In today's WSJ, Yale law prof Jonathan Macey offers a largely favorable view of the role of hedge funds in corporate governance.
Conflicts between a public company's top management and shareholders are seldom more intense than when an activist investor emerges with plans to make a substantial investment in the company's stock. These investors sometimes are hedge funds or "value investors" like Warren Buffett. Whoever they are, after they take a huge stake in the target company they have strong incentives to agitate vigorously for reforms that will increase the value of their investments.
Shareholders benefit from the reforms of corporate governance initiated by these activist investors. So does the economy generally, because the overall economy performs better when companies perform better. But managers are not so fond of this process because activist investors push incumbent senior managers hard to improve their performance. Occasionally they even fire them.
Go read the whole thing. It's very good, as typical of Macey. But then come back for my dissent
The following is an excerpt from my forthcoming book Corporate Governance After the Crises (Oxford University Press 2011). I offer it up as a partial dissent from Macey's take on hedge funds:
Shareholder activism by hedge and private equity funds differs in a number of respects from that of other institutional investors. Activist pension funds are typically reactive, intervening where they perceive (or claim to perceive) that a portfolio company is underperforming. In contrast, hedge fund activism typically is proactive, identifying a firm who performance could be improved and then investing in it.[1]
A 2007 study by Robin Greenwood confirmed the growing impact of such funds:
[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.[2]
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 transactions in corporate control, rather than corporate governance activism. Private equity funds like KKR long have been active acquirers. In the 1980s, for example, KKR was the famously prevailing barbarian at the gate in the fight over RJR Nabisco.[3] More recently, however, private equity acquisitions have simply exploded. The dollar value of announced private equity deals went from less than $50 billion in the first quarter of 2003 to $400 billion in the second quarter of 2007.[4] A mid-2007 credit crunch put the brakes on private equity deals, but long-term fundamentals continue to favor an active role for private equity in the market for corporate control.
In other cases, the private equity firm seeks not to acquire the target company, but rather to put it into play so as to profit on its stake when someone else buys the target. If the target is successfully put into play, the stock price runs up, attracting arbitragers and other short-term speculators who then put intense pressure on management to cut a deal. The private equity firm that started the ball rolling can then sell its shares at a substantial premium. In some cases, private equity holding shares in the target also may actively intervene in a pending deal by refusing to support the deal or threatening litigation unless the price and/or other important terms are improved.[5]
Conversely, where the private equity firm holds shares in a potential acquirer, it may seek to prevent the deal from happening at all. A successful bidder typically pays a premium of 30-50%, sometimes even higher, over the pre-bid market price of the target’s stock. Consequently, target shareholders demonstrably gain substantially—on the order of hundreds of billions of dollars—from takeovers.[6] In contrast, studies of acquiring company stock performance report results ranging from no statistically significant stock price effect to statistically significant losses.[7] By some estimates, bidders overpay in as many as half of all takeovers. Being aware of this risk, private equity holders have sometimes tried to block the acquirer for going forward.[8]
Greenwood argues that a preference for control rather than governance activism makes sense because “hedge funds are better at identifying undervalued companies, locating potential acquirers for them, and removing opposition to a takeover.”[9] His 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.” Another study of hedge fund engagements found that:
The financial yield, however, is disappointing. The hedge funds prove better at extracting target concessions and getting into boardrooms than at yielding long-term, market-beating financial gain. On the one hand, activist intervention led to something tangible in 88 percent of the cases, whether an asset sale, a stepped up cash payout, a board seat, or a legislative concession. On the other hand, only a minority of the targets’ stock prices beat market indices over the period of engagement, with financial underperformance being particularly notable in cases where the hedge fund entered the target boardroom.[10]
As a result, neither hedge nor private equity funds seem plausible candidates for being the ultimate solution to the principal-agent problem inherent in the public corporate form. Instead, they merely offer an alternative form—i.e., the private company.
In several cases, moreover, activist hedge funds have used financial innovations to pursue private gains at the expense of other shareholders. In 2005, for example, a hedge fund launched a proxy campaign to elect three candidates to the board of Exar Corporation. The hedge fund had boxed 96% of the shares it owned—i.e., had taken offsetting short positions on those shares—and “was thus almost completely indifferent to how the company performed since a “boxed” position is capable of generating no further profit or loss.”[11] Another well-known case involved Perry Capital’s innovative investments in King Pharmaceuticals and Mylan Laboratories. The hedge fund was a large shareholder in both Mylan and King. Mylan proposed an acquisition of King at a price many industry observers thought excessively high. Perry nevertheless supported the acquisition. As it turned out, Perry had used derivatives to hedge away its economic interest in Mylan. As a result, the only way Perry could make money on the deal was through its investment in King stock. Accordingly, Perry would prefer that Mylan overpay for King, even though that obviously would be detrimental to Mylan’s other shareholders.[12] Scholars have identified several other examples of such private rent seeking by hedge funds and other activist investors.[13] As is the case with union and state and local government pension funds, there thus is a risk that further shareholder empowerment will simply encourage additional rent seeking by hedge funds.
[1] Marcel Kahan & Edward B. Rock, Hedge Funds in Corporate Governance and Corporate Control, 155 U. Pa. L. Rev. 1021, 1069 (2007).
[2] Robin Greenwood, The Hedge Fund as Activist, HBR Working Knowledge, Aug. 22, 2007.
[3] Bryan Burrough & John Helyar, Barbarians at the Gate: The Fall of RJR Nabisco (1990).
[4] Grace Wong, Buyout Firms: Pain Today, Gain Tomorrow, CNNMoney.com. Sept. 27, 2007.
[5] See, e.g., Marcel Kahan & Edward B. Rock, Hedge Funds in Corporate Governance and Corporate Control, 155 U. Penn. L. Rev. 1021, 1037-39 (2007) (citing examples).
[6] See, e.g., Bernard S. Black & Joseph A. Grundfest, Shareholder Gains from Takeovers and Restructurings Between 1981 and 1986, J. Applied Corp. Fin., Spring 1988, at 5; Gregg A. Jarrell et al., The Market for Corporate Control: The Empirical Evidence Since 1980, 2 J. Econ. Persp. 49 (1988); Michael C. Jensen & Richard S. Ruback, The Market for Corporate Control: The Scientific Evidence, 11 J. Fin Econ. 5 (1983).
[7] See, e.g., Julian Franks et al., The Postmerger Share-Price Performance of Acquiring Firms, 29 J. Fin. Econ. 81 (1991).
[8] Kahan & Rock, supra note 128, at 1034-37 (citing examples).
[9] Greenwood, supra note 125.
[10] William W. Bratton, Hedge Funds and Governance Targets: Long-term Results 2 (Institute for Law and Economics Res. Paper No. 10-17, Sept. 2010).
[11] Thomas W. Briggs, Corporate Governance and the New Hedge Fund Activism: An Empirical Analysis, 32 J. Corp. L. 681, 702 (2007).
[12] Anabtawi & Stout, supra note 113, at 1287-88 (describing transaction).
[13] See, e.g., Anabtawi & Stout, supra note 113, at 1285-92; Briggs, supra note 132, at 695-701.
