A major criticism of activist hedge funds, and one that allegedly supports the argument that they suffer from short-termism, is that their recommendations almost always focus on disinvestment. For example, they will typically recommend raising the dividend, cutting costs, spinning off divisions or subsidiaries or preparing the company for sale.[1] Since we should expect activist hedge funds to be indifferent to the types of recommendations they make as long as they believe the recommendations will result in the highest possible stock price, then why do these recommendations seem to be so heavily biased in the direction of disinvestment?
One possible explanation is that the short-term payoff is the more valuable one.[2] For management to have the best chance of achieving long-term value creation we need them to evaluate all profitable opportunities, no matter what the investment horizon, and then pick those opportunities over time that have the expectation of maximizing the present value of the company’s cash flows (shareholder wealth maximization). This should apply equally to the activist hedge fund. If a hedge fund argues for short-term cost cutting at a company, then on its face this should mean that it expects the recommendation to help achieve shareholder wealth maximization. For example, an activist hedge fund may recommend that the company’s budget for research and development be cut in order for the company to better focus on innovation output in terms of patents and patent citations per research dollar spent.[3] This recommendation would be in keeping with the general mission of a for-profit corporation.
However, we still do not have an explanation for why there is such an absence of recommendations that involve long-term investment. In my recently posted article, Activist Hedge Funds in a World of Board Independence: Creators or Destroyers of Long-Term Value? (forthcoming, Columbia Business Law Review),
I provide two possible explanations for why this occurs. First, the cognitive limitations of those individuals who participate as activist hedge funds. Second, the limitations of what stock market signals can tell us about company performance and what needs to be corrected.
A. Cognitive Limitations
Unlike the market for corporate control, there is a real limitation to what types of institutions can participate in hedge fund activism. For example, competitors will not participate because it will not be in their self interest to improve the performance of a competitor. Vendors and customers will not participate because this will harm the relationship they have with the target entity. Competitors, customers and vendors are the types of entities that employ personnel with true insights into the operations of the target company and who could make value added recommendations with regard to reinvigorating product lines, expanding output, making new investments in plant and equipment, etc. Without these types of entities participating in offensive shareholder activism, what you have left are the financial engineers employed by hedge funds.
B. The Limitations of Stock Market Signals
Most importantly, activist hedge funds are directed to recommendations that focus on disinvestment because they are responding to the limited informational content provided by stock market signals that originate with value investors. These investors devote whatever limited time, resources, and skill they have to valuation, not to the process of trying to correct managerial inefficiencies. The value investor incorporates information on managerial inefficiencies into the price of a company’s stock by voting with their feet,[4] i.e., selling their shares rather than becoming proactive in the corporate governance of any particular firm.[5] In the market for corporate control, the selling activities of value investors would mean that the company is ripe for a takeover so that current management can be replaced.[6] In the world of hedge fund activism, such signals creates a similar message, a presumption that either current management needs to be replaced or at the very least it should be given less responsibility in terms of managing company assets. That is, value investors are telling activist hedge funds, without providing specifics, that a particular public company is ripe for disinvestment. Therefore, it is not surprising that the recommendations of activist hedge funds will focus on trying to reduce the amount of assets under current management.
If activist hedge funds are directed to focusing on disinvestment, then this is not necessarily a bad thing in terms of recommendations, only a limiting one. Activist hedge funds are not required to provide the best recommendations, only recommendations that move the company closer to shareholder wealth maximization. In sum, even if activist hedge funds are limited to making recommendations based on financial engineering, these recommendations can still be of significant benefit to public company decision making.
ENDNOTES
[1]. Dennis K. Berman, A Radical Idea for Activist Investors, What If the Goal Were More Investment With an Eye on the Long Term?, The Wall Street Journal (January 29, 2015), available at http://www.wsj.com/articles/a-radical-idea-for-activist-investors-422370260?KEYWORDS=activists. See also, Dr. Ralph K. Walkling, One Sided Activism? A Note on the Symmetry of Market Problems and the Asymmetries of Activists, MergerProf (January 29, 2015) (Going the other way and advocating for long-term investment “just doesn’t happen.”), available at http://www.mergerprof.com/2015/01/one-sided-activism-note-on-symmetry-of.html.
[2]. Marcel Kahan & Edward B. Rock, Hedge Funds in Corporate Governance and Corporate Control, 155 U. Pa. L. Rev. 1021, 1088 (2007)
[3]. Alon Brav, Wei Jiang, Song Ma, and Xuan Tian, Shareholder Power and Corporate Innovation: Evidence from Hedge Fund Activism (2014) (finding a link between improvements in innovation efficiency and hedge fund activism at firms with a diverse set of patents as a result of the activism leading to a more targeted approach to innovation), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2409404.
[4]. According to Professors Armen Alchian and Harold Demsetz in their seminal article, Production, Information Costs, and Economic Organization, “Any shareholder can remove his wealth from control by those with whom he has differences of opinion. Rather than try to control the decisions of the management, which is harder to do with many stockholders than with only a few, unrestricted salability provides a more acceptable escape to each stockholder from continued policies with which he disagrees.” Armen A. Alchian & Harold Demsetz, Production, Information Costs, and Economic Organization, 62 Am. Econ. Rev. 777, 788 (1972).
[5]. Bernard S. Sharfman, A Theory of Shareholder Activism and its Place in Corporate Law 1, __ (2015), forthcoming, Tennessee Law Rev., available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2549757.
[6]. Henry G. Manne, Mergers and the Market for Corporate Control, 73 J. Pol. Econ. 110 (1965).
The preceding post comes to us from Bernard S. Sharfman, adjunct professor of business law at the George Mason School of Business, a member of the Journal of Corporation Law’s editorial advisory board and a former Visiting Assistant Professor of Law at Case Western Reserve University School of Law (Spring 2013 and 2014).