With the increase in hedge fund activism, a growing array of corporations and corporate activity are coming under pressure. No aspect of corporate decision making, not even M&A and corporate strategy appear insulated from activists’ reach. However, amid the growing activist voice, little attention has been directed on broader corporate governance issues such as the upward spiral of CEO compensation.
In 1965, the ratio of CEO pay to that of the typical worker was 20:1. Now it’s 300:1. Between 1979 and 2011, productivity rose by 75 percent, but median pay rose by just 5 percent, yet from 1978 to 2013, CEO pay rose by a mind-boggling 937 percent.
Nancy Koehn, a Harvard researcher writing in the Washington Post said,“they [CEOs in the post war era] drew their public legitimacy by orchestrating national prosperity.” But then something changed. In the 1980s and ’90s CEOS became celebrities. Steve Jobs and Lou Gerstner were revered as saviors. In 1992 Ted Turner was Time’s Man of the Year, first CEO to win that accolade since 1955. In 1999 Jeff Bezos was Time’s Person of the Year. Koehn cites the “Great Man” theory as partial explanation for the current state of executive compensation. She notes that examining the top decile of the top one percent of income distribution between 2000 and 2010 shows that between 60 and 70 percent of those earners were top corporate managers — not celebrities or athletes.
Dodd-Frank and other regulations have attempted to create more transparency on compensation practices in order to discourage lavish compensation through, in effect, public shaming.
“I don’t think those folks are particularly ashamed,” observes Regina Olshan, head of the executive compensation practice at Skadden Arps. “If they are getting paid, they feel they deserve those amounts. And if they are on the board, they feel like they are paying competitively to attract talent.”
Ironically, CEO pay is criticized using much of the same logic that is levied against activist hedge funds: “CEO capitalism creates incentives for executives to favor policies — reducing jobs or research and development — that boost stock prices for a few years at the expense of long-term growth. How much of this is a real problem as opposed to a rhetorical debating point is unclear. But the contrast between executives’ rich rewards and the economy’s plodding performance suggests why CEOs have become political punching bags.”
For whatever reason, hedge funds have not been punching that bag.
Perhaps CEO compensation should be studied more closely by the capital markets. In a purely unscientific exercise, I compared the 50 names on Goldman Sachs’ “Very Important Short Positions” list to Equilar’s list of the 200 highest paid CEOs. The correlation is remarkable.
From the GS list of most shorted companies by hedge funds, here’s how many are also on the list of highest paid CEOs:
- 8 of the top 10
- 17 of the top 20
- 25 of the top 30
- 29 of the top 40
- 35 of the top 50
That appears to be more than coincidence. Hedge funds need to look more holistically at issues of corporate governance and spark a national discussion in the press and in the boardroom about the relationship between corporations and shareholders. For every lightning rod topic like share buybacks and every proxy battle over board membership there are important governance issues such overpaying for performance and unfair dual share structures that are not getting enough attention.
Financial engineering. Sounds bad, doesn’t it. Not as bad as “financial weapons of mass destruction,” but bad. Financial engineering is the term now used to describe a set of activist strategies, including share buybacks, dividends, spinoffs and mergers. According to Activist Insight, more than 600 activist investments since 2010 (more than a quarter of all activism) qualify as financial engineering.
The effect seems profound. S&P Capital IQ calculates that companies in the S&P 500 now spend 36% of operating cash flow on dividends – significantly more than the 29% of operating cash flow committed to capital expenditures.
Some economists fear that reducing capital spending results in lower growth and fewer jobs. A recent paper from Harvard advocates banning share buybacks. The Economist notes that US corporations spent $500 billion on buybacks in the 12 months ending in September 2014 and calls buybacks “corporate cocaine.”
Much of the criticism levied against financial engineering and buybacks, in particular, treads familiar ground: activists are forcing corporations to make decisions that sacrifice long term growth for the sake of near term reward.
A new paper from Proxy Mosaic examines activist campaigns that could be termed financial engineering and suggests critiques based on short termism are probably misplaced. According to Proxy Mosaic, total returns to shareholders increase over time and on average activist campaigns that result in buybacks, spinoffs, etc. generate more than 25% returns. Looking at individual strategies, spinoffs generate the highest returns (about 50%) followed by buybacks at nearly 30%. The caveat is that activists’ financially-driven strategies do not typically beat the market. Buybacks, for example, trail the S&P 500 performance by 3%.
Proxy Mosaic concludes that:
- The type of financial engineering matters (spinoff strategies typically generate strong returns, while acquisitions are dilutive)
- Financial engineering transactions “may actually have moderate longer-term benefits to shareholders.”
- “Shareholders have legitimate reasons to be wary of activist that advocate for financial engineering transactions…[while] financial engineering has been a valid and productive strategy on an absolute basis, it is not clear that shareholders are actually better off after the activist intervention.”
We should expect that financial engineering, particularly stock buybacks and special dividends, will be the focus of growing analysis, attention and debate. Corporate governance experts will have their say. Boards might become more hesitant to approve share buybacks. Ultimately, it might become easier for corporations to resist activists pursuing financial engineering strategies.
For activists, even in the near term, the bar is rising when it comes to pressuring companies for share buybacks. Activists are going to have to be even more persuasive among investors and the media to get support for campaigns in the financial engineering category. Activists will have to become more selective, more data driven (when making their case) and, perhaps, more prepared for long campaigns, assuming that companies have stronger ground to resist calls for share buybacks.
Those activists who are best at picking their spots, communicating effectively and bucking the financial engineering stigma, will separate themselves from other funds and enjoy the benefits that come with being perceived as leaders within the activist sector.
A commentary in the Wall Street Journal last month by Yale Professor Jeffrey Sonnenfeld marked the start of a new salvo of criticism of hedge fund performance. In the piece, Prof. Sonnenfeld argues that if activists can’t beat the S&P, they have no business in trying to get companies, such as DuPont, which are not underperforming the market, to make strategic changes.
At his annual meeting in Omaha, Warren Buffett gloated that his famous wager with Protégé Partners was still in the money, noting that the cumulative returns in the S&P handily outperformed a hedge fund index since 2008.
The pervasiveness of media focus on hedge fund returns illustrates how unsophisticated media coverage of alternative investment can be. Industry critics, such as Prof. Sonnenfeld understand this and use it to their benefit. It is extremely rare to find citations in the press of the real reasons institutions invest in hedge funds. Institutional Investor, reporting from the SALT conference noted an executive from Wellington saying “people invest in alternatives for five reasons, including to diversify, to add value in a separate bucket and to limit volatility.” But that comment was in response to Greg Zuckerman, the Journal’s long-standing hedge fund reporter who quipped that his 60% stock – 40% bond portfolio beat hedge fund returns.
Returns are not the issue. Nor, in fact are hedge fund fees or hedge fund compensation. There is nothing more elastic than demand for hedge funds. If you don’t deliver on your promise to investors, they walk. End of hedge fund. End of story. That does not stop the media from perpetuating simplistic views of the industry. According to the Journal, at the Ira Sohn conference, Barry Rosenstein of Jana Partners lamented “the media covers activist campaigns like political campaigns, focusing on the horserace rather than on the substance of their suggestions.”
Hedge funds have counter punched. Trian Fund Management defended its returns in a letter to the Journal and Daniel Loeb of Third Point swiped at Buffet during the SALT conference. A new study from UCSD goes right after the Yale data by making a case that hedge fund activism is good for stocks.
To give a forum for activists and their critics, Proxy Mosaic organized a conference call featuring Jared Landaw, GC at Barrington Capital, Kai Leikefett, partner at Vinson & Elkins, and this author. A playback is available.
The numbers from hedge fund supporters and critics will be debated forever and the media will continue to try to keep score without trying to find deeper meaning. When it comes to hedge fund activism, the game is not about wins and losses. The simmering question is are these guys good for our system?
And if you don’t remember the reference in the title to this post, here’s a hint.
The more media coverage an activist hedge fund gets, the more negative it becomes. That’s the key finding in my study of activists in the press.
Value Act, Jana Partners and Blue Harbour Group are the funds which score highest in terms of positive media sentiment. Their high scores for reputation are tempered, however, by the low volume of media coverage they receive. That said, these funds are well regarded in the press for their success in using constructive and typically non-confrontational approaches to engaging with management and boards.
The biggest names in the business (Pershing Square, Third Point, Elliott Management, Icahn and Trian) are on the other end of the spectrum. They receive enormous media attention but the sentiment in that coverage is much more negative. With greater attention comes greater scrutiny and the media are compelled to come up with new story lines about these funds. Tactics are questioned, managers’ personalities become news, wealth becomes a focus. Even when they score a victory the media coverage will often include reference to a past failure. The bigger the target or the bigger the campaign the greater the risk for negative publicity. Elliott’s fight with the Argentine government, Pershing Square’s campaigns on Allergan and Herbalife and Trian’s fight with Dupont have each been damaging to the managers’ reputation.
In studying the media coverage activist managers’ preference for letting their campaign records do the talking become clear. Most managers do not directly engage with the press, but use letters to shareholders and CEOs/boards as proxies for media relations. Of course some managers do make the rounds on TV, do live events with reporters in attendance and even sit with journalists for in depth interviews. But for the most part, the activist industry wants their record to define them. This is a mistake and the activist scorecard is insufficient to build a consistent, positive reputation. Look at Starboard Value, a fund that has become more active in recent years and received more press, as a result. Their record in terms of wins and losses has been highly positive, yet, the sentiment in the media is more or less neutral.
That is because reputation has to be about more than wins and losses. The previous post in this blog focused on whether activism is good for our financial system. That is the big question and the fact that activists have been winning a lot more than they have been losing doesn’t provide the answer.
The research shows that certain funds would probably benefit from greater media exposure and that the name brand funds would benefit from picking their public battles more carefully and calibrating campaigns based on the associated reputational risk.
From the research one can also conclude that if the activists which get the largest share of voice in the media are viewed negatively, it creates a risk for the entire sector. The case still has to be made for activism: how activists improve corporate governance, accelerate corporate performance and advance the interests of other investors. Until that happens, the activist sector itself faces the risk that the media, the market and even regulators will decide that they are part of the problem rather than part of the solution.
It’s hard to imagine how the sun would shine more brightly (or hotly) on activist hedge funds. Pershing Square scored the top spot in Bloomberg’s annual performance ranking for the entire hedgefund industry with 32.8% return. Assets under management in the sector have surged to $120 billion, according to the Alternative Investment Management Association. Funds are taking on US blue chip companies with surprising frequency: Dupont, General Motors, Apple, BNY Mellon, and the list goes on. In step with this ascendancy, the media have started to take a holistic view of activist investing and the basic question is: are these guys good for the system?
Journalists understand that investors and the economy at large benefit from counterweights to entrenched corporate management and boards of directors. The media know that companies, especially large companies, can become complacent and sag under their own weight. The media recognize that it is good to shake up the system now and then. The media, however, are not sold on whether activist hedge funds are a productive, corrective force in the capital markets.
As a result, the reputation of activist hedge funds is at an inflection point at a time when they are at their most prominent, in terms of activity in the market and footprint in the media. Recent media coverage has been thoughtful about both sides of the activist coin. As a group, journalists believe in challenges to authority and are predisposed to accepting the basic thesis of activist investing. In the words of the editors of Bloomberg View, “crafting policies that aim to stifle shareholder dissent is a dumb idea…Suppressing it [the ability of shareholders to turn on managers] with corporate-governance rules that make it harder for shareholders to challenge managers would do far more harm than good.”
The Financial Times credits activists for “advancing the cause of shareholder democracy and good corporate governance, which was otherwise moving at a glacial pace in the hands of traditional institutional equity owners. That is one secular shift that investors can take comfort in, but it brings societal and market-wide benefits, not ones that accrue to activists specifically.”
The Economist echoes the view that other equity owners have done little to advance corporate performance and governance: “they [index managers such as BlackRock andVanguard] have not in the past felt much need to worry about how the firms they invest in are run. Alongside them are the managers of mutual funds and pension funds, such as Capital Group and Fidelity. They actively pick stocks and talk to bosses but their business is running diversified portfolios and they would rather sell their shares in a struggling firm than face the hassle of fixing it.”
However, hedge fund tactics frequently alienate would be allies in the media and fuel criticism of the activist sector, especially as the largest US companies come under pressure from activists. Stock buybacks are an example. About GM’s $5 billion buyback precipitated by Harry Wilson of MAEVA Group and other funds, the Deal Professor column at the New York Times calls the push for buybacks a “worrying trend” and writes, “the haste in which G.M. rushed to comply to Mr. Wilson’s demands, and they and other companies shed cash rather than fight, shows that the activist tide pushing the stock buyback may have gone too far. Let’s hope that it doesn’t wash our companies and shareholders.” The Economist called buybacks “corporate cocaine” and an influential paper from Harvard advocates banning them.
Buyback strategies have driven many of the recent campaigns focused on blue chip companies (a trend noted here more than two years ago). What’s unusual is that about a third of recent corporate targets were outperforming the market when the activist campaign began. Media have questioned the utility of this, especially given the distraction created for management and boards. The Times comments, “trying to break up great companies only weakens one of America’s greatest competitive advantages: the leadership, strength, and adaptability of its global companies. The activists should keep their focus on the underperformers, and work to build the next set of great companies…”
It is too early to judge what Main Street thinks about campaigns to pressure major corporations that by many measures are doing well, but anecdotal evidence shows that small investors give the benefit of the doubt to management. See the comments to this story about Dupont and Trian. If investors tire of a perpetual war with activists, one idea that could gain traction is tenured voting, a way of giving long-term shareholders more voting power than new shareholders. The Wall Street Journal recognizes tenured voting as “providing a bulwark against short-termers who roam the markets, looking to force buybacks or an untimely company sale.”
Then there are the cases of obvious excess that occur with alarming regularity in the the activist sector. Herbalife: a very public case of hedge fund on hedge fund violence. Valeant: a fine line between innovation and insider trading. Now, we have Stake ‘n Shake and its activist counterattack to an activist campaign. The Journal quotes activist specialist Greg Taxin: “One could fairly worry that this [Stake n’ Shake] proxy fight represents the jump-the-shark moment for activism. Serious activism can improve performance and enable more efficient capital markets. This isn’t that.”
We are at an inflection point in the evolution of activist investing. No hedge fund has created a broader narrative about the role of activism in our market system. The jury is still out on whether activists are the market watchdogs they claim to be. The risk is that hedge fund tactics create a backlash and that corporations, with the support of institutions, small investors and even the courts, succeed in changing rules that whittle away at the activist toolbox (proxies, disclosure and short selling, etc) in order to further entrench management.
The SEC acknowledges that there is a debate bout whether activists are good for the market and the economy. While not taking a side (yet), Major Jo White said, “I do think it is time [for activists] to step away from gamesmanship and inflammatory rhetoric that can harm companies and shareholders alike.”
The Economist suggests two possible paths. Activists “could mature to become a complement to the investment-management industry—a specialist group of funds that intervene in the small number of firms that do not live up to their potential, with the co-operation of other shareholders. Alternatively it could overreach—and in so doing force index funds and money managers into taking a closer interest in the firms they own. If that is the way things go, activists could eventually become redundant.”