The Wolf At The Door: The Impact Of Hedge Fund Activism On Corporate Governance
Columbia Law School; European Corporate Governance Institute (ECGI); American Academy of Arts & Sciences
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Rutgers Business School; Center for Contract & Economic Organization
September 4, 2015
Hedge fund activism has increased almost hyperbolically. Although some view this trend optimistically as a means for bridging the separation of ownership and control, we review the evidence and find it far more mixed. In particular, engagements by activist hedge funds appear to be producing a significant externality: severe cut-backs in long-term investment (and particularly a reduction in investment in research and development) by both the targeted firms and other firms not targeted but still deterred from making such investments.
We begin by surveying the regulatory and institutional developments that have reduced the costs and increased the expected payoff from activism for activist investors. We give particular attention to new tactics (including the formation of “wolf packs” — loose associations of activist funds that do not constitute a “group” under the Williams Act) and new institutional structures (such as the alliance between an activist hedge fund and a strategic bidder struck in the recent Allergan takeover battle).
Then, we survey the empirical evidence on how the investment horizons of firms are changing. Next, we review prior studies on the impact of activism, looking successively at (1) who are the targets of activism?; (2) does hedge fund activism create real value?; (3) what are the sources of gains from activism?; and (4) do the targets of activism experience post-intervention changes in real variables? We find the evidence decidedly mixed on most questions.
Finally, we examine the policy levers that could encourage or curb hedge fund activism and consider the feasibility of reforms (including with respect to the law on insider trading). In particular, we consider possible private ordering responses, including new defensive tactics. Our policy preference is to find the least restrictive alternative.
The Wolf At The Door: The Impact Of Hedge Fund Activism On Corporate Governance – Introduction
Hedge fund activism has recently spiked, almost hyperbolically. No one disputes this, and most view it as a significant change. But their reasons differ. Some see activist hedge funds as the natural champions of dispersed and diversified shareholders, who are less capable of collective action in their own interest. A key fact about activist hedge funds is that they are undiversified and typically hold significant stakes in the companies in their portfolios. Given their larger stakes and focused holdings, they are less subject to the “rational apathy” that characterizes more diversified and even indexed investors, such as pension and mutual funds, who hold smaller stakes in many more companies. So viewed, hedge fund activism can bridge the separation of ownership and control to hold managements accountable.
Others, however, believe that activist hedge funds have interests that differ materially from those of other shareholders. Presidential contender Hillary Clinton has criticized them as “hit-and-run activists whose goal is to force an immediate payout,” and this theme of an excessively short-term orientation has its own history of academic support. From this perspective, the rise of activist funds to power implies that creditors, employees and other corporate constituencies will be compelled to make wealth transfers to shareholders.
This article explores this debate in which one side views hedge funds as the natural leaders of shareholders and the other side as “short-term” predators, intent on a quick raid to boost the stock price and then exit before the long-term costs are felt. We are not comfortable with either polar characterization and thus begin with a different question: Why now? What has caused activism to peak over the last decade at a time when the level of institutional ownership has slightly subsided? Here, we answer with a two-part explanation for increased activism: First, the costs of activism have declined, in part because of changes in SEC rules, in part because of changes in corporate governance norms (for example, the sharp decline in staggered boards), and in part because of the new power of proxy advisors (which is in turn a product both of legal rules and the fact that some institutional investors have effectively outsourced their proxy voting decisions to these advisors). Second, activist hedge funds have recently developed a new tactic—“the wolf pack”—that effectively enables them to escape old corporate defenses (most notably the poison pill) and to reap high profits at seemingly low risk. Unsurprisingly, the number of such funds, and the assets under their management, has correspondingly skyrocketed. If the costs go down and the profits go up, it is predictable that activism will surge (and it has). But that does not answer the broader question (to which we then turn) of whether externalities are associated with this new activism.
Others have criticized hedge fund activism, but their predominant criticism has been that such activism amounts in substance to a “pump and dump” scheme under which hedge funds create a short-term spike in the target stock’s price, then exit, leaving the other shareholders to experience diminished profitability over the long-run. This claim of market manipulation is not our claim (nor do we endorse it). Rather, we are concerned that hedge fund activism is associated with a pattern involving three key changes at the target firm: (1) increased leverage; (2) increased shareholder payout (through either dividends or stock buybacks), and (3) reduced long-term investment in research and development (“R&D”). The leading proponent of hedge fund activism, Harvard Law Professor Lucian Bebchuk, has given this pattern a name: “investment-limiting” interventions. He agrees that this pattern is prevalent but criticizes us for our failure to recognize that “investment-limiting” interventions by hedge funds “move targets toward…optimal investment levels” because “managements have a tendency to invest excessively.” We think this assumption that managements typically engage in inefficient empire-building is today out of date and ignores the impact of major changes in executive compensation. The accuracy of this assertion that managements are systematically biased towards inefficient expansion and investment becomes the critical question, as the scale and magnitude of “investment-limiting” interventions by activists have begun to call into question the ability of the American public corporation to engage in long-term investments or R&D. Is the new activism a needed reform to curb managerial self-interest or a hasty overreaction? Or somewhere in between?
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