The recent increase in hedge fund activism is “hyperbolic” and should be carefully assessed, according to two notable scholars, John C. Coffee Jr. (corporate law; Columbia) and Darius Palia (corporate finance; Rutgers), who have just published on comprehensive study on hedge fund activism entitled, “The Impact of Hedge Fund Activism: Evidence and Implications.” The authors address various perspectives on the benefits and repercussions of hedge fund-led corporate change, relying on statistical analysis and market data to answer four questions:
- Who are the targets of activism?
- Does hedge fund activism create real value?
- What are the sources of gains from activism?
- Do the targets of activism experience post-intervention changes in real variables?
Changes in Institutional Ownership Behaviour
Coffee and Palia begin by pointing out that diversified fund managers are willing to consider and implement an activist tactic so long as it positively affects portfolio performance, but remind readers that activism is a relatively recent phenomenon. Historically, if institutional investors were not pleased with management, they sold their stock without interfering with management or corporate structure. But hedge funds are different. They hold concentrated, significant blocks in a limited number of companies, making activism “rational” from a cost/benefit analysis. The most common tactics have included “intervention” in corporate governance that leads to destaggered boards or calls for independent chairpersons; more significantly, activists have sought to fire the CEO or sell divisions or the company wholly.
Hedge Fund Demographics
Although there were 1,115 activist campaigns between 2010 and 2014, 148 of those were in the first six months of 2014. And although hedge fund activism used to focus on small-cap companies, nearly 1/3 of all activist campaigns today focus on companies with a market cap of over $2 billion; the number of campaigns against large cap (over $10 billion) companies has doubled since 2011. Whereas hedge funds, generally, earned increases of 3.1% in the first half of 2014, the subset of activist hedge funds more than doubled that, at 6.5%. It is no surprise, then, that their assets managed have grown over seven times from $23 billion to $166 billion between 2002 and early 2014. These funds specialize in short-term holdings, with a median period of only 266 days for ownership.
Sustaining their growth is their overwhelming success rate of nearly 80%: Hedge funds accounted for 24 of the 35 proxy contests that took place in 2013, winning 19 times. As such, the face of institutional ownership is not one of defensive passivism, as seen during the days of corporate raiders in the 1980s, but instead, one of advanced, offensive activism that seeks to bring about change with the intention of increasing shareholder value.
To explain why shareholder activism has risen sharply, the authors point to a number of factors:
- There is today a significant decrease in costs in activist behaviour (relative to the very high profits hedge funds are able to now exact), which had traditionally hampered efforts;
- The decline of staggered boards means director plans are no longer deeply entrenched within the organization and are now subject to change by external influences;
- The rise of proxy advisory firms has meant that, in reality, most voting decisions are today outsourced to the likes of either Institutional Shareholder Services or Glass Lewis, which have supported activists in the past;
- The Securities and Exchange Commission (“SEC”) has, in recent years, reconsidered policies that had a chilling effect on shareholder dissent, now permitting: (1) proxy advisors to distribute their advice; (2) allowing proxy solicitation; and (3) adopting a policy of “access-equals-delivery,” which allow proxy materials to be posted online; and
- Other factors, including: new restrictions against brokers who would otherwise vote on behalf of their clients, as well as the favorability of activist plans that return cash to shareholders.
By and large, the most notable success factor for activists in recent years is the prevalence of ‘wolf pack’ behaviour, which has resulted in the creation of “loose network[s] of activist investors” that take action collectively once a campaign is launched. Once these ‘wolf packs’ (a term first used by Vice-Chancellor Donald Parsons of the Delaware Court of Chancery) collectively cross the beneficial ownership threshold (5%), they continue buying even more stock in the ten-day window before they have to file a Schedule 13(d). It is only at that point that they must finally disclose their intentions with respect to their holdings. The authors have found that most of the appreciation of the stock price occurs just before the filing, which allows activists who have been tipped off regarding the forthcoming filing a “riskless opportunity” to purchase shares at current (which might later appear discounted) prices for “profitable trading” based on an asymmetry of information. Moreover, the “noisier” the campaign (which often degenerates into one that is also both “nasty and personal”), the more likely it is that activists may be able to launch calls for changes in corporate governance that are based not on the merits of the policies, but rather, on the “high probability” that those who purchase shares prior to the filing of the Schedule 13(d) “will profit handsomely” and “exit quickly.”
The remainder of the paper addresses these issues in the context of past and current activist campaigns, and particularly focuses on the attempts by Pershing Square Capital Management to help Valeant Pharmaceuticals acquire Allergan in a hostile takeover (it was announced this week that white knight Altavis PLC would be acquiring Allergan). The authors consider the impact of these recent tactics by pointing to market data, as well as the statistical analyses of a number of other scholars. The paper concludes with a number of recommendations—which are “the least drastic in establishing policy goals”—and provides an expanded discussion on what the long-term effects may be in having a regulatory system conducive for this type of activism. Coffee and Palia close by pointing to one externality that is little discussed but may have the greatest impact: “the shortening of investment horizons and the discouragement of research and development,” which may ultimately “disserve the American economy.”
Co-author: Reuben Zaramian, Articling Student