Hedge funds have been taking a pounding, both in the market turmoil and with the SEC's decision to ban short selling. They often been demonized and viewed as damaging to the markets. A good example occurred a month or so ago, when Lynn Stout, a professor at UCLA, wrote an editorial in the WSJ titled "Why Carl Icahn Is Bad for Investors." We penned a response and slated it for publication on another blog, but alas, it was never published. So we take a moment or two to provide the comments here.
The editorial largely attacked hedge funds (in general and Carl Icahn in particular). She characterized the funds as short term investors and views their investment strategies as inherently destructive. As the editorial observes:
- Hedge funds want to make money, quick. They push for strategies that raise the stock price of the few companies they own but may lower the stocks of other companies, or that raise prices in the short term while harming companies’ long-term prospects.
What did it mean to be short term? She cited a study showing that hedge funds had a median holding period of twelve months. In other words, at least half of all hedge funds stayed in a company over a year, hardly ringing proof of a short term investment horizon.
What about the harmful tactics? A “favorite” hedge fund tactic, according to the editorial, was to urge the sale of the company. But when a company is sold, the shareholders typically receive a premium. So what’s the harm? That the share prices of the acquiring company would drop. In other words, the hedge funds were harming the market because the acquirer overpaid. The problem was not with hedge funds but with management. To the extent there was an overpayment problem, the solution was not to penalize hedge funds but to tighten fiduciary obligations of the acquirer’s board. In other words, the best way to prevent overpayment is to make the acquirer more careful, not to prevent the seller from selling.
But there is another problem with the contention. Professor Stout referenced a 2005 study in the Journal of Finance. Presumably she is talking about an article titled “Wealth Destruction on a Massive Scale?” The article’s conclusion that there was a $240 billion loss to shareholders of acquiring companies was based upon data from 1998 through 2001. In other words, the data comes from a period that predates hedge fund activism. In fact, the study examined acquisitions in general, not those involving hedge funds. The data, therefore, shows at most that acquirers overpay, irrespective of the involvement of hedge funds. Said another way, she tagged hedge funds for a potential problem that is not of their making.
Potential because the evidence cited does not in fact show that acquirers routinely see their share prices drop. The study in fact showed that the “massive loss” occurred because of a small number of very large acquisitions. As the study notes:
- The losses result from relatively few acquisition announcements, as can be seen from the fact that from 1998 through 2001, the equally weighted average abnormal return associated with acquisition announcements is positive. Without the acquisition announcements with shareholder wealth losses of $1 billion or more in our sample, that is excluding just over 2% of the observations, shareholder wealth would have increased with acquisition announcements. Looking at the aggregate performance of acquisitions, the economic importance of acquisitions with large announcement losses overwhelms that of thousands of other acquisitions.
In other words, she didn't cite convincing evidence that most acquisitions result in losses to the acquirer as a general matter much less show that any losses that did occur can be blamed on the seller.
The other strategies she points to? A “second favored” transaction is to demand the payment of a “massive dividend” that drains cash and results in an over-leveraged company. Put aside that boards have fiduciary obligations and presumably would violate them if they paid out so much money the company was harmed. More importantly, her objection would apply to any transaction that drains cash, whether or not instigated at the request of a hedge fund. Thus, she presumably opposes leveraged (including management) buyouts since they usually leave companies highly leveraged with cash reserves drained.
Finally, she contends that “shareholder activism hurts average investors by making entrepreneurs and managers more reluctant to operate as public companies.” This is an unproven assertion but a popular one to raise about any development that somehow threatens the status quo. In fact, the argument is belied by the fact that private equity funds are now going public, with KKR having recently announced that it would do so.
Professor Stout, therefore, hasn’t made the case. It is instead an attempt to demonize hedge funds. In that regard, she is not alone. The Chairman of the SEC used hedge funds as the excuse to deny access and amici in the CSX case contended that the Second Circuit should give the trial courts the tools needed to battle hedge funds. There are likely some hedge funds that are destructive, a quality not limited to those funds. One wonders whether the real objection is the existence of shareholders willing to promote strategies that management doesn't like. It would, for example, explain the scorn sometimes heaped on unions, a view apparently shared by one former commissioner at the SEC.
There are legitimate issues about the relative balance between shareholders and managers in the corporate governance process. Likewise there are legitimate legal issues surrounding hedge funds that require resolution. Reporting obligations should be increased and, as we have been discussing on the Race to the Bottom in connection with the CSX case, there needs to be stricter beneficial ownership reporting obligations that would affect some hedge funds. But branding entire categories of shareholders as somehow destructive does not significantly advance the analysis.