The Symbiosis of Institutional Investors and Activist Hedge Funds
By: Astrid F. Kowlessar
Second quarter 2016 has waxed brutally for hedge funds in the realm of regulatory compliance. The Securities and Exchange Commission (SEC) has called on investigative authority over hedge funds such as RD Legal Capital LLC and Platinum Partners LP for full disclosure of investment vehicles and practices. Of late, Visium Asset Management has joined the growing list of hedge funds flagged for insider-trading. The Wall Street Journal recently cited SEC’s Director Andrew Ceresney as stating hedge fund “Valuation [to be] one of the core issues.”
As we pointed out in our prior article Hedge Fund Performance and Regulation hedge funds historically had greater leeway in choosing how to value and categorize the portfolio’s underlying investments, drawing on the Securities Act of 1933’s Regulation D safe harbor rules. We also stated that regulatory compliance dictates from the SEC should remain constant, and not increase as hedge funds are above all performance driven. There is deep reasoning behind support for hedge funds, especially activist hedge funds, in the investment world – reasoning that laymen may not understand, but which focuses on the benefits institutional investors derive from seemingly mutually exclusive activist hedge fund activity.
Activist hedge funds exhibit corporate control activism, which according to L. Bebchuk, A.Brav, and W. Jiang, Harvard Law Review authors of The Long-Term Effects of Hedge Fund Activism, can be categorized via three strategies. First, as shareholders of a potential acquirer company, the strategy involves taking high stakes in a target company to ensure full acquisition over competition. Second, as shareholders of a potential target, hedge funds may use blocking strategies to benefit target shareholders. Third, hedge funds have themselves taken aggressive positions in a portfolio of companies solely in order to become activist, rather than diversifying and becoming involved when companies are exhibiting non-performance. Although not widely publicized, traditional institutional investors such as large pension and mutual funds engage in shareholder activism mainly through SEC Rule 14a-8, forcing inclusion of shareholder proposals in the proxy statements of vested public companies.
Marcel Kahan and Edward B. Rock of University of Pennsylvania Law Review do a superb job of explaining the constraints of institutional investor activism and the ensuing need for hedge fund activism via Hedge Funds in Corporate Governance and Corporate Control. We examine the most poignant points:
- Governance changes through shareholder proposals have largely been a practice of public pension funds due to the sheer asset size and scope. We have seen a surge of shareholder engagement from pension funds from 2015 to present, with the plunge in global economic and business climates. However, while proxy contests from pension funds aid in activism, the activism is more post-event reactive to company performance than pre-event business structuring. As the authors put it, pension funds traditionally handle only the “motherhood and apple pie issues” of shareholder engagement.
- Pension funds have political constraints that inhibit an aggressively proactive approach to shareholder activism. Many pension fund trustees tend to overlap between private and public sector duties such as “gubernatorial appointees or elected politicians.” Such positions may lead to a bias towards political establishment dictates as opposed to actively working with company Boards to ensure optimal investment returns. The authors cite CalPERS as a prime example of such constraints, as historically the pension fund has held a strong pro-union position and has widely held union representatives on the Board.
- Mutual Funds are generally retail investors. The authors state that only TIAA-CREF has held what can be considered as an activist position in the industry. Mutual funds tend to take even a more passive position than pension funds in shareholder engagement. Specifically, the necessary semiannual filing of all amounts and values of securities renders it difficult for mutual funds to take aggressive “pre-emptive strike” positions in a portfolio of companies.
- SEC guidelines clearly stipulate the percentage of assets that all mutual funds can have in illiquid investments. In addition, mutual funds have requirements to redeem shares on short notice. These requirements put mutual funds in a passive shareholder engagement position.
- Diversified mutual funds have major regulatory barriers and expenses that inhibit assertive activism. Unlike hedge funds, mutual funds for the most part do not charge performance based fees, and so depend on feed based on a fixed percentage of the of the mutual fund’s assets under management. Since activist investor proxy contests are costly, we find that most index mutual fund management would prefer to take a reactive position.
- Most mutual funds have conflict of relationships due to affiliations with other non-activist financial institutions such as insurance companies and conservative pension funds. Many mutual funds have corporate pension plans as core business, and may not want to practice aggressive shareholder activism so as to not jeopardize client preferences.
Shareholder proposals from both pension and mutual funds are more a corporate governance wish list from shareholders, and fall more under the category of broad shareholder engagement than the activism partaken by activist hedge funds. Mutual and pension funds do not use the leverage that activist hedge funds employ to take the necessary positions for pre-emptive strikes to change company financial and operating structures. As the authors rightly state, “hedge fund activism is strategic and ex ante: hedge fund managers first determine whether a company would benefit from activism, then take a position and become active.” Hedge funds have become almost synonymous with activism. However, Kahan and Rock point out that only US$50 billion of the US$3 trillion global hedge fund assets under management are structured for shareholder activism. The point being that hedge funds are not solely formed to be activist investors. Yet, the small number of hedge funds that are activists truly pack a punch in active corporate governance.
The Columbia Law School’s Blue Sky blog’s article, Hedge Fund Activism: A Guide for the Perplexed has a bit of a mixed review when it comes to the activist hedge fund outlook. While there is an acknowledgement of activist hedge fund influence on company performance, the article takes an almost tongue in cheek approach to the effectiveness of activism, stating that “institutional investors and knee-jerk academics…both believe that activists are doing the Lord’s work” as the champion of shareholder engagement, but in actuality hedge funds are by and large self-interested. From the points offered by Kathan and Rock on the limits of institutional investors to actively engage in pre-emptive structuring of companies to bolster shareholder interests, the industry must avow to the need for activist hedge fund activity, whether the motives are self-interested or otherwise. Regulatory dictates of the hedge fund industry may bring about transparency in valuations and curb insider-trading in the short term, which can be beneficial. However, a plethora of punitive regulatory barriers can seriously hinder effective shareholder engagement and corporate governance that may only be achieved through hedge fund activism.
- Bebchuk et al. 2015. “The Long Term Effects of Hedge Fund Activism.” Harvard Business Law Discussion Paper. Columbia Law Review. Pages 1064 – 1154.
- Coffee, John C. Jr. 2016. “Hedge Fund Activism: A Guide for the Perplexed.” The Columbia Law School Blue Sky Blog.
- Copeland, Rob et al. 2016. “Scrutiny of Funds Grows.” The Wall Street Journal. Print Edition.
- Kahan, Marcel, et al. 2007. “Hedge Funds in Corporate Governance and Corporate Control.” University of Pennsylvania Law Review. Pages 1029 – 1069.