Activist Investors and the Revaluation of Governance Rights

Equity ownership in the United States no longer reflects the dispersed share ownership of the canonical Berle-Means firm. Instead, in our new working paper, The Agency Costs of Agency Capital:  Activist Investors and the Revaluation of Governance Rights, Ron Gilson and I observe the reconcentration of ownership in the hands of institutional investment intermediaries, which gives rise to what we call “the agency costs of agency capitalism.”

This ownership change has occurred because of (i) political decisions to privatize the provision of retirement savings and to require funding of such provision and (ii) capital market developments that favor investment intermediaries offering low cost diversified investment vehicles.

A new set of agency costs arise because in addition to divergence between the interests of record owners and the firm’s managers, there is divergence between the interests of record owners – the institutional investors – and the beneficial owners of those institutional stakes.

The business model of key investment intermediaries like mutual funds, which focus on increasing assets under management through superior relative performance, undermines their incentive and competence to engage in active monitoring of portfolio company performance. Such investors will be “rationally reticent” – willing to respond to governance proposals but not to propose them.  While this reticence leaves a governance gap that gives rise to agency costs, the gap also creates an arbitrage opportunity that can be profitably exploited by other investment intermediaries, such as hedge funds.  Such actors can specialize in developing the skills to identify and invest in strategic and governance shortfalls with significant valuation consequences, and then present reticent institutions with their value proposition:  a specified change in the portfolio company’s strategy or structure.

We posit that such shareholder activists should be seen as playing a specialized capital market role of setting up intervention proposals for resolution by institutional investors. The effect is to enhance institutional investor voice, increase the value of the vote, and thereby reduce the agency costs we have identified. Activist shareholders are commonly portrayed as interlopers to a well-established pattern of relationship between shareholders and managers.  The thrust of our paper is to explain their rise as a governance complement to changing patterns of equity ownership.

We therefore argue against recent proposed regulatory changes – such as accelerated disclosure of beneficial ownership stakes under the Williams Act – that would undercut shareholder activists’ economic incentives by making it harder to assemble a meaningful toe-hold position in a potential target.

Our most recent draft is available here on SSRN.  The paper will published in the May 2013 Columbia Law Review.