Genzyme and Relational Investors: Science and Business Collide

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Furthermore, like most others in biotechnology sector, Genzyme had not conducted open market share repurchase or paid dividend to its shareholders. The CEO Termeer believed that retained earnings facilitated company on financing growth opportunities rather than issuing debt or new stocks. This policy is logical because of some reasons. First, floatation costs of external financing make it more costly than the internal. Second, according to pecking order theory of Donaldson (1961) and Myers and Majluf (1984), under information asymmetry, managers are likely to issue debt or new stock if they are overvalued, which benefit existing shareholders at the expense of new shareholders or debtholders. As a result, the market will react by decreasing the value of stock if they expect the firm carry out these activities. Third, Termeer could be a conservative manager who does not prefer use leverage and face to financial distress. Thus, in spite of the benefit of tax shield from debt, Termeer did not want to use this type of financing.

Beside the desire of increasing the number of curable diseases through creating various kinds of drugs, Genzyme also provided free life-saving treatment for patients in developing countries as an expression of humanity. They had expressed the social responsibility of the firm. However, sometimes it could conflicts with the demand maximizing value of some investors.

Unlike most other firms, Genzyme still performed well during financial crisis in 2007-2008, because the demand for drugs of patients was not affected by the economic changes. However, Relational Investors proposed that the downfall of Genzyme stemmed from its diversification strategy. First, some segments was underperformed and thus provided low rate of return. Under estimations of Relational Investors, in 2008, while GD produced 25.8% cash flow return on investment (CFROI), more than 50% of invested capital only provided 8.8% ROIC. Especially, nearly 10% of total invested capital created negative CFROI (-8.3%). Clearly, there were significant differences between various segments. Second, as a result of rapid expansion, operating management competence decreased, which lead to a scandal: contaminations was discovered in one of the most important plants of Genzyme (Allston). Not only did it negatively affect the reputation of company but also directly lead to the fall of stock price.

2.2. Relational Investors

Penman (2007) classified investors into two categories: passive and active. Passive investors assume the market is efficient and therefore there is nothing they can do to increase stock price. Thus, the best choice is following the market. On the contrary, active investors collect information, analyse intrinsic value of stocks, and make decision based on these analysis. Relational Investors is one kind of the latter. Founded by Ralph Whitworth and David Batchelder in 1996, RI was classified as an activist investment fund. It raised capital from its members who are also shareholders, then invested in financial assets to make profit. Whitworth and Batchelder were the representatives of all shareholders and responsible for managing these assets. RI had an obvious strategy. First, it found low performance companies (market price of stock is lower than their intrinsic value), which stems from the inefficiency of capital allocation or corporate governance, over-diversification, private benefit of managers and so on. Then, it bought stocks of company to become a major shareholder (usually 1 – 10% of total outstanding stocks); and engaged in corporate governance through various methods, which depend on how targeted firms react to RI’s recommendations, including:

- Request and raise pressure on managers to change business strategy

- Request a seat on the board of directors; suggest change in executive managers, board composition; or persuade other investors vote for RI as their authorized representative, which allow them to have the power to elect and replace executive managers (proxy fight).

- Review management compensation scheme. However, it “had no objections regarding high compensation for managers” (Eades et al., 2011). As long as the managers perform well, they deserves to receive high compensation.

From discussions above, it can be seen that Relational Investors mainly paid attention on cash flow and quick money, as well as always sought for highest profit. It reached these targets by actively engaging in firm management activities. Its final goal is to increase market stock price to its intrinsic value, then it could make profit from the gap.

2.3. Conflicts between Termeer and Whitworth

2.3.1. Whitworth’s requests

Whitworth – the co-founder and representative of Relational Investors in Genzyme, was the eighth largest shareholder of Genzyme in 2009 (with 2.6% of total shares outstanding). Being consistent with operational goals of RI, Whitworth really took care of his wealth in Genzyme, which was reflected on Genzyme stock price. Therefore, maximizing current share price was his primary target.

Based on his estimation that Genzyme market stock price was lower than intrinsic value at that time, Whitworth suggested some solutions, including (1) limit diversification and focus only on highest expected return segments, (2) carry out open market share repurchase and/or dividend program, (3) change capital structure by issuing debt, (4) add more financial experts into board of directors, and (5) compensate executive managers based on their achievement and performance.

Reasoning for these demands

All rational shareholders want to maximize their value in the firm. Although there are many measures of value, from the point of view of RI, the value is the current market value of its asset which is reflected on stock price. Whitworth’s recommendations aligned totally with this purpose.

- Dividend and stock repurchase

The purpose of first two demands is to improve the efficiency of capital allocation and find ways to meet the demand of market. From Whitworth’s point of view, Genzyme was overinvesting and Termeer was wasting company’s resource on inefficient investments and acquisitions, thus they should be cut down. In addition, Whitworth proposed that the underestimated value of Genzyme stock also partly stems from its dividend-free policy. Therefore, instead of these ineffective and risky activities, redundant cash flows in the future should be paid back to shareholders through dividend or share repurchase.

So, what reasons lead to Whitworth’s