By Alessio M. Paces – Professor of Law and Finance at Erasmus University Rotterdam
Activist hedge funds are the big thing in corporate governance today. They intervene in the governance of publicly held companies with the goal to make changes happen.
Although hedge fund activism has emerged as an US phenomenon, it has now become international. Hedge fund activism is increasingly prominent in Europe, for instance in the UK. Moreover, hedge funds are active in concentrated ownership structures, too. Somewhat surprisingly, activist hedge funds have succeeded in extracting concessions also in the presence of dominant shareholders.
Activist hedge funds screen the market for underperforming companies and buy a significant stake in them in order to engage their management. The goal of activists is to profit from increasing the company’s performance, which will be reflected by an increase in the value of their stake when it is sold back to the market. In doing so, hedge funds are coping with the fundamental agency problem stemming from separation of ownership and control, namely the failure by management to maximize shareholder value. However, because hedge funds profit from a short-term change in the stock price of the target company, they may also be responsible for short termism in corporate governance. Feeling the pressure of hedge funds, managers may pursue short-term stock returns at the expenses of long-term value creation. For this reason, hedge fund activism is highly controversial today.
From a law and economics standpoint, the question is whether hedge fund activism remedies or exacerbates market failure. On the one hand, the reduction of agency costs stemming from activism improves the efficiency of corporate governance. On the other hand, if the profitability of hedge funds activism depends on short-term pricing, the ability of corporate governance to sustain certain long-term projects may be undermined. To answer these questions and identify the right policy towards hedge fund activism, it is crucial to understand what drives such activism as well as the factors affecting its success.
Hedge fund business model
Hedge funds have a different business model than other institutional investors. Hedge fund managers charge a performance fee in addition to a percentage of the asset under management. The remuneration usually follows the so-called 2-20 rule: two per cent of the asset under management plus 20 per cent of any increase in the value of the portfolio. This remuneration structure aligns the hedge fund incentives with investors having a relatively high appetite for risk.
Two factors are key for the success of entrepreneurial activism. First, the hedge fund needs to be able to buy the bulk of its stake in the company while the stock market does not anticipate the engagement. The moment the engagement is revealed, investors will anticipate gains and free ride on them. Second, the activist needs to be able to persuade the management to implement the desired changes. For this purpose, the support by institutional investors is crucial.
The typical hedge fund stake in a target company is slightly above six per cent, which is not nearly a controlling one. As a result, activists must persuade other investors to vote for them. The tremendous influence activists have gained in corporate governance depends on the reconcentration of ownership that has occurred in the past few decades. The bulk of equity investment is no longer in the hands of thousands of dispersed shareholders, but is managed by a few institutional investors. Although the style of engagement differs considerably across countries, hedge funds activism consistently gets traction wherever institutional ownership is concentrated. Despite their positive role in activating institutional investors’ voice, activist hedge funds have attracted a lot of criticism.
Critique of hedge fund activism
A first point of criticism is that the institutional investors voting on a hedge fund engagement may fail to exercise judgment. Rather, they would blindly follow the recommendations of proxy advisors, notably including global market leaders, such as Institutional Shareholders Services (ISS) and Glass Lewis, to decide whether to vote for or against hedge funds. Empirical research suggests that the impact of proxy advisors on the voting by institutional investors may be not as decisive as it looks. For instance, a US study of uncontested elections reveals that ISS advice against the management shifts 10 per cent of votes at most. Moreover, it is impossible to determine how much proxy advisors influence large institutional investors and how much they are influenced by them.
Another fundamental critique levelled at hedge funds is that they may succeed without any screening by institutional investors if they act as a coalition, namely as a so-called ‘wolf pack’. Empirically, wolf packs account for more than 20 per cent of the engagements observed internationally and are associated with a much higher success rate than individual engagements. Therefore, wolf packs look like a nearly riskless strategy for hedge funds. However, the impact of wolf packs could be overestimated. Note that nearly 80 per cent of the engagements mapped internationally are not wolf packs. This cannot be random because hedge funds choose their battles. If they decide to join and form a wolf pack only when success is more likely, the success rate of wolf packs is overestimated.
“The tremendous influence activists have gained in corporate governance depends on the reconcentration of ownership that has occurred in the past few decades. The bulk of equity investment is no longer in the hands of thousands of dispersed shareholders, but is managed by a few institutional investors”
The recurrent objection to hedge funds activism is short-termism. In one respect, this critique is not borne out by the empirical evidence. The announcement of hedge fund engagement leads, on average, to a significant increase of the stock price. This increase is not reversed for up until five years down the road, provided that the engagement is effective in determining change. However, while useful to defend hedge fund activism from an easy rhetoric against them, this result says nothing about whether the stock markets are myopic relative to some horizon longer than the activists’ holding period (about two years on average).
Theory and evidence on hedge fund activism
Underlying the short-termism discussion, there is a fundamental question about the desirability of hedge fund activism. If financial markets were informationally efficient, there would be no difference between short-term and long-term maximisation of shareholder value. However, if stock markets overweight the short-term profits of a company relative to its long-term profits, albeit temporarily, there is market failure and hedge fund activism may be a problem, despite its positive impact on agency costs.
The question whether public companies should be managed for a shorter or a longer term cannot be answered empirically. Data reveal that successful activism, on average, is associated with a stock price increase. However, this result is uninformative because hedge fund activism produces unobservable effects, too, and because the companies for which we observe engagements cannot be meaningfully compared to those that are not engaged.
In theory, whether hedge fund activism is efficient depends on context. Some companies benefit from the correction of underperformance fostered by activist hedge funds, particularly in the presence of investor expropriation or misuse of free cash. For other companies, though, underperformance is temporary and the change of strategy promoted by hedge funds can destroy value. The disagreement on the proper length of time in which to assess performance reflects a more fundamental conflict between two views of the target firm, one by the activist hedge fund and the other by the incumbent management. These views normally differ on strategic issues, such as whether the company should be leaner, more focussed on certain businesses and cost-effective in carrying them out, which hedge funds typically like to see perhaps because they are impatient to cash in the profit from engagement. The opposite view that the company should pursue longer term goals, typically fostered by the management, is equally legitimate although it may procrastinate the acknowledgement of mistakes or conceal the extraction of private benefits of control. For this reason, hedge fund activism should be framed as a conflict of entrepreneurship.
The role of index funds
Framing hedge fund activism as a conflict of entrepreneurship brings up the question of who decides on the conflict and whether this is efficient. Hedge funds need to garner institutional investors’ support in order to succeed. Institutional investors, however, differ considerably from each other and so does their propensity to exercise voice.
Index funds are likely to cast the decisive votes on a hedge fund campaign because they cannot exit an investment they are dissatisfied with, so long as this investment is part of the index they track. Drawing on their long-term commitment to index tracking, managers of large index funds have recently made public statements to distance themselves from the short-termism of activist hedge funds.
Such statements must be taken with a grain of salt. Index fund managers cannot benefit from firm-specific monitoring because their competitors can free ride. In pursuing relative performance, index fund managers will rather choose low-cost voting policies that are generally appreciated by investors. For instance, index funds may vote for a hedge fund’s request to cut R&D expenditures not because it is efficient, but because the target has poor corporate governance.
Because index funds do not have incentives to make an informed decision on individual company’s strategy, they cannot always be trusted to screen hedge fund activism. Nevertheless, the incentives of index funds are aligned with the interest of the investing public regarding the control of agency costs. Therefore, the problem whether a company should be exposed to hedge funds activism does not warrant a one-size-fits-all solution. Different companies may need different degrees of exposure to activism at different points in time.
Policies towards hedge fund activism
Policymakers have been sceptical towards hedge funds activism, based on a twofold assumption. The first is that hedge fund activism always leads to short-termism in corporate governance. The second is that short-termism is always value destroying. Although neither of these assumptions holds true across the board, they have supported anti-activist policies, such as ownership disclosure regulation and shareholder identification.
Regulation mandates transparency of large ownership on both sides of the Atlantic. The purpose of ownership disclosure is to unveil the build-up of significant stakes in a company. For instance, in the US, ownership disclosure is triggered by the crossing of a five per cent beneficial ownership threshold, after which the shareholder has 10 days to disclose its stake. A lower threshold or a shorter window to disclose undermines hedge fund activism by reducing their ability to profit from the purchase of undervalued stock. While a few proposals have been made in the US along these lines, none of them has become law.
In the EU, curbs on hedge fund activism stem from the obligation to identify all shareholders owning more than 0.5 per cent of voting rights. This obligation will be introduced by the revision of the Shareholder Rights Directive. Although this rule differs from ownership disclosure, it may lead to a similar chilling effect on hedge fund activism unless multiple toeholds can be purchased below the threshold. This chilling effect is at odds with the purpose of the Directive to encourage shareholder engagement, considering that hedge funds are crucial to activate the voice of longer-term investors.
“One-size-fits-all curbs on hedge fund activism are inefficient and should be replaced by rules enabling individual companies to choose, with their shareholders, the optimal exposure to activism”
One-size-fits-all curbs on hedge fund activism are inefficient and should be replaced by rules enabling individual companies to choose, with their shareholders, the optimal exposure to activism, and to alter this choice over time. In several jurisdictions, companies can opt out of hedge fund activism through dual-class shares, which are interesting relative to other anti-activist tools (such as low-trigger poison pills) because they commit some of the controller’s own wealth to a long-term project. However, dual-class shares can only be introduced before the company has gone public, unless they are presented as loyalty shares.
Formally, loyalty shares do not discriminate between shareholders because they provide super-voting rights to any owner that retains the shares for long enough – say, two years. Practically, however, loyalty shares are only interesting for controlling owners, because institutional investors are reluctant to give up the higher liquidity of common stock. Therefore, loyalty shares effectively operate as dual-class shares, although they can be introduced after companies have gone public. Explicit dual-class recapitalisations, which are currently prohibited, would be preferable to loyalty shares to the extent that institutional investors can veto them. The recent experience with French law (Loi Florange) reveals that institutional investors may be unable to stop the introduction of loyalty shares.
This article has discussed the role of hedge fund activism in corporate governance. Activist hedge funds are an important source of feedback in corporate governance. However, their influence is not always efficient. Although other institutional investors are typically decisive on a hedge fund campaign, their judgment cannot always be trusted.
The optimal decision about whether a company should be managed for the short or the long term depends on the circumstances faced by the individual company. Therefore, individual companies should be able to tailor the exposure to hedge fund activism
to their needs, and to alter this choice over time, for instance by way of loyalty or dual-class shares.
About the Author:
Alessio M. Pacces is Professor of Law and Finance at the Erasmus School of Law, Erasmus University Rotterdam. Prior to entering academia, he worked at the research department of the Bank of Italy and at the Italian Securities Authority (Consob). Since 2009, he has been Research Associate at the European Corporate Governance Institute (ECGI). Since 2014, he has been Director of the European Master in Law and Economics (EMLE).
Alessio’s research focuses on the economic analysis of corporate law and financial regulation. On these topics, he published books and chapters with houses such as Elgar, Routledge, and Oxford University Press, as well as articles in journals such as Harvard Business Law Review, American Business Law Journal, and International Review of Law and Economics, among others. He has been invited to speak by several policy institutions, such as among others the OECD, the European Central Bank, and the European Commission. He has held several visiting appointments, including among others at Berkeley Law School and Columbia Law School.