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Hedge Fund Activism

JW Verret claims:

The conventional wisdom has always been that institutional investors are unwilling to engage in substantive oversight of their investments because of conflicts of interest and collective-action problems. Activist hedge funds are changing that calculus because they are able to internalize future reputation benefits from oversight. As I explain in my forthcoming article Pandora’s Ballot Box, or a Proxy With Moxie?, these activists benefit from improved capital flows from institutional investors through reputational benefits, and can use their reputational capital to engage in more cost-efficient saber-rattling in future contests. That reputation benefit only works, however, if the activist fund builds value for the large, long term investors that dominate the electorate.

I’ve got two problems with this line of argument. First, it’s true that the impact of activism by hedge and private equity funds has been growing, as a recent study by Robin Greenwood confirms:

[B]etween 1994 and 2006, the number of public firms targeted for poor performance by hedge funds grew more than 10-fold.

More importantly, hedge funds may be up to the task of monitoring management—a number of recent academic papers have found that hedge funds generate returns of over 5 percent on announcement of their involvement, suggesting that investors believe these funds will increase the value of the firms they target.

But do these funds generate value by effecting governance or operational change? Greenwood argues that hedge fund managers generally are poorly suited to making operational business decisions and, with their short-term focus, are unlikely “to devote time and energy to a task delivering long-term value. After all, there are no guarantees that the effort will pay off, or that other shareholders would recognize the increase in value by paying a higher price per share.”

Instead, hedge funds profit mainly through corporate control—rather than corporate governance—activism. He argues that “hedge funds are better at identifying undervalued companies, locating potential acquirers for them, and removing opposition to a takeover.” This hypothesis was confirmed by his study of over 1000 cases of hedge fund activism, which found that “targets of investor activism earn high returns only for the subset of events in which the activist successfully persuades the target to merge or get acquired.” Robin Greenwood, The Hedge Fund as Activist, HBR Working Knowledge, Aug. 22, 2007. As a result, hedge fund and private equity fund activism will matter only when market conditions favor such acquirers relative to unassisted strategic buyers.

Second, if shareholder activism is to be encouraged, the first prerequisite for such a regime would be a system of shareholder voting in which one has confidence. In fact, however, the shareholder franchise is rife with serious pathologies. “First, there are pathologies caused by the sheer complexity of the system. Second, there are pathologies caused by a misalignment of the property concepts implicit in the beneficial-owner-as-shareholder paradigm and the property rules that, in fact, govern the voting of shares held by nominees. Third, there are pathologies caused by a misalignment between voting rights and economic interests.” Marcel Kahan & Edward B. Rock, the Hanging Chads of Corporate Voting (2007), available at http://ssrn.com/abstract=1007065. These sorts of pathologies are particularly troubling because exploiting them is one of the major profit strategies of most hedge funds.  Even were that not the case, however, the infirimities of the shareholder franchise call into serious question the merits of shareholder activism. If we cannot have confidence in the fairness and accuracy of the process of shareholder voting, the case for further shareholder empowerment rests on a foundation of sand.