Gun Sales and the Capital Markets

Columbine.  Virginia Tech.  Aurora.  Sandy Hook.  These are only some of the most recognized mass killings that have occurred in the US since 1999.  For a longer list, go here.  The Obama Administration has indicated that it intends to propose some type of legislation in this area, including a possible closing of the gun show loophole and restrictions/prohibitions on high-capacity clips and magazines. 

Whatever happens along these lines, there is the potential for another source of regulation, the capital markets.  Freedom Group, the alleged maker of the semi-automatic rifle used by Adam Lanza at Sandy Hook is owned by Cerberus, a private equity firm.  Shortly after the shooting, Cerebrus apparently fielded a call from at least one influential investor.  As DealBook described:

An official at the California teachers’ pension fund, which has $750 million invested with the private equity firm, Cerberus Capital Management, was on the line, raising questions about the firm’s ownership of the Freedom Group, the gun maker that made the rifle used in the Connecticut school shootings.

Cerberus has since announced that it is putting Freedom Group on the market. The Firm issued a statement acknowledging the seriousness of the matter and the ongoing debate. 

It is apparent that the Sandy Hook tragedy was a watershed event that has raised the national debate on gun control to an unprecedented level. The debate essentially focuses on the balance between public safety and the scope of the Constitutional rights under the Second Amendment. As a Firm, we are investors, not statesmen or policy makers. Our role is to make investments on behalf of our clients who are comprised of the pension plans of firemen, teachers, policemen and other municipal workers and unions, endowments, and other institutions and individuals. It is not our role to take positions, or attempt to shape or influence the gun control policy debate. That is the job of our federal and state legislators.

Although professing a mostly agnostic position in the debate, Cerberus noted that "[t]here are, however, actions that we as a firm can take."  Their interest in Freedom Group would be put on the market.

we have determined to immediately engage in a formal process to sell our investment in Freedom Group. We will retain a financial advisor to design and execute a process to sell our interests in Freedom Group, and we will then return that capital to our investors. We believe that this decision allows us to meet our obligations to the investors whose interests we are entrusted to protect without being drawn into the national debate that is more properly pursued by those with the formal charter and public responsibility to do so.

The decision to sell right after Sandy Hook probably amounts to the worst time to put Freedom Group on the market.  As DealBook noted:  "It is not clear whether Mr. Feinberg [at Cerebrus] will find a ready buyer for the Freedom Group."  Nonetheless, the Firm has decided that any hit in the sale price is preferable to retaining ownership.

DealBook suggested that the difficulty in finding a buyer wasn't based on reputation and publicity but the increased possibility of gun control legislation.   As the Article noted, "Over the last two days, shares of the publicly traded American gunmakers, Sturm, Ruger & Company and Smith & Wesson, have dropped precipitously on fears of increased gun regulation." 

But, in fact, there may well be a much broader dynamic taking place.  The market is not necessarily reacting to the preceived decline in profits.  After all, some modest gun control legislation is not likely to significantly impact sales or profits.  

What may well be driving down value is the reaction of shareholders.  The profits of owning Freedom Group are outweighed by the publicity.  Certainly, this is suggested by the concerns expressed to Cerberus by CalSTRS.  Any other private equity fund with significant investments from CalSTRS or other similarly opinionated pension plans would likely be hesitant to buy Freedom Group.  Other gun companies may see downward pressure on shares as other pensin plans consider disinvestment. 

Clearly, this is an area of concern for at least some public pension plans.  Adam Kanzer at Domini Funds, in an editorial, Let’s stop investing our retirement funds in lethal weapons, suggests that mutual funds may also need to be concerned with ownership interests in gun manufacturers.  

His editorial focuses on the ownership interest by Vanguard in Smith & Wesson and Sturm, Ruger, "the largest publicly traded gun manufacturers."  Apparently Vanguard justified the interests both because the gun manufacturers were included in various indexes used by Vanguard funds and because the funds had a fiduciary obligation to maximize profits. These are, as he notes, explanations that could be given by an advisor to any mutual fund complex.  

The approach, he asserts, "should serve as a wake-up call for the millions of Americans invested in so-called ‘low cost’ index funds."  Said another way, individuals can play a role in the capital market response by considering the investments held by the mutual funds where they leave their IRA. To the extent that investors withdraw their holdings, investment advisors will react accordingly. 

Should gun manufactureres have trouble in the capital markets, they may have an incentive to adopt self-imposed limits.  They could, for example, opt to end the manufacture of certain weapons that, if used in a mass killing, would bring the most negative publicity.  The penalty exacted by the capital markets, to the extent there is one, may be reduced for companies that are seen as less likely to produce the sort of negative publicity engendered by what happened at Sandy Hook.