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.
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.
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.