This past summer, the Securities and Exchange Commission (SEC) proposed eliminating quarterly disclosures for 90 percent of institutional investment managers by raising the reporting threshold under Section 13F of the Exchange Act from $100 million to $3.5 billion. The proposal generated widespread opposition. One key criticism — advanced on this blog, in various media outlets, and by many of those who submitted comments to the agency — was that the agency’s proposal would bolster hedge fund activism by allowing many activists to “go dark,” build up positions in companies in secret, and then “ambush” unsuspecting managers.
Although the SEC’s proposal now seems to be dead in the water, the agency is reportedly still considering possible changes to the 13F reporting regime. So, it is worth scrutinizing this popular “going dark” thesis that helped bring down the proposal.
In a new essay, I show that this thesis exaggerates the likely effects of the SEC proposal on the volume of hedge fund activism and that it misses a separate and more significant potential cost it might have imposed: reducing the long-term benefits derived from activism.
First, an exemption from 13F disclosures would not make a difference in the subset of campaigns where activists establish their positions too quickly for these disclosures to matter. Rule 13f-1 requires disclosure of end-of-quarter holdings within 45 days. So, for example, a fund that begins building a position in early January doesn’t have to make any 13F disclosures until mid-May. Activists often move much faster than this. An early study found that fewer than one-third (312 out of 1,032) of 13Ds filed by activists between 2001 and 2006 were preceded by a 13F disclosure. Moreover, activists often announce themselves to the target voluntarily before disclosing their position on 13F or 13D.
Nor would the 13F proposal likely have induced a massive change in activist timing. Sitting on a sizable investment in a potential target firm for an extended period without taking any action is likely to be inconsistent with activists’ core investment strategy. The longer an activist sits on its position before taking action, the more likely conditions on the ground may change – other attractive opportunities may come and go, the potential target’s institutional ownership may change, making it less amenable to an activist campaign, market conditions may make activism more or less profitable, etc. And managers of activist funds are likely to have compensation structured to encourage moving quickly. All of this should be familiar; it is precisely this investment model that motivates the fundamental criticism that activism produces only short-term gains. All of the well-known reasons hedge funds tend not to hold positions for very long would presumably remain just as powerful notwithstanding any change to 13F, which would likely mitigate any going-dark effect.
In fact, the SEC proposal might have even reduced the volume of activism. Because activists typically acquire just a 5-10 percent stake in the target, not a controlling share, their success depends on winning support from other firm shareholders. Activists have a good reason to try to learn about the ownership composition of potential targets and to select targets based in part on whether the shareholder base is likely to be supportive of its campaign. A recent study confirmed the point, finding that activists are more likely to target firms whose shareholder base is comprised of more activist-friendly shareholders. The SEC’s proposal to eliminate 90 percent of 13F filings might have made it harder for activists to predict whether they would likely be able to win support from a majority of existing shareholders before launching a campaign, thereby increasing the risk that a campaign would fail.
The best reason to celebrate the SEC’s decision to shelve this proposal is not that it would have increased the volume of hedge fund activism, but rather that it might have reduced the long-term benefits associated with activism. Scholars have long conjectured that activists’ need to win support from other institutional investors that hold shares of a target firm could mitigate activists’ short-term incentives and force them to pursue agendas that would increase the company’s value over the long-term. A recent working paper provides strong empirical support for this conjecture, finding that long-run (five year) returns are better for activist campaigns where more pro-activist institutional investors were present at the outset of the intervention. By obstructing activists’ vision into potential targets’ shareholder base, the SEC’s proposal might have curtailed this beneficial interdependence between activists and other institutional investors – reducing exactly the kind of shareholder activism that benefits long-term shareholders the most.
Compounding this effect, activists could respond to the lack of visibility into the pre-existing shareholder base of potential targets by shifting towards a strategy of wolf-packs and activist tipping. If so, the result of the SEC’s proposal might make activism relatively less reliant on long-term investors and relatively more reliant on other short-term-oriented hedge fund investors, further reducing the long-term benefits of activism.
To be sure, there are many unanswered questions about these effects. Both of two key studies referenced above on activist targeting were completed well before the SEC’s proposal, so, unsurprisingly, neither specifies what would happen to their results if all institutions under the proposed $3.5B threshold were excluded. If these studies were re-run without institutional investors managing portfolios under $3.5 billion, we would have a better sense of how the SEC’s proposal might have interfered with activist targeting and the beneficial interaction between hedge funds and longer-term investors that produces good long-run returns.
As the SEC heads back to the regulatory drawing board on 13F reform, it can draw upon the substantial body of analysis and commentary produced by experts, industry participants, and other stakeholders in response to its proposal. However, the agency should proceed with caution; not all of this commentary hits the mark.
This post comes to us from Alexander I. Platt, associate professor at the University of Kansas School of Law, and is based on his recent essay, “Beyond ‘Going Dark:’ The SEC’s 13F Proposal and Hedge Fund Activism,” available here.