More than a year ago, an academic paper argued that the concentration of equity ownership among large fund management companies discouraged competition.
The Azar-Schmalz study suggested that since mutual funds and ETFs own more than one company in a sector, they are harmed by price wars which might reduce profitability across the sector and pricing for consumers is artificially high as a result. The study looked to the airline industry for evidence.
The theory is interesting but far fetched. First, air travel is a heavily regulated sector and regulation has many market-skewing effects. Also, with dramatic consolidation among US airlines, there are more obvious reasons for why fares might appear homogeneous. More fundamentally, however, a direct correlation between cross ownership and pricing trends would demand an unfathomable and unsustainable degree of coordination between boardrooms and fund companies.
Nonetheless, credence is growing among media. Matt Levine, author of the influential Money Stuff daily email from Bloomberg View, began as a skeptical admirer of the novelty of theory, but has referenced it regularly for several months. In a recent piece, he writes, “What I like about the mutual-funds-as-antitrust-violation theory is that it is both crazy in its implications — that diversification, the cornerstone of modern investing theory and of most of our retirement planning, is (or should be) illegal — and totally conventional in its premises.”
Professor Schmalz is author of a new paper, “Common Ownership, Competition and Top Management Incentives” which expands the theory and links cross ownership to the prevalence of ultra high executive compensation. Levine explains, “But ‘say-on-pay’ rules mean that shareholders get at least some formal approval rights over compensation, and I guess the boards and consultants and managers have to design pay packages that will appeal to investors. And if those investors are mostly diversified, then they won’t have much demand for pay packages that encourage one of their companies to crush another.”
Executive compensation is a major corporate governance issue and an area where large shareholders do have a lever over corporate policy. A year ago, this blog noted that hedge funds are uncharacteristically quiet on the topic of exec pay. I also uncovered that the companies paying their CEOs the most are very likely to also be the most shorted. However, despite pervasive questions on how to best structure executive compensation plans, the 10 largest asset managers supported the pay plans at about 95% of the S&P 500 companies. And yet, new research shows that looking at return on corporate capital, 70% the top 200 US companies overpay their CEOs, relative to sector and revenue size.
Furthermore, Wintergreen Advisers notes that there are hidden costs to high pay. First, stock grants to executives dilutes existing shareholders. Second, companies often initiate stock buybacks to offset that dilutive effect on other stockholders’ stakes (and we all know most buybacks are not good for shareholders). “We realized that dilution was systemic in the Standard & Poor’s 500,” Mr. Winters tells the New York Times, “and that buybacks were being used not necessarily to benefit the shareholder but to offset the dilution from executive compensation. We call it a look-through cost that companies charge to their shareholders. It is an expense that is effectively hidden.”
The issues of competition and compensation illustrate how central asset managers have become in the discussion about how corporations operate. The media increasingly identify stock ownership with direct influence (perhaps due to how successful activist investors have been in recent years) and the media are ready to lay a raft of corporate ills at the feet of those with the most votes. It logically starts with executive compensation, but it could quickly extend into other corporate practices such as employee compensation, retirement policy, health benefits — issues which most asset managers would view as outside their sphere of influence. With the role of government and the social safety net shrinking, society looks to corporations to step into the breach. The challenge for large asset managers is that the media and perhaps others expect them to be the defacto regulators of the corporations.
The largest asset managers, led by BlackRock, are elbowing activists out of the spotlight on the topic of corporate governance. This blog has tracked tracked how mutual funds are putting distance between their priorities and the activist agenda (see here, here, here, here and here). The rift widened earlier this month when BlackRock, Fidelity, Vanguard and T. Rowe Price met with Warren Buffet and JPMorgan to create guidelines for best practice on corporate governance. Discussions have focused on issues such as the role of board directors, executive compensation, board tenure and shareholder rights, all of which have been flashpoints at US annual meetings.
This effort appears to be in direct response to the prominence of activist hedge funds (now managing in excess of $100 billion) and the success they have had in forcing share buybacks and other financial moves by corporations to increase returns to shareholders.
On the heels of the meeting, BlackRock CEO Larry Fink sent another letter to chief executives of S&P 500 companies urging “resistance to the powerful forces of short-termism afflicting corporate behavior” and advocating they invest in long-term growth. Make no mistake, “short-termism” is code for activist hedge funds and paragraph two of the letter takes aim at common goals of activists:
Dividends paid out by S&P 500 companies in 2015 amounted to the highest proportion of their earnings since 2009. As of the end of the third quarter of 2015, buybacks were up 27% over 12 months. We certainly support returning excess cash to shareholders, but not at the expense of value-creating investment. We continue to urge companies to adopt balanced capital plans, appropriate for their respective industries, that support strategies for long-term growth.
The letter asks CEOs to develop and articulate long term growth plans and move away from quarterly earnings guidance. “Today’s culture of quarterly earnings hysteria is totally contrary to the long-term approach we need,” writes Fink. Without a long term plan and engagement with investors about the plan, “companies also expose themselves to the pressures of investors focused on maximizing near-term profit at the expense of long-term value. Indeed, some short-term investors (and analysts) offer more compelling visions for companies than the companies themselves, allowing these perspectives to fill the void and build support for potentially destabilizing actions.”
With respect to “potentially destabilizing actions,” Fink acknowledged that BlackRock voted with activists in 39% of the 18 largest U.S. proxy contests last year, but says “companies are usually better served when ideas for value creation are part of an overall framework developed and driven by the company, rather than forced upon them in a proxy fight.”
With this letter and the group of large investors that is in formation, traditional fund managers are giving corporate America a buffer against activists. If a company were to explain to the largest asset managers “how the company is navigating the competitive landscape, how it is innovating, how it is adapting to technological disruption or geopolitical events, where it is investing and how it is developing its talent,” and had their support, it would be more straightforward to resist an activist campaign, particularly one based on a financial strategy like buybacks. “Companies with their own clearly articulated plans for the future might take away the opportunity for activists to define it for them,” writes Matt Levine in Bloomberg View.
If the pendulum is to shift from activists to traditional fund managers, are they ready to be proactive on governance matters? The AFL-CIO’s key vote survey which tracks institutional voting on proposals to split the roles of chairman and CEO, curb executive compensation, give shareholders more say in board appointments and improve disclosures about lobbying, found many of the largest mutual/index fund companies to be in the bottom tier of firms in their support for these governance-related votes.
The FT suggests that the size of these institutions may limit their involvement, “any governance principles that emerge from a consensus of the large managers are likely to fall short of those typically supported by the powerful proxy advisory services ISS and Glass Lewis, which offer voting recommendations to pension funds and other investors.”
However, a research paper entitled Passive Investors, Not Passive Owners finds that ownership by passively managed mutual funds is associated with significant governance changes such as more independent directors on corporate boards, removal of takeover defenses and more equal voting rights.
Investing for the long term is an issue in the Presidential campaign and is becoming more relevant in corporate America as the US adjusts to globalization, technology that is disrupting many sectors and the continuing shift from manufacturing to service and knowledge-based industries. The practice of quarterly reporting limits disclosure and discourse about long term objectives. As Matt Levine notes, “If you are an investor, you might want to know your company’s plans, no? It is odd that corporate disclosure is so backward-looking; like so much in corporate life, it is probably due mostly to the fear of litigation…Also, notice that Fink’s list of “what investors and all stakeholders truly need” is exactly what isn’t (for the most part) in companies’ public disclosures.”
In the UK, quarterly earnings reports are optional and more companies are giving them up. “I am surprised that more people haven’t stopped,” Mr Lis [of Aviva Investors] says. “For long-term investors it really wouldn’t matter whether there are quarterly reports or not in any sector.”
The investor group and the BlackRock letter are more examples of fund managers pursuing a governance agenda independent of activists. It remains to be seen how wide the rift between index/mutual fund managers and activist hedge funds will become, but it is clear that some major asset managers have seen limitations in today’s forms of activist investing, been put off by regular overreach by activists and maybe concluded that activists have jumped the shark.
Passively managed funds are under attack again. Last summer Carl Icahn famously blasted fixed income ETFs and this month, Bill Ackman devotes one third of Pershing Square’s annual letter to investors to criticizing index funds.
To start, the letter suggests that as asset flow to index funds accelerates it creates momentum in the indexes they seek to represent which raises the bar for hedge funds benchmarking to those indexes. Violins. Returns are down among activist managers and when looking at individual stocks, excess gain from activist campaigns dropped significantly from 2012 to 2015. S&P’s US Activist Interest Index is down 31% in the last year.
His primary claim is that index funds have no incentive to pursue good governance at companies within their portfolio and cannot have the bandwidth to make intelligent proxy decisions. “Index funds managers are not compensated for investment performance, but rather for growing assets under management. They are principally judged on the basis of how closely they track index performance and how low their fees are. While index fund managers are, of course, fiduciaries for their investors, the job of overseeing the governance of the tens of thousands of companies for which they are major shareholders is an incredibly burdensome and almost impossible job. Imagine having to read 20,000 proxy statements which arrive in February and March and having to vote them by May when you have not likely read the annual report, spent little time, if any, with the management or board members, and haven’t been schooled in the industries which comprise the index.”
He cites the example of Dupont when last year index managers who owned 18% of the stock voted against board members proposed by Trian Capital Management. He also says that the lack of index fund support for Pershing Square’s teaming with Valeant to buy Allergan shows how those firms “did not take this issue [corporate governance] seriously.”
This is an extremely thin argument, especially the case involving Valeant in which the legality of Pershing Square’s actions were broadly questioned. In reality, index fund companies are getting much more involved in governance and are engaged with corporations and their boards. Evidence is everywhere. BlackRock, State Street and Vanguard are members of the Shareholder-Director Exchange, a group formed to enhance shareholder-director engagement.
Recently, Doug Braunstein of Hudson Executive Capital called Michelle Edkins, BlackRock’s head of corporate governance, the most powerful person in corporate America because of BlackRock’s ability to influence corporate boardrooms.
The assertion that index managers are not motivated by performance is wrong. If indexes keep going up, assets will keep flowing in. The index manager is constrained in terms of allocation of the portfolio and cannot sell an underperformer. This creates a powerful incentive to ensure that index constituents perform. Governance is the steering wheel whereby passive investors can influence performance. This makes them natural allies of activists, not disinterested bystanders as Ackman might have us believe.
Larry Fink CEO of BlackRock which manages $2.7 trillion in index funds wrote an open letter to 500 CEOs encouraging a new focus on clear long-term vision, strategic direction and credible metrics against which to assess performance. “At BlackRock we want companies to be more transparent about their long-term strategies so that we can measure them over a long cycle. If a company gives us a five-year or a 10-year business plan, we can measure throughout the period to see if it’s living up to the plan. Is it investing the way it said it would? Is it repaying capital to shareholders?” he asks.
To me this is about getting leverage on corporations and holding them accountable.
As index fund managers ramp up their focus on governance, there is broad opportunity for activists to tap into that growing sector for support because to a large extent, their interests are aligned. What activists have to worry about is the possibility that index funds diverge from hedge funds and forge their own path in advancing the governance principles they perceive as enhancing long term corporate performance. Braunstein predicts that in five years every public company will have an investor member on its board.
The SDX is one example of how index fund managers are pursuing a governance agenda independent of activists. Last month another step in going it alone was taken when it was announced that BlackRock is among the founders of Focusing Capital on the Long Term, a group of large global investors which also founded the S&P Long-Term Value Creation Global Index.
So much went so wrong at Theranos that it’s hard to know where to begin. At its core, it is another case of deeply flawed, if not failed, governance at a company that too quickly achieved global recognition and a $9 billion valuation.
Some might say that as a private company, there is no harm or foul. That would be a mistake.
The Food and Drug Administration is investigating whether Theranos administered diagnostic blood tests despite knowing its system was inaccurate and whether the company modified its equipment during the FDA approval process, a violation of research practices. Recently Walgreens announced that it has postponed deployment of blood testing centers in partnership with Theranos and Safeway has delayed the launch of a similar program.
Thirteen years in, Theranos’ technology has never been independently tested.
Despite longstanding questions about the efficacy of its technology, the firm has surrounded itself with an all star cast of investors and advisors, including:
- Riley Bechtel, chairman, Bechtel Group (director)
- David Boies, attorney (director)
- Timothy Draper, Draper Fisher Jurvetson (investor)
- Larry Ellison, CEO, Oracle (investor)
- William Foege, former director of the U.S. Center for Disease Control and Prevention (medical board member, former director)
- Bill Frist, former Senate majority leader (medical board member, former director)
- Henry Kissinger, former secretary of state (advisor, former director)
- Richard Kovacevich, former CEO and chairman, Wells Fargo (advisor, former director)
- Don Lucas, earl investor in Oracle (investor)
- Sam Nunn, former senator (advisor, former director)
- William Perry, former U.S. Secretary of Defense (advisor, former director)
- George Schultz, former secretary of state (advisor, former director)
Among a recent flurry of highly skeptical media coverage, The New York Times credits Theranos founder Elizabeth Holmes with executing the Silicon Valley playbook perfectly from dropping out of college to embracing quirks worthy of Steve Jobs to championing a humanitarian mission. “But that so many eminent authorities — from Henry Kissinger, who had served on the company’s board; to prominent investors like the Oracle founder Larry Ellison; to the Cleveland Clinic — appear to have embraced Theranos with minimal scrutiny is a testament to the ageless power of a great story.”
Last year, $633 million in new investment flowed into Theranos. This demonstrates the degree to which many investors will suspend disbelief for a hot commodity.
While Silicon Valley and the VCs who typically speak for innovative technology companies are known for their skewed views on governance, the executives and board at this company appear guilty of large scale malpractice. Reports that in October the company had filed to issue more shares suggest that the board could have been complicit in Ponzi-like plans to cash out early investors, even as the company’s troubles continued to mount.
Despite the setbacks experienced at Theranos, the board hardly appears chagrined. A press release from the firm attributes this quote to the board and other advisors: “Theranos’s technology is both transformative and transparent: Our blood tests are faster, less expensive and require less blood than traditionally required. As a group, we embrace this promise and stand with Theranos.”
This saga demonstrates how boards of directors, despite their pedigrees, can be far, far out of touch with the companies they are supposed to oversee. Many directors are simply spread too thin to be effective. In the case of Theranos, Bill Frist is on 3 public company boards, seven private company boards and six non profit boards.
Theranos is just the latest proof of the need for continuous vigilance in our markets. It shows how the system continues to benefit from, even encourage activist hedge funds, whistle blowers and regulatory watchdogs to ensure that investors get reasonable protection and, when it comes to health and public safety, rigorous standards based on peer reviewed science.
Breaking Views says that they Theranos case could reflect badly on unicorns, privately held startups valued at more than $1 billion. Good, it should be hard to achieve a high valuation and it should be harder still for companies which hide behind walls of secrecy like Theranos, regardless of who is on their board.
Media jury still hung on whether activist hedge funds are part of the solution or part of the problem
Last month, The Wall Street Journal published its Activist Investor Report Card, a study of 71 activist campaigns at large companies since 2009. The study aimed to measure whether activists are good for business. The conclusion? “Activism often improves a company’s operational results—and nearly as often doesn’t.” The Journal says that the best corporate response to activism is to analyze the proposal and the track record of the activist making it. Some research.
Not to be outdone, The New York Times published a report on activism in November, complete with its own infographic, Short-Term Thinking. The conclusion? Activists hold stocks longer than people think and the the market would be a better place if everyone had a long-term investment horizon. No wonder people don’t want to pay for news.
In April, this blog noted that media are trying to paint a more holistic picture of activism by asking the key question of are these guys good for the system? As the Journal and Times studies show, the media are undecided on whether activist hedge funds are a productive, corrective force in the capital markets. Part of the problem is that scoring activist success and failure is not the right metric.
There is disconnect in the media between the big picture of activism and the headline grabbing confrontations between activists and corporations. But the media must begin to connect the dots. In the same report on activism, the Times also has a story on corporate governance, saying there is little consensus about what constitutes good governance. Issues like dual class share structures create a world of “haves and have-nots of corporate governance,” writes the Times. 14% of IPOs in the US this year are dual class, compared to 1% in 2005.
How can it be that on the important issue of one share one vote, corporate governance is backsliding and the media continue to be lukewarm at best on activists? Activism is about doing the hard, risky work no one else wants to do. The media need to understand that and acknowledge that there is work in our markets that is uniquely suited to hedge funds..
In discussing a hedge fund lawsuit against the federal government over the ownership of Freddie Mac and Fannie Mae, Bethany McLean, the journalist who uncovered the fraud at Enron, acknowledged the important role hedge funds can play. “It takes someone with a lot of money and ad a lot of power to sue the US government. I think it’s fantastic that we have a group of people who are willing to shine a light on the government’s actions. That’s a value. The transparency that hedge funds can provide is a huge value, not something we should be seeking to get rid of.”
The media need to understand that activism is about much more important than wins and losses. It’s about creating a marketplace of ideas, being a counterweight to corporations and a channel for asset managers to engage with companies about performance. While not all activism is about corporate governance (particularly the recent spike in buyback campaigns), who if not activists will hold companies accountable for governance? Are activists good for the system? If you look at the big picture, the answer is yes.