Hedge Funds Activism as Conflict of Entrepreneurship

Hedge funds have boosted shareholder activism worldwide. In the article “Exit, Voice and Loyalty from the Perspective of Hedge Funds Activism in Corporate Governance,” which was recently published in the Erasmus Law Review, I discuss the policy response to hedge funds activism. I argue that the short-termism debate cannot shed light on the desirability of hedge funds activism. Rather, hedge funds activism should be regarded as a conflict of entrepreneurship, namely a conflict about the most efficient horizon to maximize profit. The choice of this horizon, which is uncertain, belongs to the entrepreneur. An engagement by hedge funds reveals that their views about this particular point differ from that of the incumbent management. Because the efficient horizon to maximize profit varies with the individual company, and with time, companies should be enabled to choose whether to be exposed to hedge funds activism and to alter this choice during their existence. In particular, companies should be allowed to introduce dual-class shares in the midstream, subject to a majority-of-minority shareholder vote. Such transactions would only be acceptable for institutional investors in the presence of investor protection guarantees, such as for instance board representation, and sunset clauses. I argue that this solution is more efficient than general curbs on activism, including loyalty shares.

Hedge funds activism is an important feedback mechanism in corporate governance. Activist hedge funds screen the market for underperforming companies, buy a toehold in them, and seek to determine a change in the strategy, the governance, or the management of the target in order to be able to sell the toehold at a profit. Such business model, called entrepreneurial shareholder activism, has made hedge funds a prominent influencer of corporate governance nowadays. Because hedge funds purchase a relatively small stake in their targets (well below 10%), the success of hedge funds engagement depends on the voting support of other shareholders. This is a major difference from hostile takeovers. Similarly to the latter, however, hedge funds activism is regarded with suspicion on the grounds that it brings short-termism into corporate governance.

In one particular respect, empirical evidence does not support the claim that the gains from hedge funds activism are short-term. Returns from (successful) hedge funds engagements are not subsequently reversed by the stock market. However, on the assumption that stock markets are not always efficient, these findings say nothing about whether hedge funds instill short-termism into corporate governance and whether this is welfare-enhancing. There are two problems, which make this question unsuitable for empirical analysis. Firstly, data tell us nothing about the impact of unobservable activism, either because it takes place behind closed door or because managers already account for potential engagements in their choices. Secondly, the performance of engaged companies tell us nothing about how the company would have performed in the absence of engagement. These problems tend to overestimate the returns on observable activism. More important, they make it impossible to ascertain the real impact of hedge funds activism, let alone its desirability for corporate governance.

From a theoretical perspective, the impact of hedge funds activism and its efficiency for corporate governance varies with context. Many companies benefit from the correction of underperformance fostered by activist hedge funds, particularly in the presence of investor expropriation or misuse of free cash. However, for other companies, underperformance is temporary and the change of strategy promoted by hedge funds may destroy value. Not knowing the ‘right term’ to assess corporate performance, whether management is ‘long-termist’ or hedge funds are ‘short-termist’ is hard to say when the conflict occurs. This conflict is rather about how the company should be managed, that is, a conflict of entrepreneurship. In the presence of hedge funds engagement, institutional investors have to decide on this conflict.

In this paper, I argue that institutional investor cannot always be trusted to make the right decision. Although there are no studies on which category of investors are decisive in hedge funds campaigns, conceptually the key investors are those that vote without having the option to exit strategically, namely the index funds. Empirical evidence reveals that most index funds managers vote actively and independently. However, asset managers usually base their voting on low-cost policies that tend to enhance the returns on their portfolio as a whole. As a result, the judgment by index fund managers is trustworthy as far as standard behaviors, such as expropriation or mismanagement of free cash, is concerned. The same judgment, however, cannot be relied upon when the issue is more about the strategy that a company should pursue.

For these reasons, the policy response to hedge funds activism cannot be one-size-fits-all. Curbs on the ability of hedge funds to profit from overt or covert activism, such as tightening the ownership disclosure requirements, should be avoided. Hedge funds activism should be welcome as default. However, companies should be allowed to opt out of this default by deviating from the one-share-one-vote norm. Several companies already do this by going public with dual-class shares voting structures. Both in Europe and in the U.S., the law makes it difficult, if not impossible, to introduce such structures in the midstream. Companies have reacted to this rigidity by introducing, or lobbying legislators to introduce, loyalty shares. These are de facto dual-class shares in disguise which may even be imposed on minority shareholders. I argue that corporate law should, instead, enable managers to negotiate dual-class recapitalizations explicitly with institutional investors. This solution would provide the following advantages. First, the veto right by the institutional investors would screen for the companies for which curbing hedge funds activism can arguably increase value. Second, managers would have to commit to protecting investors against expropriation and mismanagement while the dual-class structure is in place. Third, institutional investors could only accept the restriction if it expires within a defined period, after which managerial performance will again be assessed by the market. In this way, dual-class shares would deliver one unfulfilled promise of loyalty shares, namely the temporary character of the departure from one-share-one-vote.

Alessio M. Pacces is the Professor of Law and Finance at the Erasmus School of Law, Erasmus University Rotterdam.