Activist Hedge Funds In A World Of Board Independence: Creators Or Destroyers Of Long-term Value? via SSRN
Independent
May 1, 2015
Columbia Business Law Review, Forthcoming
Abstract:
Numerous empirical studies have shown that hedge fund activism has led to enhanced returns to investors and increased firm performance. Nevertheless, leading figures in the corporate governance world have taken issue with these studies and have argued that hedge fund activism leads to long-term value destruction.
In this article, it is argued that an activist hedge fund creates long-term value by sending affirming signals to the board of directors (Board) that its executive management team may be making inefficient decisions and providing recommendations on how the company should proceed in light of these inefficiencies. These recommendations require the Board to review and question the direction executive management is taking the company and then choosing which path the company should take, the one recommended by executive management, the one recommended by the activist hedge fund or a combination of both. Critical to this argument is the existence of a Board that can act as an independent arbitrator in deciding whose recommendations should be followed.
In addition, an explanation is given for why activist hedge funds do not provide recommendations that involve long-term investment. There are two reasons for this. First, the cognitive limitations and skill sets of those individuals who participate as activist hedge funds. Second, and most importantly, the stock market signals provided by value investors voting with their feet are telling the rest of the stock market that a particular public company is poorly managed and that it either needs to be replaced or given less assets to manage. These are the kind of signals and information that activist hedge funds are responding to when buying significant amounts of company stock and then making their recommendations for change. Therefore, it is not surprising that the recommendations of activist hedge funds will focus on trying to reduce the amount of assets under current management.
Activist Hedge Funds In A World Of Board Independence: Creators Or Destroyers Of Long-term Value? – Introduction
Numerous empirical studies have shown that hedge fund activism has led to enhanced returns to investors and increased firm performance.
Rose and Sharfman explain these results by arguing that activist hedge funds act as a corrective mechanism in the corporate governance of a public company, leading to higher stock prices and better company performance.
Nevertheless, leading figures in the corporate governance world, most notably Martin Lipton, have taken issue with these studies and have argued that hedge fund activism leads to long-term value destruction:
While there is no question that almost every attack, or even rumor of an attack, by an activist hedge fund will result in an immediate increase in the stock market price of the target, such gains are not necessarily indicative of real value creation. To the contrary, the attacks and the efforts by companies to adopt short-term strategies to avoid becoming a target have had very serious adverse effects on the companies, their long-term shareholders, and the American economy.
If so, then the actions of activist hedge funds allegedly compel public companies to enter into detrimental short-term strategies in order to be removed from the activists’ target list.4 This is something akin to greenmail where the corporation must deplete its resources to make the hostile bidder go away.5 Moreover, according to Lipton, the strategies of activist hedge funds are meant to achieve short-term gains without regard to the welfare of the companies they target:
Institutional investors on average own more than 70% of the shares of the major public companies. Their voting power is being harnessed by a gaggle of activist hedge funds who troll through SEC filings looking for opportunities to demand a change in a company’s strategy or portfolio that will create a short-term profit without regard to the impact on the company’s long-term prospects.
The short-term profit presumably refers to the capital gain that would accrue to the activist hedge fund after buying a significant amount of company shares and then selling those shares for a higher price at the end of its relatively short investment horizon.7 The paradoxical nature of the statement that an increase in the price of a company’s shares can be harmful to a company’s fortunes allegedly results from the recommendations of the activist hedge fund, if implemented by the company, being tainted with an approach to corporate governance that is referred to as “short-termism:”
Short-termism refers to companies taking actions that are profitable in the short term but value-decreasing in the long term, such as increasing near-term earnings by cutting research that would pay off later on. Activist investors with short investment horizons, it is argued, seek actions that boost short-term stock price at the expense of long-term value and often succeed in pressuring companies to take such actions.
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