Idea Brunch with Ken Traub of Delta Value Advisors
Welcome to Sunday’s Idea Brunch, your interview series with great off-the-beaten-path investors. We are very excited to interview Ken Traub!
Ken is currently the managing partner of Delta Value Advisors, a strategic consulting and investment advisory firm. Ken is an expert in corporate governance, turnarounds and crisis management with a broad range of successful experience as a CEO, Chairman of the board, independent director and active investor in numerous public companies at times of critical business transition and transformation. Ken focuses on active investments and how investors can identify whether or not a shareholder activist campaign is likely to lead to shareholder value creation. Ken earned an MBA from Harvard Business School in 1988.
(Editor’s Note: Sunday’s Idea Brunch extends our congratulations to @Mike10947310 for pitching our first-ever 10x Idea Brunch idea. In his June 2, 2024 interview, Mike pitched Finch Therapeutics OTC: FNCH, a small shell company with outstanding patent litigation as “asymmetric if sized conservatively.” Since the pitch, the company won a major legal ruling and shares have risen from $0.97/share to $12.95/share, a 1,200% return in less than three months. Well done Mike!)
Ken, thanks for doing Sunday’s Idea Brunch! You had a really interesting career as an operating executive before you turned your focus to corporate governance and active investing. Can you please share your experience as an operating executive and how that got you interested in corporate governance and active investing?
Sure Edwin. Thanks for having me.
In my first job after getting my MBA, I focused primarily on mergers and acquisitions as Assistant to the Chairman of Trans-Resources and often took an active role in helping the companies we acquired in addressing challenges in their business and developing turnaround and growth strategies. While I was at Trans-Resources, a young engineer who was working on technology in speech coding, came to me for career advice. I co-founded a company called Voxware around his technology in 1994 while still at Trans-Resources and expected to be just a founding shareholder and an external supporter.
The investors that I brought into the start-up required that I focus full time on building the company so I left Trans-Resources, and became the Executive Vice President, Chief Financial Officer and member of the board of directors of Voxware as well as a founding shareholder. We moved very quickly to establish Voxware as a pioneer and leader in audio on the Internet and other bandwidth-constrained environments and we became one of the first companies in the world to implement widely deployed Internet telephones. We secured support from VCs as well as Intel as financial backers. We wanted to establish the initial standard for Voice over IP ("VoIP") and sought to get the 2 leading software companies at the time - Microsoft and Netscape (who had an 85% market share in the Internet browser market) to back our technology. I was advanced in negotiations with Microsoft, when Netscape made a pre-emptive offer on the condition that it was exclusive vs. only Microsoft. I entered into the partnership with Netscape which then released >30 million Internet telephones powered by our technology and additional complementary deals with hundreds of other companies including Apple, IBM, AOL, Oracle, Lucent, Nokia, Disney, etc. We took Voxware public in 1996 in a high-profile IPO. But as you probably know, Microsoft crushed Netscape which resulted in one of the biggest anti-trust cases in history. This killed most of Voxware's business model in 1998 and we needed to downsize significantly - including myself. I sold my founders stock and made more money than I ever had at that point in my life, but it is fair to say that it was an enormous disappointment. This was a very humbling experience - and as an early Internet entrepreneur I had other opportunities in that market, but I decided to move away from the Internet/start-up world and the unpredictability of who Microsoft would crush next. My goal was to find a healthy company that is well-positioned in a more stable market - and frankly, a less stressful position.
I found the polar opposite of Voxware in a company called American Bank Note (ABN). Unlike Voxware which I started in my studio apartment in NYC, American Bank Note was established in 1795 as the original printer of American currency (bank notes) and had a 200+ year pedigree with prestigious customers, high margins and strong cash flows as a leading supplier of secure products and documents designed to prevent counterfeiting and fraud. In the early 1980s, ABN pioneered the use of holograms to help authenticate documents and prevent counterfeiting, and pursued that nascent market through a new subsidiary, American Bank Note Holographics (ABNH), which became the market leader in the secure hologram/anticounterfeiting market. In 1998, ABN spun off ABNH in an IPO and as part of the IPO process, it promised it would hire a new CFO for the newly independent ABNH. I accepted the job of EVP and CFO of ABNH starting on January 12, 1999 with a mandate to grow the company through a series of acquisitions, and believed this was a good fit for what I was looking for after Voxware - a relatively low stress job with a prestigious, well-established and profitable company.
On my first day of work, I met with ABNH’s auditors at Deloitte and Touche (D&T), senior management at both ABN and ABNH, and customers. Shockingly, by the end of my first day I was certain that the company’s 2 most recent 10-Qs filed with the SEC required restatement and nobody in the company or D&T appeared to be aware of this yet. On my second day of work, I met with the board of directors of ABNH and resigned as CFO. The board asked me whether I would be a consultant during this transition which I agreed to do in an unofficial capacity. Following that, D&T dug deeper, and concluded that all of the financial statements that they had previously audited for the past 5 years were materially misstated and withdrew all prior audits. This created an enormous crisis: JP Morgan Chase and the other banks declared defaults on the outstanding bank debt precipitating a liquidity squeeze; the SEC and DOJ commenced civil and criminal investigations; numerous lawsuits were filed; the NYSE delisted the stock; customers were terminating contracts; suppliers were cutting the company off; key employees were quitting, competitors were capitalizing on the crisis, etc.
During this crisis, the board came back to me a few weeks later and said they decided to terminate the President and offered me the job of President and Chief Operating Officer (the #2 position in the company) reporting to the Chairman/CEO. I accepted the job knowing that the company’s viability as a going concern was now in serious jeopardy. Clearly, this would no longer be the low stress job at the healthy, stable company I had envisioned.
Shortly after I started the job as President, it became clear to me that the errors that I and D&T had found in the financial statements were no accident, but was part of a deliberate, multi-faceted fraud. Furthermore, I discovered additional problems such as violations of the Foreign Corrupt Practices Act in which ABNH bribed officials of the Saudi Arabian government for a contract to put holograms on their currency, and not only was this illegal, but the company failed to meet the necessary specs and the holograms fell off the currency once in circulation. But worse yet, I discovered abundant evidence that the fraud and other illegal conduct was directed and overseen by my new boss, the Chairman/CEO. I presented my findings to the independent directors and discovered that there was essentially one credential for board membership at this public company and that was loyalty to a CEO that I now believe not only directed a massive fraud, but his continued presence is digging the company into an ever deeper hole of corruption and misconduct (which was particularly ironic and troubling since the business of the company for over 200 years was to produce secure products to prevent counterfeiting and fraud). I fought with the board, and they stayed loyal to the CEO despite the obvious evidence of his corruption and the damage he was continuing to do to the company and its reputation. I developed a turnaround plan and submitted it to Chase, and they agreed to support the company on the condition that I become the CEO. I also met with the DOJ and SEC and provided them with a remediation plan, and they agreed to not take action against the company if I implement the remediation plan as CEO and cooperate with the government on their investigations of the individuals responsible (which they ultimately prosecuted and convicted of fraud). With the assistance of Chase and the DOJ and SEC, I forced all of the directors who were aligned with the CEO to resign and fired my boss. I then became the CEO. I fired every member of the management team and senior financial staff and was the only officer of the company for a period of time. I also recruited an entirely new board of directors and started to resolve all of the problems I inherited from prior management including settling the extensive litigation, repaying the defaulted bank debt 100%, bringing in new financial and strategic partners, earning the trust of existing and new customers to start to regrow the revenue, earning the trust of key employees and suppliers and transforming operations resulting in a return to positive cash flow.
One additional challenge I faced while managing the turnaround of ABNH was that a group of activist shareholders who owned about 20% of our stock filed a 13D and then a proxy statement proposing to keep me but replace the entire new board of directors that I recruited with their own candidates. My first reaction was outrage that these activists would seek to replace the entire new board who I trusted and was supportive of the turnaround I was managing. But ultimately, I came to realize that they had a valid point – I personally handpicked every new director and never asked shareholders for their input. I thought I had good reasons to do that since former management committed fraud and the problems ran so deep that I wanted to make sure I could trust the board. But the activist’s point was, as the CEO managing this complex situation, I should be reporting to an independent board that can independently and appropriately hold me accountable. It wasn’t easy to see at first – but they were right so I settled with the activists and brought their directors onto the board.
With the new board, I continued to execute a successful turnaround and earned the trust of key stakeholders and rebuilt a market leader in product and document authentication. We sold the company in 2008, and shareholders that stayed for the ride, earned returns exceeding one thousand percent (1000%).
Wow Ken, that is a really remarkable story! Can you share some of the lessons that you learned from that experience?
Sure. Here are some key takeaways that I believe are helpful when looking at businesses in general and investing.
1. "You don't always get what you want, but..." - After Voxware, I wanted a low stress job with a stable company - and ABNH was obviously the complete opposite of that! My choices were to either leave or commit to fix a broken company. Think about this in the context of investing: when most investors realize that the company they invested in is not living up to their expectations - their choice is usually the obvious one - they leave, by selling the stock. That selling pressure depresses the stock price, and other investors may look at the same situation and see opportunities to fix what is broken and create significant upside. This creates compelling opportunities for nimble, active investors and it was the first insight that informed how I look at active investing.
2. Trust is the most essential key to success in business, especially in turnarounds. There is no way I would have been able to save ABNH from the crisis that resulted from former management’s fraud and corruption if I did not earn the trust back from the key stakeholders. In investing, the most critical issue is to trust that the board and management have the integrity and competence required to be successful - if not, either exit promptly or develop a plan to replace them.
3. Focus on key priorities. There were so many issues that threatened the viability of ABNH – ranging from DOJ and SEC investigations and prosecutions, widespread corruption, massive litigation, bank defaults, key employee resignations, customer cancellations, supplier cutoffs, etc. – and each of these issues had to be addressed with the urgency and sensitivity they demanded.
4. Governance is important. The original board of ABNH neglected their responsibility to oversee management and ensure the company was acting with integrity and legally. It failed. It is key to recognize whether the boards of the companies that you invest in have the competence, independence and motivation to properly oversee management and ensure that the company's and shareholders' interests are protected.
5. Shareholders have rights that need to be respected. While I thought I was justified in hand picking every director since I believed I needed to trust the board in the perilous situation facing ABNH, the activists were right to point out that as the CEO I should report to an independent board. Bringing shareholder representatives onto the board was helpful as we continued the turnaround and delivered value for shareholders. Management and the board should always remember that they are accountable to the shareholders.
These are really great insights Ken. What attracted you to active investing after your operational career?
I became interested in active investing for several reasons and I sincerely believe this is the asset class in which investors can create the most Alpha. Here are some of the primary reasons:
1. Value Investing Plus Creating Catalysts - Most investors like to consider themselves value investors- buying a security at less than what it should be trading considering all relevant factors. But markets are generally efficient so if a stock is cheap, it is usually cheap for good reasons and will stay there unless something changes. Active investing enables shareholders to identify the reasons the stock is cheap and assist the company in addressing those issues to build and unlock value.
2. Predictable Patterns of Underperforming Companies - In studying companies whose stock has gotten cheap for fixable reasons, there are common and predictable patterns. One example that applies broadly is simply a function of human nature. Virtually all humans are reluctant to admit when they make a mistake. But if you are the board or management of a public company and you make mistakes in the business and rather than admit the errors and correct them, you double down on the bad bets, it can have a material negative impact on the value of the business. Sometimes it is innocent myopia and other times the incentive structure does not lead the board and management to identify and correct their mistakes, but an objective outside investor may be able to help the leadership of the company understand the issues that are undermining the value of the business and help address the issues before it is too late.
3. Corporate Governance Can Enhance Shareholder Value, or Undermine It - The purpose of corporate governance is to clearly define the roles, rights and responsibilities of shareholders, board and management. The board is elected by shareholders and has the responsibility to oversee management and hold them accountable - while both the board and management have fiduciary obligations to the company and to maximize shareholder value. Unfortunately, in some companies, corporate governance goes astray, misalignment of interests arise among management, board and shareholders and value is suboptimized. This is why our system gives shareholders the right to elect directors and propose changes that are in the best interest of the company and the shareholders.
4. Good Ideas Are Often Welcome - I have found that boards and management teams are often receptive to good ideas delivered in a constructive manner from shareholders. This does not need to involve public letters, 13D's and proxy contests if the shareholder chooses to privately bring value enhancing suggestions and the board and management is willing to implement them. Fellow shareholders are also likely to be supportive and appreciative of value-enhancing ideas that are delivered in a supportive and constructive manner.
5. Reg FD Does Not Apply To Shareholder Ideas - Reg FD precludes public companies from disclosing material non-public information to certain investors without publicly disclosing it to all potential investors, and this is intended to prevent investors from trading on superior information from the company that other investors don't have. On the other hand, as a shareholder if you have a good idea of how the company can improve and enhance shareholder value, you are free to trade on these insights up to the point that you become an insider.
6. Shareholder Activism is Controversial - Activism has earned its controversial, tainted reputation since there have been plenty of instances in which shareholder activists have misunderstood the business and pushed inappropriate agendas and other times in which activists acted with conflicted interests to the detriment of the company and other shareholders. This sounds negative - so why is that a positive reason to be interested in activist investing? Because it creates an opportunity for investors that have the skillset and motivation to develop the ideas and take the actions to fundamentally improve the company and create value for all shareholders.
Can you please describe the major factors to look for to determine whether a company would be an attractive target for an active investment?
Sure. Here are some of the key things to look for:
Is the company undervalued based on either a current valuation of its assets and cash flow or its potential cash flows if changes are made?
Are there identifiable actions that the company should be taking that the current board and management are either unable or unwilling to take?
Will the board and management listen to constructive ideas so that improvements can be made privately or is a public activist campaign necessary?
If the activist gets sufficient representation on the board, will other directors listen to good ideas and is it practical to implement the actions that are necessary?
Does the activist or the directors they designate bring the skillsets to the board that are needed to address the issues facing the company?
Can the investor acquire enough stock both to make the economics of a campaign worthwhile and to get a seat at the table for negotiations with the company?
Is the shareholder composition supportive of the kind of changes that the activist shareholder is proposing?
You have been involved in shareholder activism from all angles - as a CEO who defended against and settled with activist investors, as a partner in an activist hedge fund and as a director nominated by activist investors. Can you explain what it is like for a director candidate who is nominated by an activist investor joining a public company board?
Everyone serving on a public company board needs to recognize that he/she has just one vote in the governing body responsible for overseeing management and accountable to shareholders. To get things done, particularly if you are coming with ideas to change strategy or policy, requires building consensus. An activist director needs to be thoughtful in how to make the transition from outside critic (usually unwelcome) to a member of the board that works collaboratively together with other directors, but with some specific changes in mind. This can be facilitated by immediately adding value in non-controversial areas that help pave the way for fellow directors to start to welcome your presence on the board and listen to your other ideas that may be more challenging to the status quo. When introducing ideas that require major changes in personnel, strategy or policy, it is best to be very specific about the benefits of the change and how it is consistent with the board’s responsibilities. In doing this, it is preferable not to criticize the past too much which generally elicits a defensive response from the longer serving directors, but to focus on how the company will be better because of the changes you are proposing. Being effective as a director who was nominated by an activist is really an intriguing dynamic as it combines creative thinking on changes in business strategy, capital allocation, governance, etc. with the social dynamic of building a consensus among a group of people that previously may not have welcomed your presence. When this works well, it is extremely rewarding.