Activism for profit

The big embrace: Carl Icahn and Bill Ackman

Activist hedge funds have been playing an increasingly central role in corporate governance. Stock markets do not capture the long term costs of short-term pillaging. As a result, these activist investors can pursue transactions that increase prices at the expense of long-term performance, such as cutting project investments or reserve funds.

Background

Pressure to boost short-term performance metrics was one of many concerns identified by Congress, regulators and corporate governance experts as they investigated the reasons for the financial crisis of 2007–2008. In her last speech as FDIC chairman in 2011, Sheila Bair said “the overarching lesson of the crisis is the pervasive short-term thinking that helped to bring it about”.

Martin Lipton, partner of M&A law firm Wachtell, Lipton, Rosen & Katz and Rich Ferlauto, former director of Corporate Governance and Public Pension Programs for the American Federation of State, County and Municipal Employees, were from both sides of the issue, and summarized their rather similar concerns. This led to a call to overcome short-termism with a more responsible approach to investment and business management signed by 28 business, investment, academic and labor leaders in September 2009. The call to action offered numerous proposals, e.g. taxation, SEC market rules, labor law for employee retirement and pension fund management, to government for consideration.

The impact was nil.

The syllogism

Lucian Bebchuk, Director of the Harvard Law School Program on Corporate Governance, believes that shareholders should have the right to control all of the material decisions of the companies in which they invest. In 2013, Bebchuk established the Harvard Law School Shareholder Rights Project to promote corporate governance, based on his policy beliefs. The project’s stated intent is to facilitate activist hedge fund attacks on companies.

Bebchuk claims that adversarial interventions by hedge funds employing hostile tactics actually improve long-term corporate performance. He describes concerns to the contrary as myopic, despite such concerns being expressed by legal academics, economists, business school professors, business organizations and corporate lawyers.

Bebchuk bases this claim on an empirical study, The Long-Term Effects of Hedge Fund Activism in which he analyzes 2,000 interventions by activist hedge funds between 1994–2007, with a five year follow-up interval.

We test the empirical validity of a claim that has been playing a central role in debates on corporate governance — the claim that interventions by activist shareholders, and in particular activist hedge funds, have an adverse effect on the long-term interests of companies and their shareholders. While this “myopic activists” claim has been regularly invoked and has had considerable influence, its supporters have thus far failed to back it up with evidence.

Bebchuk uses Tobin’s Q as his primary metric to gauge the five-year performance of companies that were the targets of activist attacks.

              Tobin’s Q = market value/ book value 
         where book value is a proxy for replacement value

A higher Q value indicates a more favorable outlook for a company, and vice-versa.

There are two flaws in Bebchuk’s work. One is in the statistical analysis of calculated Tobin’s Q values. The other is methodological, in using Tobin’s Q as a proxy for company performance to begin with!

Statistical analysis

Bebchuk uses average Q values over the five year interval following an activist investor attack. Averages are skewed by extreme values, though. Median outcomes would be a better choice.

Re-running the analysis using median outcomes reveals that the median Q value for each of the four years after the attack is less than the Q value in the year of the attack. Only in year five does the median Q value recover sufficiently such that it is equal to or greater than the Q value in the attack year.

These results, even using median Q values, are further weakened because only 47% of the 2,000 companies survived, five years later!

Methodology

It is unclear whether Tobin’s Q is an appropriate measure of company performance at all. Per Tobin’s q Does Not Measure Firm Performance: Theory, Empirics, and Alternative Measures:

Tobin’s Q is often used to proxy for firm performance when studying the relation between corporate governance and firm performance. However, our theoretical and empirical analysis demonstrate that Tobin’s Q does not measure firm performance since under-investment increases rather than decreases Tobin’s Q.

Operational measures such as scale efficiency and cost discipline, which are justified by the ideal of maximizing firm value net of invested capital, lead to a different conclusion than Tobin’s Q when run on the same firms, using the same data.

Identifying the activists

One expert who did not see things the same way as Bebchuk was Delaware Supreme Court Chief Justice Leo Strine:

The direct stockholders of private companies are typically not end-user investors, but instead money managers, such as mutual funds or hedge funds, whose interests as agents are not necessarily aligned with the interests of long-term investors...Bebchuk’s crusade for ever more stockholder power…and his contention — that further empowering stockholders with short-term investment horizons will not compromise long-term corporate value — is far from proven.

The creation of durable wealth through fundamentally sound economic activity is what really matters for investors, citizens and our society as a whole.

Bebchuk responded, rather dramatically, with Don’t Run Away from the Evidence: A Reply to Wachtell Lipton. His supporters chimed in, claiming that Martin Lipton was a threat to the Ontario Stock Exchange, because he was suggesting that the allegedly beneficent actions of corporate raiders like Carl Icahn be reined in, thus harming small investors, see Speaking with the enemy.

Wachtell reiterated, in April 2014, that a short-term focus dominates both investment strategy and business management:

The individuals who are directly responsible for the stewardship and management of our major public companies…are nearly uniform in their desire to get out from under the short-term constraints imposed by hedge-fund activists and agree, as do many of their long-term shareholders, that doing so would improve the long-term performance of their companies and, ultimately, the country’s economy.

Consequences

Investor demography

Individual investing choice is stratifying by affluence. Asset allocation preferences by those earning more than $75,000 are in real-estate and stocks, whereas employed poor people are investing in gold or time deposit savings accounts. Investors scared to death of stocks:

The disparity highlights the difference in attitude toward the future. Where the wealthier who have benefited far more proportionately from stock and real estate gains have a more positive outlook on those assets and the future, the poor have languished in a recovery that has seen income disparity surge to historic highs. It is also related to a general view of the world as being very threatening.

Market inefficiency

Other issues of concern are front-running type effects and transaction opacity. Both impair financial and commodity market efficiency. In combination with shifting investor preferences as described above, I suspect that liquidity and trading volume will suffer too. Both are attributes of a competitive marketplace.

Activist hedge funds have recently exploited loopholes in existing 13(d) regulatory requirements to accumulate significant, control-influencing stakes in public companies rapidly without timely notice to the market. These techniques are facilitated by the widespread use of derivatives, advanced electronic trading technology and increased trading volumes.

During a single week in May, there were several transactions under scrutiny for exactly such activity. SunEdison and Conn stock jumped on news of David Einhorn having an interest in them. He opened new positions in both, an example of traders acting in agreement with a hedge fund manager. The day prior to that, Bill Ackman began a run-up of share purchases as part of his effort to acquire botox manufacturer Allergan.

Disclosed activist campaigns are at an all-time high, 250 in 2014, up sharply from merely 27 in 2000. Wachtell labels Bebchuk’s argument, that

attacks on companies by activist hedge funds benefit, and do not have an adverse effect on, the targets, thus should not be restrained but should be encouraged

a syllogism. If it were not a syllogism, then the targeted companies would tend to be mismanaged, financially weak or fallen stars. Instead, no company is too large, too popular or too successful, to be preyed upon:

Even companies that are respected industry leaders and have outperformed peers can come under fire. Among the major companies that have been targeted are Amgen, Apple, Microsoft, Sony, Hess, P&G, eBay, Transocean, ITW, DuPont, and PepsiCo. There are more than 100 hedge funds that have engaged in activism.
Activist hedge funds have approximately $200 billion of assets under management. Additional capital and new partnerships between activists and institutional investors have encouraged increasingly aggressive activist attacks, e.g. CalSTRS with Relational in attacking Timken [a profitable, innovative, locally-owned specialty steel mill in Canton, Ohio], Ontario Teachers’ Pension Fund with Pershing Square in attacking Canadian Pacific, and Valeant partnering with Pershing Square to force a takeover of Allergan.
Timken Steel
Many major activist attacks involve a network of activist investors (“wolf pack”) who support the lead activist hedge fund, but attempt to avoid the disclosure and other laws and regulations that would hinder or prevent the attack if they were, or were deemed to be, a group that is acting in concert.

Social justice irony

For many years, Carl Icahn and Martin Lipton have been fierce rivals. Icahn is the raider, attacking corporate boards versus Lipton, who has spent his career defending those companies from Icahn. Recently, Icahn defended Ackman and Einhorn, praised Bebchuk and criticized Lipton, regarding the net benefit to society, and the national economy, realized through the efforts of activist investors.

This comes as no surprise.

End notes

For further background reading about issues related to hedge fund activism, see UCLA School of Law’s recent Micro-Symposium on Competing Theories of Corporate Governance (62 UCLA L. Rev. Disc. 66, Full Text), which includes essays by Lucian Bebchuk and Stephen Bainbridge.

I have an obvious ideological sympathy toward the Lipton espoused argument. Nota bene! All activist investors are not hedge funds. Stay tuned for my follow-up post, Profile of a benevolent activist shareholder.