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.
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.”
Activist hedge funds have never had more influence and success. While it may be the golden age of activism, these funds are still underdogs, in the grand scheme of things. Staggered boards, poison pills, the resources available to large corporations and many more factors make it difficult, even risky for activists to go after big companies.
Here’s another: it is hard for activists to recruit qualified board candidates for proxy contests. Institutional Investor’s Alpha interviews Steven Seiden of executive search firm Seiden Krieger Associates about the challenge of finding dissident director candidates.
“I have to call at least four times as many people when it’s a proxy battle as I do for a non-contested election,” says Seiden, who has been recruiting directors since 1984. “ISS and Glass Lewis prefer directors with industry knowledge, impeccable reputations, committee eligibility and total independence.”
A director with the best chance of getting elected must “have the courage of their convictions and aren’t going to act like sheep when they’re on the board. The activist can’t bind them to vote his way once they’re elected,” says Seiden.
Clearly, having a strong slate of directors is an enormous advantage for the activist, but how does the fund position itself to recruit the best candidates? Negative perception can be a factor that complicates the process. “People often bridled when they were asked to be on a contested slate. They knew their names would be in the news. They thought it might sully their reputation and figured they’d never be invited to serve on another board,” explains Seiden.
The answer is to invest in reputation. The funds known for the best strategy and most effective techniques for engaging with corporations, not the ones that generate the most headlines, will be the most palatable to would-be directors. The funds that have that important back story about what makes them tick instead of just a scorecard of wins and losses will be the ones most likely to rally coalitions of qualified board candidates, institutional investors, proxy advisory firms and media around their causes.
The Lead Director Network, an organization of lead independent directors and non-executive chairmen, recently published a paper on trends in activist investing and how boards deal with activists. The paper notes that while activist investing can trace its roots to 1927, several trends are combining to elevate the amount of influence activists have in th market today.
Among the trends cited:
More money: It is estimated that AUM in the activist sector has gone from $12 billion to more than $100 billion in the last 10 years. SkyBridge Capital, a fund of funds, says that it has $4 billion of its $10 billion total committed to the activist sector.
Media interest: Activists are using social media and traditional media as levers and they are exerting influence that is disproportionately large compared to the size of their stakes in a target company.
Going large: In 2009 there were only seven activist campaigns involving companies with market cap higher than $10 billion. Last year there were 42.
Partnering up: Institutional funds like CALSTRS are increasingly working with activists. This powerful trend is a regular subject of this blog, most recently here.
Results: The average return for the activist sector was double that of non activist funds last year. In addition, ISS says that activists won 68% of contested fights for board representation in 2013. This combination of outcomes should only embolden activists.
The change in the balance of power indicated by these trends (which include the top trends of 2013 identified by this blog) have led companies to to realize that ” it is no longer enough to tell shareholders or proxy advisory firms that yo do not like the activists (or their ideas) and that management has a better plan.”
The paper concludes that “companies that maintain an open mind about activism and are willing to acknowledge their own mistakes may benefit from working with any shareholder focused on creating or unlocking value; it is the responsibility of boards and shareholders to determine whether a given activist and strategy qualifies.”
- T. Rowe Price voted with dissident shareholders 52% of the time in in board contests between 2009 and 2013. Fidelity voted with dissidents 44% of the time.
- Institutional Investor reports that from January through September last year, hedge funds were “somewhat victorious” in 19 of 24 proxy contests they initiated.
- The Shareholder Rights Project at Harvard Law School, in just one proxy season, succeeded in getting about a third of all the S.&P. 500 companies that had a staggered board to eliminate it.
- Even PR firms, law firms and the legendary Martin Lipton (inventor of the poison pill) whose bread is buttered by corporations acknowledge that it is getting harder to fight activists.
Corporate defenders like Mr. Lipton are trying to frame the debate around the issue of long term value. Hedge funds, they argue, are short term opportunists that interfere with corporations’ ability to manage for the long term.
This week Larry Fink, CEO of BlackRock, sent a letter to CEO of every S&P 500 company advocating for greater focus on creating long term value. While the letter doesn’t specifically reference activist hedge funds, it does call into question why companies raise dividends and buy back shares — some of the low hanging fruit that a company use to placate an activist. BlackRock, though, is working all angles. It also is a member of the recently formed Shareholder-Director Exchange which aims to formalize how corporations engage with institutional shareholders. (The Conference Board also has developed a set of principles to increase public trust in big business.) Yet, despite these efforts to work within the system, BlackRock voted with dissident shareholders 34% of the time last year.
There is a real issue tied to short vs long-termism. The ratio of corporate cash to capex is almost at all time low (click to see chart), raising the important question of whether corporations are investing enough to be competitive in the future. It appears disingenuous, though, to suggest that activism is the cause.
If defenders of the status quo are really concerned with long term growth and corporations delivering on long term strategy, they should be as vocal about the myriad of other factors that work contrary to those principles. Take the issue of quarterly earnings guidance. Most companies still provide earnings guidance and presumably manage based on that guidance. I would argue that is a greater short term pressure on corporate America than any group of hedge funds.
In order to capitalize on the tailwinds that are helping activists, they must realize that their reputation is the most powerful weapon in their arsenal. Funds that strike an effective balance between quiet advocacy and calibrated confrontation with boards, establish working relationships with pension funds, and become viewed as positive agents for change by the media, proxy advisory firms and others in the corporate governance arena will be the ones who translate the golden age of activism into riches for their LPs.
It used to be that pension funds and other real money asset managers were passive investors. If they didn’t like a stock or management at a corporation, they sold their positions and moved on. Things are changing, though, and these “sleeping giants” are stirring. Indeed, they are being forced to wake up because they are being pulled in two opposite directions.
On one side are the activists, who have learned that it’s better to have allies among institutional shareholders than go it alone when trying to pressure boards and management. On the other side is management, which realizes that if they keep their institutional shareholders close, they have a better shot at resisting or event deterring activist campaigns.
Corporations have stepped up their IR game and a pension plan like TIAA-CREF can meet with as many as 450 companies in the span of one year. On the corporate agenda: getting support for pay packages, board members and other governance issues that are frequently the target of agitation by hedge funds.
Furthermore, a new working group among pension funds and corporate boards intends “to establish more open lines of communication between companies and institutional investors, allowing companies to get their message out, and investors to express concerns, more frequently.” Called the Shareholder-Director Exchange, the working group developed a 10-point protocol to facilitate more productive interaction between boards and investors. Activist hedge funds are not part of the SDX group. This shows a preference, at least among several influential asset managers, like BlackRock, to to give the system a chance — to focus on evolution rather than revolution.
So, which way is the pendulum swinging? Are boards regaining firmer footing? Or are activists finding support among firms that didn’t historically advocate for corporate change?
It appears that the corporate strategy of engagement is having mixed results. A report last year by Institutional Shareholder Services called said that 2013 witnessed a “pivot point where the central focus of shareholder activism shifted” to “direct challenges to board members.”
Put your money on the activists. The SDX is a nice idea and formalizing how large shareholders engage with boards is probably overdue. But, corporations don’t like change and their first instinct is to resist outside pressure, regardless of the source. The SDX was formed in part by law firms and consultancies closely aligned with the corporate status quo and they may find that their plan backfires if pension funds follow the protocol but corporations don’t effectively engage or dismiss shareholders’ concerns. That would have the effect of driving pension funds into the waiting arms of activists.
Good for the Icahns of the world, right? Not so fast. Not all activist hedge funds are created equal and the question is which activist funds are positioned to win the support of real money funds? It will take a special kind of activist to effectively enlist the heretofore reluctant support from pension funds. The activist has to demonstrate a strategy and culture that is acceptable to the more conservative world of pension funds. The activist winners will have the brands that a) pension funds feel comfortable supporting and b) enhance the pension funds own brand by affiliation.
It boils down to reputation, but reputation and brand management are relatively new to the activist world. Today, there is no IBM, no safe partner in activist investing. The big firms have uneven reputations and the small firms might be too small to be seen as effective partners for big pension funds. There is much work to be done.
No better time than the present (even if it’s already March) for a review of the year that was in the world of hedge fund media. Three story lines were recurring and continue to be extremely relevant this year: activist funds taking on “big game” in the form of global corporations; whether or not “real money” asset managers will stay on the sidelines or join forces with activists; and, the ongoing saga involving Herbalife.
Trend #1: 2013 was the year that activist funds upped the ante and consistently turned up the heat on global corporations. Hess, Apple, Sony, and Pepsi were/are targets of a who’s who of activist investing: Elliott Management, Greenlight Capital, Third Point, and Trian, respectively. Elliott won board seats at Hess, Apple started a share buyback plan and increased its dividend, Third Point has lost money on Sony buy continues to call for the company to make “difficult decisions” and spin off parts of the company, and Trian is still arguing for Pepsi to spin off its beverage business and bulk up in snack foods. Not a bad track record, given size of these corporations.
Expect more of this big game hunting by activist funds. Indeed, investment banks and the largest law firms are increasingly advising corporate clients on how to cope with, and better yet, avert activist attention. It remains to be seen how corporations can begin to think like an activist (in attempts to avoid being targeted). If they do, it should result in higher profits, sharper strategy and better governance. According to a Conference Board Report, as of September 2013, hedge funds were “somewhat victorious” in 19 of 24 proxy contests initiated to that point last year, suggesting that shareholders are also starting to think like an activist.
Trend #2: Pension funds and other traditional asset managers are beginning to engage more with corporate boards and activists. Called “sleeping giants” by this blog, pension funds are where the muscle is. The enduring question is do they have the stomach to advocate forcefully for change aimed and boosting share prices. Calpers and Calstrs have long focused on good corporate governance and evidence is mounting that other pension funds are ready to be more proactive with corporate boards. Nell Minow, the co-founder of the governance advisory firm GMI Ratings, says there has been “a shift in tactics” among big pension funds “from shareholder proposals to engagement and director replacement.”
The newly-formed Shareholder-Director Exchange is a group comprised of corporations and asset mangers that developed a “protocol” for institutional investors and board members to follow when either side wants to talk to the other. While the SDX operates within the traditional realm of corporation-shareholder relations, pension funds want more engagement and presumably more accountability from boards. Activists are not part of the SDX, but if I were an activist, I would view this as promising for my strategies (more on this next time).
Trend #3: What is going on with Herbalife? Herbalife was the biggest headline getter in 2013 and it produced an almost a non-stop series of tabloid quality story lines that included the likes of Pershing Square, George Soros, Third Point, Perry Capital and others. The saga continues and now the government is investigating Herbalife (chalk one up for Pershing Square). Net net, no one really knows what’s the deal with Herbalife. The longs won out in 2013, but it’s a new year.