Endowment's plan to diversify erodes one of Lilly's takeover safeguards

July 31, 2006

Since 1937, the fortunes of Eli Lilly and Co. and Lilly Endowment Inc. have been closely intertwined. With its $8.4 billion stake, the charitable endowment is by far the drugmaker's largest shareholder.

But on July 21, the endowment announced it will reduce its holdings by $2 billion. The diversification will have enormous repercussions. It's meant to decrease volatility in the endowment's assets. Properly managed, it could also improve the market returns it uses to underwrite grants.

It also erodes one of Eli Lilly and Co.'s key antitakeover provisions.

"A concentrated voting bloc is one of the best takeover defenses you can have, especially if that bloc is friendly to the incumbent management team," said David Denis, Purdue University's Burton D. Morgan chairman of private enterprise. "If you're reducing that bloc, that by itself has to increase the probability you could be the target of a takeover."

Lilly incorporated three anti-takeover provisions into its bylaws in the mid-1980s. Two aren't affected by the endowment's diversification: The company staggers appointments to its board, which prevents a hostile suitor from gaining control of the board in a single year. Lilly also has a "poison pill" provision that allows shareholders to buy stock at half its market value in the event of an unsolicited bid.

But Lilly Endowment's stock sale could wear against the third provision, known as a "supermajority." It requires takeover proposals not approved by the board to receive at least 80-percent shareholder approval.

About 5 percent of most every public company's shareholders never exercise their votes, Denis said. Lilly Endowment holds a 14-percent stake. Between the endowment and the silent shareholders, it would be nearly impossible to overcome the supermajority requirement. Selling holdings worth $2 billion would reduce the endowment's stake to 10.6 percent.

Hypothetically, the endowment's diversification would make it easier for a rival company to scoop up the necessary shares. It's an even bigger threat if Lilly Endowment ever diversifies all its assets. But Lilly observers agree the chances are remote a suitor will try a hostile acquisition.

"At the margin, this reduction in holdings of the Lilly Endowment would increase the probability of becoming a takeover target," Denis said. "But in my opinion, that increase is very small, because of the other anti-takeover mechanisms already in place."

Lilly spokesman Ed Sagebiel confirmed the company has no concerns about the endowment's decision to diversify.

"Eli Lilly and Co. has several measures in place to ensure shareholder interests are safeguarded in the event of a takeover attempt," he said. "A partial reduction in the endowment's holdings of Lilly stock does not detract from those measures."

Kevin Scotcher, a Lilly analyst for HSBC Securities, said a more probable--albeit still unlikely--scenario would be for Lilly's board to change direction and consent to a friendly acquisition. If the premium were high enough, members would have no choice but to consider it. There aren't any current rumors of such a deal. But blockbuster mergers are relatively frequent on Wall Street.

"You can never say never in this business. So many deals have happened," Scotcher said. "But it's clear at the moment, [Lilly board members are] on record as saying they don't have to be bigger to be successful in the drug industry."

Unexpected change is exactly what Lilly Endowment needs protection against. Most large foundations, endowments and pension funds diversified their holdings long ago. By spreading investments across every market sector, from bonds to equities, they reduce the risk of being tied to one company's fortunes. But Lilly Endowment has defied that strategy. Its assets are still concentrated almost entirely in Lilly stock.

"If you're holding everything in one stock, there are states of the world in which you'll do very well," Denis said. "But if that stock is down, you'll do horribly."

That's been exactly the case for the endowment in recent years. According to its annual reports, endowment assets were worth $15.8 billion at their peak in 1998. Today, those assets are worth $7.4 billion less. The volatility affects Lilly Endowment's charitable efforts. In 2001, it made a record $778 million in grants. Just two years later, its grants had dropped $592 million to a nadir of $186 million.

"Lilly Endowment has for many years enjoyed substantial benefits from its holding of Eli Lilly and Co. stock and still believes that Lilly stock will continue to be a rewarding investment," said Lilly Endowment Chairman Thomas Lofton in a statement announcing the diversification strategy. "Nonetheless, there is wisdom in embarking upon some level of diversification."

"This transition will take time and our thinking is fluid," he added. "Circumstances may change and alter our plans. This will be a work in progress, and many details are still being studied."

Lilly Endowment declined to answer questions about why its investment policy changed this year in particular.

Former Lt. Gov. John Mutz, now chairman of Lumina Foundation, has long advocated Lilly Endowment's diversification. He served as its president from 1989 to 1994. Lilly Endowment says it won't finish its current diversification plans until 2010; about $6 billion in Eli Lilly and Co. stock will remain in Lilly Endowment's hands. But if the board has any plans to fully diversify the rest, Mutz said, it wouldn't announce them now.

"In a case like this, where such a large block of stock is owned, you want to be very careful not to destroy the value by putting it all on the market at the same time," Mutz said. "Even suggesting it could have that effect."

When the $7.5 billion Indiana State Teachers Retirement Fund began a similar diversification process in 1997, the heavy lifting took eight years, said TRF Chief Investment Officer Bob Newland. Consultants had to be hired to evaluate new asset classes, then map a plan to move billions without losing any value. Even today, the process isn't finished.

"We're still doing it," Newland said.

This won't be the first time Lilly Endowment has sold Eli Lilly and Co. stock. Annual reports show it has quietly traded $1.9 billion worth since 1999--nearly as much as it is planning to move now. The difference is that earlier stock sales underwrote grants. The diversification process, Mutz said, requires a great deal more management expertise.

"You're going to need some assistance, if in the past all you've done is exist in one stock plus your cash. A small internal staff can handle that sort of thing," Mutz said. "But $2 billion in diversified investments ... it's a whole new world when you get into that. And, of course, they've not had to deal with that for a long time."

The endowment's prepared statement said diversification decisions would be made internally, with help from outside advisers.

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