Hedge Funds: Good Activists?

Hedge funds, which even at their peak of popularity, were regarded with considerable suspicion, have taken a shellacking in the last few months as subprime tainted funds have folded or reported poor results, and “quant” strategies have failed spectacularly, due to extraordinary, allegedly unprecedented market turmoil. Of course, the problem with that defense is that extraordinary turmoil seems to happen roughly once a decade.

Now even though much of this criticism of hedge funds is deserved, it tends to lump them all together, when they in fact employ a variety of strategies. Yes, quant and various favors of fixed income investing are on the list, along with event driven (the new term for merger arbitrage), global macro, emerging markets, and equity long/short, to name a few.

One strategy that may deserve a better reputation than it currently enjoys is activist investing. Hedge funds, as well as some institutional investors (the giant California Public Employees Retirement System, or Calpers, is a leader) and individuals, ranging from old-style raiders like Carl Ichan to Harvard Law professor Lucian Bebchuk, buy shares in companies with poor governance practices, like pay way out of line with performance, and agitate for change, often via shareholder resolutions or trying to change the composition of the board.

In simple terms, activists seek to remedy a deficiency in the operation of stock markets. Corporate officers are supposed to work for shareholders (or at least balance their interests against those of other constituencies). However, in public companies, shareholders have only a small ownership position and lack the resources and leverage to oversee company executives effectively. This produces what in the economic literature is called an agency problem: they’ve hired an agent, but cannot control him, and the result is that the agent, in this case corporate top brass, take advantage of the lack of effective oversight.

Activists target the most extreme cases of self-serving corporate behavior. And company officers seek to demonize their efforts. Hedge funds are painted as being raiders in new clothing, out for a quick buck, shaking down companies and then moving on to the next victim, um, target.

But is this characterization accurate? AllAboutAlpha discusses two academic studies, both of which conclude that hedge funds are more effective activists than either institutional investors or individuals.

The first paper, by Nicole Boyson and Robert Mooradian of Northeastern University, finds that hedge fund agitation leads to improvement in cash flows and operating performance. The reason seems to be that hedge funds, unlike their counterparts, target smaller firms that have decent operating performance. By implication, the hedge fund pressure leads them to improve financial management (particularly getting rid of excess cash and curtailing excessive executive rewards) and sharpen their operational management as well.

By contrast, institutional investors target large, poorly performing companies that are overpaying executives. While the harsh scrutiny may lead to some corporate governance reforms, these companies are so badly led (or unfixable) that the activists are unable to produce any improvement in the business’s fundamentals. Another reason the big institutional investors fail to achieve as much is that their shareholdings are generally too small. By contrast, hedge funds typically acquire a 10% stake, making them a force to be reckoned with.

The authors also note that, contrary to popular perception, activists are not short term players. The average time of ownership is over two years, while the average time a NYSE share is held is a mere seven months.

The second study, by Harvard’s Robin Greenwood and Morgan Stanley’s Michael Schor, is less charitable, but still finds hedge fund activists more effective than their institutional investor peers. However, they attribute their success primarily to better targeting, and the best targets are companies that can be put in play. Note that the study doesn’t say that the hedge fund activists, like the raiders of old, are out to force the companies they pursue to put themselves up for auction. The activists persist and try to get board seats and effect change. But they produce the best financial outcome when a target is sold.

This discussion begs the question of whether hedge fund activism benefits anyone other than the hedgies and their investors. If policing is ineffective, their efforts might have a deterrent effect and discourage some of the worst abuses. In other words, vigilante justice is better than no justice at all.

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