Super Hedge Fund

Sharon Hannes is Dean and Professor of Law at Tel Aviv University Faculty of Law. This post is based on recent article by Professor Hannes.

Activist hedge funds revolutionized corporate America and generated both excitement and criticism alike. This article suggests that a novel market mechanism, a “super hedge fund,” would maintain the benefits of hedge fund activism, while curbing its downsides. The super hedge fund would not really be a fund but, rather, a contractual arrangement among a broad group of institutional investors and a task force of financial experts. The task force would pool together the potency of the institutional shareholders in a sophisticated manner and then unleash its sting on target corporations. Unlike current hedge fund activism, the super hedge fund would not necessitate substantial financing or purchase of securities and, therefore, would be extremely efficient and highly accessible. Importantly, the super hedge fund mechanism is designed to ensure that its incentives are closely aligned with the interests of the long-term shareholders of the targeted corporations. Hence, the new mechanism should respond to the claims of short-termism lodged at current hedge fund activism.

Hedge fund activists are able to rally institutional investors to promote certain operational goals at major U.S. companies. Hedge fund activism, however, is an extremely indirect mechanism for institutional investors to wield their power. The purpose of this article is to propose a more direct mechanism for institutional investors’ activism. This new mechanism would seek to improve, at minimal costs, the performance of the companies in which institutional shareholders invest.

Imagine that an organization gathers teams of experts to form independent task forces for each market sector or a well-defined group of corporations. This initial recruitment of experts for the task forces would become unnecessary once the task forces gained reputations in their own right. The organization would also draft a standard agreement to be signed between each task force and as many institutional investors as possible. The standard contract would initially provide for minimal financing for each task force, to be paid for by the members of the large group of institutional investors who joined. The initial funding would enable each task force to search, within its mandate, for potential targets that may benefit from shareholders activism.

The standard contract would provide that once a task force has begun to zero-in on a potential target, it would be authorized to make a “capital call” to cover the costs of actively engaging the target. Importantly, however, this considerable additional financing would be requested only from those institutional investors with shares in the target, pro rata to their holdings. Thus, the capital call provision in the contracts between the task force and all institutional investors that are not owners in the target would remain dormant. This funding structure is crucial in creating the task force’s direct accountability as an activism agent to the institutional investors of the specific target in question. If a task force does not serve these investors well, it will soon find itself out of business. Moreover, to minimize the “free-riding risk,” the standard agreement would also include a provision that allows the task force to engage a target only if the aggregate holdings of the parties to the agreement top certain threshold, perhaps 25%.

With the additional financing, the task force could actively engage the target and push it towards a certain goal, much in the same way hedge fund activists work today. However, the task force would not hold proxies of institutional investors. In any action that requires the vote of the institutional investors, including proxy fights that the task force may initiate, the super hedge fund would only hold an advisory role in relation to the institutional shareholders.

There would be two major channels of monitoring of the super hedge fund. First, the task force would be required to renew its contracts with institutional investors periodically and also request a “financing reload” after a certain number of activist campaigns. Second, the standard contract may stipulate that certain actions require the consent of the relevant institutional shareholders, even if such actions do not require a shareholder vote. Nevertheless, backed with the financing of the institutional shareholders and with its influential advisory role, the task force would be quite powerful. Assuming enough institutional investors sign the agreement with the task force, the power of the latter may exceed the power of any activist hedge fund operating today.

Institutional investors often collaborate with hedge funds and benefit from their activism. Institutional investors are a major source of funding for hedge funds, and frequently support their actions with their votes. This, however, is not necessarily the optimal form of investor activism. To understand why, consider the following analogy: a condominium building is in urgent need of renovation, but the unit owners fail to take concerted action. The wealthier unit owners therefore find an audacious third party and provide it with money to purchase some of the units. This third party then uses its influence as an owner to improve the condominium management and ensure the necessary renovations. In the end, the third party activist sells its units to cash out, takes its profits, and moves on. While this third party will have improved the condominium property to the benefit of all unit owners, its involvement will have incurred huge transaction costs.

This article seeks to cut out “the middleman” and to employ a more direct agent at much lower costs. To continue the analogy, assume that the wealthy unit owners who financed the third party are actually condominium owners in another building, but not necessarily unit owners in the building in question. This situation is comparable to the financing of a hedge fund by general institutional investors who do not necessarily have holdings in the specific target that is subject to activism. In the condominium example, such a funding structure actually reduces the incentives and ability of the unit owners (or the institutional investors in the hedge fund context) to monitor the agent, thus leaving much room for improvement. Only the unit owners in the specific building in need of repair can make sure that the agent caters directly to the long-term welfare of their property.

In sum, there are certain flaws to the common market mechanism of hedge fund activism that make it less than optimal. First, the hedge fund business model entails huge transaction costs. Billions of dollars must be raised for an activist to buy a stake in the target, which is then followed by in-and-out market transactions. Second, hedge fund activism is not closely monitored, and an activist bears no long-term duties to the large shareholders of the target corporation. As a result, there is a need to fine-tune and improve hedge fund incentives and align them with those of the long-term shareholders of the target. Third, instead of retaining all gains from enhancing the value of the target, the public and the institutional shareholders must share them with the wealthy individuals who commonly finance the hedge funds operations and share their profit. Fourth and lastly, activist hedge funds own only a minute slice of the market in comparison to the holdings of institutional investors. Hedge fund activism thus offers less of an opportunity to make an impact on the market than what can be expected of the more direct mechanism of institutional shareholder activism, such as the super hedge fund.

The full article is available for download here.

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