By Paul Rose, Bazler Designated Professor in Business Law & Executive Director at the Ohio State University’s Moritz College of Law
Activist investing by hedge funds hit new highs in 2015, but activism now seems to be resettling into a new era as investors are increasingly questioning the value of hedge fund interventions.
The stakes are high, as the number and size of hedge funds have grown considerably in recent years. Fifteen years ago a handful of activist hedge funds managed a combined total of less than $20bn in assets. As of June 2015, the financial research firm Preqin reports that 519 activist hedge funds were in operation, with assets under management of $140bn.
What have activist hedge funds done with all that cash? A positive view of shareholder activism holds that activists serve as a check on opportunistic or obstinate managers, while a negative view sees activists, and especially activist hedge funds, as short-term investors that jeopardise long-term corporate growth. And, of course, both views can be true, as in some cases activists may provide a necessary correction to managerial inertia, while in other cases activists may pressure well-governed companies to make unnecessary and unwise changes in capital structure or corporate investments.
The playbook for activist funds has been relatively simple, with only a few strategies necessary to generate alpha for investors desperate for returns in a low interest rate environment. Activist funds often try to squeeze cash from a company through dividends or share buybacks. In other cases, activists push for changes in business strategy designed to unlock value in the firm, encourage firms to spin off divisions, or engage in (or resist) certain mergers, acquisitions and asset sales.
Many activist campaigns seek to obtain seats on the board, which serves to increase the influence of the fund on corporate strategy and make the financial or strategic goals of the fund easier to achieve. These strategies have worked well for several years, buoyed by cheap leverage and a rising stock market. However, by late 2015 returns have been harder to come by and many activist hedge funds have posted large losses. While some investors will undoubtedly abandon activist funds – typically investors are locked in just for a year, and in some cases investors can request and receive a redemption in a matter of weeks – other investors will continue to be drawn to the enticing potential of strong returns.
Takeover activity set to slow
Such investors will likely be disappointed in 2016. Aside from the damage that a down market will do to these funds, as ‘The Deal Professor’ Steven Davidoff Solomon recently noted, the performance of activist funds is jeopardised by a systemic supply and demand problem that arises irrespective of market conditions: quite simply, returns will decrease if there is too much money pursuing too few opportunities. There is now evidence that some of the past strong performance by activist funds may be explained by funds selecting the low-hanging fruit of poorly performing firms.
Finance professors Martijn Cremers, Erasmo Giambona, Simone Sepe and Ye Wang recently investigated activist hedge fund performance and found not only that activists (unsurprisingly) targeted poorly performing firms, but that after controlling for selection bias, firms targeted by activist funds also actually performed worse than those not targeted. They also found evidence that such poor performance is most pronounced in firms that tend to be engaged in innovative businesses and in firms where relationships with stakeholders are key to long-term performance. Some activist hedge funds, at least, have been earning their returns not only by picking the low-hanging fruit, but also by picking the fruit before it is ripe.
“Real engagement should not be a reaction to a perceived governance threat, but an opportunity for the company to inform long-term investors of its plan for the company”
Despite the large number of activist hedge funds in operation, most companies will not find themselves targeted by activist funds in a given year. However, hedge fund activism has important ripple effects in the economy, as companies seek to make themselves less attractive targets for hedge funds activism. This, along with the fact that many companies have already made changes to accommodate the demands of activists, should make it more difficult for hedge funds to find attractive targets in 2016 and beyond. But if most of the low-hanging fruit is gone, how will activists respond?
One can imagine desperate funds pursuing more challenging opportunities, including larger companies and better-governed companies. They will also be under continued pressure from their investors, who may withdraw capital fairly quickly if the activist fund is not performing well (one of the ironies of shareholder activism is that many of the investors in activist funds clamouring for higher returns in the short term are those with the longest investment time horizons, including public and private pension funds). If the poor returns from 2015 are any indication, activist hedge funds are likely to be less powerful and perhaps fewer in number in 2016 and beyond.
Opportunities to engage
For companies and boards, the reshaping of the activist investment industry presents a great opportunity. Critically, in this new new era of activist investing, companies can change the way that they engage with their shareholders. Some of the engagement between companies and shareholders in recent years has taken the form of reactive shareholder appeasement after activists threaten a proxy fight. This ‘engagement’ provides an opportunity for activist investors and activist hedge funds in particular, to provide an alternative vision for how the company should be managed.
In some cases, these discussions present the company and the board with value-creating plans that serve to enhance long-term value. In other cases, however, the activists are merely interested in negotiating the terms of the board’s surrender to a short-term action. But what has often been missing from engagements is a serious, proactive plan from the company on how it will create long-term value. As BlackRock CEO Larry Fink recently wrote in his 2016 corporate governance letter to CEOs, “some short-term investors (and analysts) offer more compelling visions for companies than the companies themselves, allowing these perspectives to fill the void and build support for potentially destabilising actions”.
Real engagement should not be a reaction to a perceived governance threat, but an opportunity for the company to inform long-term investors of its plan for the company. Boards and managers also benefit from increasing scepticism of the value of hedge fund activism by these long-term investors, particularly as the low-hanging fruit – simple changes at poorly governed companies – become scarcer. For companies and boards concerned about continued battles with activist hedge funds, the old adage holds true: the best defence is a good offense.
About the Author:
Professor Paul Rose teaches Business Associations, Comparative Corporate Law, Corporate Finance, Investment Management Law, and Securities Regulation. He has written extensively on sovereign wealth funds, corporate governance, and securities regulation, and he has consulted with and provided testimony on these topics to numerous regulators and other agencies, including the U.S. Senate Committee on Banking, Housing and Urban Affairs; the U.S. Securities & Exchange Commission; the Government Accountability Office; and the Congressional Research Service. He is an affiliate with the Sovereign Wealth Fund Initiative, a research project at The Fletcher School at Tufts University, and is a non-resident fellow of the ESADEgeo-Center for Global Economy and Geopolitics. He blogs on issues relating to his research at statecapitalist.org.