For better or for worse, two major transitions are now in progress. First, corporate governance is moving from a “board-centric” system toward a “shareholder-centric” system.249 Second, public corporations are increasingly under pressure to incur debt and apply earnings to fund payouts to shareholders, rather than to make long-term investments. Neither transition is wholly the product of hedge fund activism, but that force is accelerating both transitions.
These transitions cannot simply be halted or prohibited. Nor do we propose to freeze activists in place. But we submit that greater transparency is needed. Tactics such as the “wolf pack” enable some to earn a low-risk, short-term gain by pushing an agenda of more leverage and higher payout, coupled with less long-term investment. In many respects, the recent ascendancy of the activist hedge fund takes us back in time to an earlier era when, at the end of the 1980s, “bust-up” takeovers became briefly dominant. Then too, there was the same concern that managements were being pushed excessively to focus on the short-term.250 Both the “bustup” takeovers of that era and the contemporary activist campaigns for restructurings are fueled by the same desire to realize “negative synergy,” based on the expectation that the value of the target firm broken exceeds its value fully assembled. The “bust-up” takeover of that era was slowed by a variety of forces, of which judicial acceptance of the poison pill was the most effective.251 But today, activists have outflanked that barrier through the “wolf pack,” which makes possible the sudden assembly of a near controlling block.
We acknowledge that the “wolf pack” tactic is but one means by which a more “shareholder-centric” system of governance is emerging. But, unlike other means, it essentially enables a majority of short-term shareholders to gain de facto control, only to exit on average within a year after their appearance.252 At least sometimes, this temporary majority will view issues differently than a majority of indexed (or at least largely diversified) shareholders. This tactic may increase target firm value on the announcement of the wolf pack’s appearance, but long-term gains (according to most studies) seem to depend upon the activists achieving one of two outcomes: a takeover or a restructuring.253 Mere changes in corporate governance or payout practices produce little impact, and if a takeover or restructuring does not result, the expected takeover premium for the target firm will eventually erode.254 Activists may well gain from these tactics, but their gains may come at a considerable cost. The clearest of these costs is the reduction in R&D expenditures by targeted firms in subsequent years.255 R&D is probably more efficiently conducted within larger firms because the directions in which basic research will lead are often unpredictable.256 Thus, the larger firm is better positioned to exploit these opportunities than a smaller firm with a limited number of product lines. The policy issue then is whether the gains from realizing negative synergy in the short-run exceed the long-term losses from reduced investment in R&D. We do not assert that this question can be dispositively answered today, but it needs to be raised. Moreover, takeover gains and bust-up premiums do not necessarily reflect economic efficiency, but may instead be the product of other factors, such as acquirers gaining market power or bidder overpayment.257 Some will respond that our preference for more transparency implies that we are rejecting shareholder democracy. Not so! Rather, we are only expressing doubt about a novel form of shareholder democracy that enables a temporary majority to take irrevocable action. Neoclassical finance theorists may doubt that different constituencies of shareholders have different investment horizons or may assert that arbitrage will mitigate any such differences, but growing evidence suggests both that the composition of the shareholders owning the firm much affects the firm’s investment horizons and that there are significant limits to arbitrage.258 The appearance of a short-term majority is a distinctly new phenomenon. Traditionally, a majority of the shareholders meant a majority of the firm’s long-term equity holders. Until very recently, few shareholders bought stock in order to initiate a proxy contest. Although takeover bidders might buy stock in advance of a tender offer, their purchases were constrained by the Williams Act’s disclosure rules and the poison pill. That has now changed, as the “wolf pack” today can effectively outflank both the Williams Act and the poison pill (as currently drafted). As a result, the old equilibrium has been destabilized by the prospect of the sudden appearance of a 20% (or greater) block that hovers on the brink of possessing control for the short-run.259 At its worst, such a short-term majority resembles giving voting control of the corporation to its option holders, as both constituencies have incentives to undervalue long-term outcomes.260 Proponents of activism in effect argue that the majority has the right to rule, even if it remains only for the short-term. Although we recognize that there is no alternative to shareholder democracy, it does not follow that accountability need be a daily process (or that elections should be held at the choice of insurgents). One can accept shareholder democracy, but still debate the appropriate time-frames and processes for elections. By analogy, the President of the United States can only be replaced by the voters every four years. That may or may not be the optimal period, but virtually no one would shorten this period to, say, six months. Any such change would result in a virtually constant election contest and much diversion of the President’s time. This article has argued for the desirability of moderating sudden transitions in corporate governance. Changing the tax laws to require a longer holding period for capital gains (as Hillary Clinton has proposed261) could achieve this purpose, but increased transparency is an alternative and complementary approach. Increased transparency will not preclude shareholder activism, but it will slow marginally the acquisition of de facto control (as the Williams Act originally intended).
Finally, we must observe that the case for strengthening shareholder power on the premise that any such shift will always enhance economic efficiency is far from self-evident.262 A generation of legal academics has too quickly equated optimal corporate governance with maximizing shareholder power.263 Nonetheless, a basic and problematic tradeoff must be recognized. Even if one believes that management is biased in favor of inefficient growth and expansion, one must still recognize that management has better information than outsiders (including hedge funds). Curbing managerial discretion thus precludes at least some efficient investments that are based on management’s superior knowledge. Exactly how this tradeoff between management’s self-interest and its superior knowledge balances out remains a very open question. We offer no general theory on what is optimal, either in terms of shareholder power, corporate leverage, or when investments in R&D become excessive. Nonetheless, we do observe that strong incentives are today pushing us toward higher leverage and reduced long-term investment. Over time, we predict that hedge fund activism will yield diminishing returns. Too many activists will eventually chase too few legitimate targets.264 But in the interim, we also see the prospect of what we term a “hedge fund bubble,” as major and successful firms are disrupted and/or broken up. We do not endorse preclusive reforms to prevent such a bubble, but we do suggest that greater transparency is the least drastic reform. In this interim, we also submit that what can be done by regulatory reform can also be done by private ordering.”
For the full working paper, see: