A while back, when the W$J recently reported that Carl Icahn and two of his allies won election to Blockbuster's board of directors, with substantial support from hedge funds, it opined:
Mr. Icahn's victory starkly demonstrates the growing willingness of hedge funds to wield clout in corporate boardrooms. A number of the large, private investment pools rank among Blockbuster's biggest shareholders and were enthusiastic backers of Mr. Icahn. (Pay Link)
Are hedge funds the next big thing in corporate governance, solving the principal-agent problems inherent in that governance structure? Or will they fizzle out the way hostile takeovers and, to a lesser extent, institutional investor activism have?
My guess is the latter.
First, thus far hedge funds have been mainly followers. The high profile cases in which hedge funds have - or likely will - played a major role have mostly been cases in which there was an individual activist around whom the hedge funds rallied: Roy Disney and Stanley Gold at Disney, Icahn at Blockbuster, and, possibly coming down the pike, Kerkorian at GM. The leading recent case in which hedge funds tried to affect boardroom deliberations without a rallying figure was MCI, in which the hedge funds (thus far) failed to sway the MCI board from its preference for Verizon over Qwest. Given the constr aints on shareholder activism in US corporate and securities law, it seems likely that hedge funds will be most successful in those limited number of cases in which there is a central coordinating figure driven by a private agenda.
Second, at least two of the above-referenced cases - Icahn at Blockbuster and Kerkorian at GM - look a lot more like 1980s-style greenmail raids rather than efforts to improve corporate governance long-term. Granted, there is a theory (most prominently advanced by law professors Jon Macey and Fred McChesney) that greenmail sometimes benefits not just the greenmailer but rather target company shareholders generally. The empirical data, however, as summarized by Gilson and Black (at 788) suggests that greenmail only does so where the greenmailer's raid is followed by a successful takeover of the target company by another acquirer. To the extent hedge funds are simply piggybacking on the efforts of greenmailers like Icahn and Kerkorian, they therefore are more likely to obtain private benefits through wealth transfers than to provide systemic benefits.
Third, much of the success of hedge funds has been attributed to the fact that they are lightly regulated. The WSJ report, for example, quotes a hedge fund manager who "said there is no doubt hedge funds are gaining power, in part because the lightly regulated funds are able to challenge companies without the restrictions that can encumber mutual funds and other institutional investors." The prospects for hedge fund activism are thus circumscribed in two ways. First, hedge funds in fact are subject to many of the constraints on shareholder activism that have helped prevent institutional investor activism from becoming much more than a thorn in management's side. Second, the SEC and Congress have already been flirting with efforts to regulate hedge funds. If hedge funds succeed at becoming something more than annoyance, one can expect the business lobby (such as the Business Roundtable, NAM, and the Chamber of Commerce) to provide critical support for such efforts.
Should we mourn the likely failure of hedge funds as activists? No. Granted, the separation of ownership and control in publicly held corporations, pursuant to which directors and managers exercise control while shareholders nominally own the corporation, results in a classic principal-agent problem. In other words, directors and managers may use their control to extract private benefits to the detriment of shareholders.
A narrow focus on these agency costs, however, can distort one?s understanding. We could substantially reduce, if not eliminate, agency costs by eliminating discretion; that we do not do so suggests that discretion has substantial virtues. A complete theory of the firm thus requires one to balance the virtues of discretion against the need to require that discretion be used responsibly.
The root economic argument against hedge fund (and other forms of shareholder) activism thus becomes apparent. It disrupts the very mechanism that makes the public corporation practicable; namely, the centralization of essentially nonreviewable decisionmaking authority in the board of directors.
Put another way, the chief economic virtue of the Berle-Means corporation is not that it permits the aggregation of large capital pools, but rather that it provides a hierarchical decisionmaking structure well-suited to the problem of operating a large business enterprise with numerous employees, managers, shareholders, creditors, and other inputs. In such a firm, as economist Kenneth Arrow explained, someone must be in charge: ?Under conditions of widely dispersed information and the need for speed in decisions, authoritative control at the tactical level is essential for success.?
While some argue that shareholder activism ?differs, at least in form, from completely shifting authority from managers to? institutions, it is in fact a difference in form only. Shareholder activism necessarily contemplates that institutions will review management decisions, step in when management performance falters, and exercise voting control to effect a change in policy or personnel.
In a very real sense, giving institutions this power of review differs little from giving them the power to make management decisions in the first place. To quote Arrow again: ?If every decision of A is to be reviewed by B, then all we have really is a shift in the locus of authority from A to B and hence no solution to the original problem? of allocating control under conditions of divergent interests and differing levels of information.
In sum, the basic precept of corporate law and governance is separation of ownership and control. Hedge fund activism is unlikely to put them back together again. And, as Martha Stewart might say, that's a good thing.
