pressure on management to waste cash flow through organizational slack or investments in unsound projects is often irresistible.” Jensen’s solution was the leveraged buyout — what’s now known as private equity — in which somebody borrows lots of money to take over the company and of necessity becomes obsessed with cutting costs and removing cash. Most activist hedge funds are simply pushing a less extreme version of the same basic idea.

On the whole, it seems to work. The activist approach is clearly good business for hedge funds; activist funds have dramatically outperformed their hedge-fund peers in recent years. Activist campaigns also appear to boost the operating performance (“The Long-Term Effects of Hedge Fund Activism,” by Lucian Bebchuk, Alon Brav, and Wei Jiang) and productivity (“The Real Effects of Hedge Fund Activism,” by Brav, Jiang, and Hyunseob Kim) of targeted companies.

It’s not all good news. The latter study shows that workers at manufacturers targeted by hedge funds don’t see any of that increased productivity in higher pay — the gains apparently all go to shareholders. Also, a recent Citibank study (the full text isn’t available online but there’s a summary here), found that while activism brings better stock performance overall, most targeted companies actually end up trailing the market. That is, the gains come from a minority of big winners; most activist campaigns are losers. And in HBR back in 2008, Robin Greenwood and Michael Schor reported that on balance activism only paid off when the target firm was acquired.

Which brings us back to Paul Singer and Juniper. Are we seeing a billionaire trying to steal money from the pockets of hard-working engineers? Or an outside investor doing what outsiders are supposed to do and pushing a company to accept reality?

Hmmm. Maybe it’s both.

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