[Song Seungseop's Financial Light] How Activist Funds Shook SM

Activist Funds Increasing Profits Through Shareholder Rights
Align Partners Pressuring Unyielding SM
Lee Soo-man Acts as Hive's 'White Knight' to Defend Management Rights
Conducting Tender Offers with Premium to Buy Shares

Editor's NoteFinance is difficult. Confusing terms and complex backstories are intertwined. Sometimes, you need to learn dozens of concepts just to understand a single word. Yet, finance is important. To understand the philosophy of fund management and consistently follow the flow of money, a foundation of financial knowledge is essential. Therefore, Asia Economy selects one financial issue each week and explains it in very simple terms. Even those with no financial knowledge can immediately understand these 'light' stories that illuminate the 'light' on finance.

[Asia Economy Sejong=Reporter Song Seungseop] The battle for management rights between 'Lee Soo-man,' former chief producer of SM Entertainment, and the activist fund 'Align Partners' is fierce. To take control of the company SM, another major entertainment agency, Big Hit, and the Kakao Group, aiming to enter the entertainment market, have also declared their participation. How was the activist fund able to shake the firmly established SM governance built by Lee Soo-man?

Activism Started 100 Years Ago... Perspectives Are 'Polarized'

Activist funds are a type of 'hedge fund.' Hedge funds collect large sums of money from fewer than 100 investors and aim for high returns through various financial investment products. There are many ways to achieve high returns, right? One of them is 'shareholder activism.' This involves buying company shares and then pressuring management or owners to run the company in a way favorable to shareholders. For example, demanding higher dividend rates, correcting inappropriate corporate practices, or implementing restructuring. If the stock price rises as a result, the activist fund sells its shares to make a profit.

Professor Benjamin Graham

The history of activist funds dates back about 100 years. Benjamin Graham, who first proposed the concept of 'value investing' and was Warren Buffett's mentor, first attempted this in 1926. He discovered that the American pipeline company 'Northern Pipeline' held millions of shares including railroad bonds. As a shareholder of Pipeline, Graham insisted that the company sell unnecessary shares and distribute profits to shareholders. The company rejected the proposal, but Graham met with shareholders holding more than 100 shares to persuade minority shareholders and succeeded in receiving dividends.

Views on activist funds are divided. Especially in Korea, negative public opinion toward activist funds increased after the 1990s foreign exchange crisis. In 1999, the American 'Tiger Fund' bought shares of SK Telecom and demanded the replacement of management and the introduction of outside directors. Tiger Fund made billions of won in profits. In 2003, Sovereign Asset Management targeted SK Group, and in 2015, Elliott Fund attacked Samsung Electronics, leading to management disputes. At that time, concerns were high that activist funds pursued excessively short-term profits and that domestic companies suffered losses defending against attacks.

However, recently, perceptions of activist funds have subtly changed. They consolidate forces on behalf of powerless minority shareholders and strongly criticize problematic companies that negatively affect stock prices. The 'Kang Sung-bu Fund (KCGL),' which emerged in 2018, is a representative example. Kang Sung-bu Fund pointed out inappropriate behaviors of the family heads in incidents like the 'Peanut Incident' and the 'Water Cup Abuse' case, advocating for improvements in Hanjin Group's governance and financial structure. Cho Won-tae, chairman of Hanjin Group, who was at risk of losing management rights, defended his position while repeatedly expressing his willingness to improve governance.

Activist Fund 'Align' Criticizes SM Management

Changhwan Lee, CEO of Align Partners Asset Management

The activist fund Align also points out problems with former producer Lee Soo-man's management style and SM Entertainment's governance. Because of this, the company SM is not generating appropriate sales and its stock price is not rising. In other words, the attack's justification is that shareholders are suffering losses due to SM management damaging corporate value. Align claims that their goal is to correct improper management practices and raise the stock price.

Behind Align's claims is 'Like Planning.' Like Planning is a company in which the former producer holds 100% of the shares. Since 2015, SM has provided up to 6% of its sales to Like Planning. According to Align, the former producer was entitled to receive a 6% royalty on existing released music revenue until 2092. Align's point is that the former producer is unfairly receiving over 100 billion won of company funds.

How did Align carry out its attack? Align holds only 1.1% of SM shares. The former producer held 18.46%. Align first attracted minority shareholders' attention using a 'shareholder letter.' A shareholder letter is a letter sent by a shareholder to management. In March 2022, Align sent a letter to SM demanding the termination of the producer service contract with Like Planning. SM did not accept this demand.

Align Unites Minority Shareholders, Kakao Joins as Ally

Lee Soo-man, former Chief Producer of SM Entertainment, leaving after delivering the keynote speech at the 'Korea-Mongolia Business Dinner' held on the 14th at the Grand Hyatt Hotel in Seoul.
[Image source=Yonhap News]

Then, at the shareholders' meeting held the same month, Align united minority shareholders. They demanded that the auditor recommended by Align be appointed to the SM board and won the vote. In August of that year, Align publicly sent a second shareholder letter demanding an announcement on how the contract with Like Planning had been improved. In October, they pressured SM by requesting accounting books and board meeting minutes. Criticism of SM among shareholders intensified. Eventually, SM announced the early termination of the contract with Like Planning.

Afterward, Align exercised the 'right to file a derivative lawsuit.' This right can be exercised by shareholders holding more than 1% of the company's shares. If management or board members have acted improperly causing company losses and no action is taken, shareholders can sue the directors. Align claims that SM directors tacitly allowed the former producer to earn unfair profits through Like Planning.

Align then began efforts to replace management. But to secure shares, money is needed, right? So they recruited an ally: the Kakao Group. The process is as follows. Align had SM issue 1.23 million shares through the board. These shares were issued as a 'third-party allotment paid-in capital increase,' meaning the shares were specifically sold to Kakao. Kakao also secured 1.14 million shares through convertible bonds. Kakao became the second-largest shareholder with a 9.05% stake.

Lee Soo-man's 'White Knight' HYBE Defends with Tender Offer

Hive Building, Yongsan-gu, Seoul
Photo by Yonhap News

The former producer also responded. To defend against the takeover attempt, he devised a defense strategy called the 'white knight.' A white knight is a friendly party that management turns to during a hostile takeover attempt, transferring shares to them. The white knight Lee Soo-man found was none other than HYBE chairman Bang Si-hyuk. Chairman Bang received 14% of SM shares from the former producer. Now, Align and Kakao face not the individual former producer but the white knight HYBE with massive financial power.

The next step was a 'tender offer.' This is a strategy used by major shareholders to increase their stake for management defense. It involves publicly announcing the purchase of shares at a certain price in the stock market. The price is set higher than the current market price with a premium. HYBE announced a price of 120,000 won per share and will conduct the tender offer until the 1st of next month. The target is 25% of all SM issued shares (5,951,826 shares). If successful, HYBE's stake will rise to 39.8%.