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.
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.
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.
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.
In his 1964 study of media theory, Understanding Media, Marshall McLuhan wrote “the medium is the message” to suggest that the way by which a thought is conveyed is more important that the actual message itself. In thinking about a flurry of recent profiles of hedge fund profiles in the press, all you need to know is the title (medium) to know what is being said about the hedge fund (message).
With a medium like Bloomberg BusinessWeek or Institutional Investor’s Alpha, you know what you are going to get: in depth analysis of a manager, what makes his/her strategy successful and some facts about how the fund handles risk management or other critical operating procedures. Recent profiles of David Einhorn/Greenlight Capital and Starboard Value follow a the traditional fund profile template. Two other, even more exemplary profiles, written last year were recognized with the Hedge Fund Article of the Year Award.
At the same time, with a medium like Vanity Fair, you also know what you are going to get: a personality-driven puff piece that is light on investment process and heavy on the cliches that all too often define successful hedge fund managers. This didn’t deter Pershing Square’s William Ackman from participating in a feature in the April issue focused on his well-documented short position in Herbalife. The result is an uneven account of Pershing’s investment that, by outlining fallings out between Ackman and other respected investors, like Daniel Loeb and David Einhorn, promotes the idea that Ackman has a “Superman complex” and “an uncanny knack for….pissing people off.”
If we believe that the medium is the message it should not be a surprise that Vanity Fair emphasized conflict, ego, drama and wealth (of course the writer could not refrain from weaving Ackman’s private jet into the story) over the business of running a multi-billion dollar hedge fund. So why answer the phone when a celebrity magazine calls? I don’t know. The outcome cannot be valuable to a hedge fund’s core audience of institutional investors. Maybe Pershing Square wants to reach a different audience — high-net-worth investors, for example.
Ackman has been playing the media game for a long time and understands the risks and rewards, but anyone else should hang up if Vanity Fair happens to call.