Hedge Fund Activism and the Revision of the Shareholder Rights Directive

Alessio M. Pacces is Professor of Law and Finance at the Erasmus School of Law in Rotterdam. This post is based on a recent paper by Professor Pacces. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here); The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here); and Who Bleeds When the Wolves Bite? A Flesh-and-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System by Leo E. Strine, Jr. (discussed on the Forum here).

In my recent ECGI working paper, Hedge Fund Activism and the Revision of the Shareholder Rights Directive (SRD), I investigate whether the revised SRD promotes shareholder activism in Europe, as it intends to do. I find that the SRD includes a number of curbs to hedge fund activism for want of a longer-term engagement by institutional investors that cannot stand on its own feet. Overlooking that hedge funds are the key activators of institutional investors’ voice, the European Union (EU) legislator missed the opportunity to let individual companies choose the efficient regime towards hedge fund activism. The SRD’s prescriptive stance on the long-term characteristics of shareholder activism seems based on financial stability concerns. However, this approach undermines the efficiency of corporate governance.

Hedge fund activism has become prominent in Europe, too. Hedge fund activism is a key disciplinary mechanism in corporate governance. It consists of actions aimed to change the way a company is managed, without trying to gain control. Two factors are key for the success of hedge fund activism. First, to avoid free riding, hedge funds need to be able to buy the bulk of their stake in the company while the stock market does not anticipate the engagement. Second, to persuade the management to implement the desired changes, hedge funds need a majority of institutional shareholders supporting them.

Although institutional investors are decisive for the success of hedge fund activism, they are usually not pro-active. Hedge funds are different from other institutional investors because they can charge performance fees and overcome free riding. Hedge funds business model allows them to profit from correcting management failure to maximize shareholder value. However, because hedge funds profit from short-term changes in stock prices, they may also be responsible for short termism in corporate governance. Feeling the pressure of hedge funds, managers may pursue short-term stock returns at the expenses of long-term value creation. For this reason, policymakers on both sides of the Atlantic have been skeptical towards hedge fund activism.

Underlying the short-termism discussion there is a more fundamental question whether hedge fund activism is desirable for corporate governance. If financial markets were informationally efficient, there would be no difference between short-term and long-term maximization of shareholder value. However, if stock markets overweight the short-term profits of a company relative to its long-term profits, albeit temporarily, there is market failure and hedge fund activism may be a problem. Whether hedge fund activism is efficient ultimately depends on context. Some companies benefit from the correction of underperformance fostered by activist hedge funds, particularly in the presence of investor expropriation or misuse of free cash. For other companies, though, underperformance is temporary and the change of strategy promoted by hedge funds can destroy value. As I argue in a companion paper, the key question about hedge fund activism is who should decide on two conflicting views of the target company, one by the activist hedge fund and the other by the incumbent management.

Index funds are normally decisive on a hedge fund campaign because they cannot exit an investment they are dissatisfied with, so voting is their only option. However, index fund managers cannot be trusted to screen hedge fund activism. Because they pursue relative performance, index fund managers have no incentives to decide on firm-specific strategies and rather choose low-cost voting policies that investors appreciate overall. For instance, index funds may vote for a hedge fund’s request to cut on R&D expenditures not because it is efficient, but because the target has arguably ‘poor’ corporate governance. Therefore, the problem whether a company should be exposed to hedge fund activism does not warrant a one-size-fits-all solution. Different companies may need different degrees of exposure to activism at different points in time. Individual companies should ultimately decide ‘who decides.’

Reflecting an aversion towards short-termism, the EU legislator has rather chosen a one-size-fits-all approach. The revised SRD supports the engagement of institutional investors based on long-term policies. Moreover, the SRD links the definition of long-term engagement with the pursuit of Environmental, Social, and Governance (ESG) goals. In principle, institutional investors could opt out of both long-termism and ESG goals. However, the possibilities for institutional investors to profile themselves as short-termist and anti-ESG are nowadays only theoretical. The revised SRD curbs hedge fund activism directly, too, by mandating shareholder identification. In every EU member state, shareholders of public companies will have to be identified unless they have stakes below 0.5%, or the lower threshold set by the national legislator. While such a rule seemingly facilitates shareholder voice by increasing transparency, it undermines the business model of hedge funds, which are the main activators of such voice. Depending on the national implementation of this provision, hedge funds may have to disclose their presence upon crossing the 0.5% or lower threshold, which may be not enough for them to secure a reward from screening the market for undervalued companies.

If the goal of the EU legislator was to counter short-termism in corporate governance, the SRD has failed it entirely. Promoting the engagement of long-term investors does not solve the problem. Long-term investors such as index funds are already decisive on hedge fund activism. The problem is that index fund managers do not have the right incentives to decide whether the (threat of) engagement by hedge funds, and the relative short-termism that it entails, is efficient because that depends on the particular company.

The EU legislator missed the opportunity to let individual companies decide directly whether to welcome hedge fund activism. In several jurisdictions, companies can effectively opt out of hedge fund activism through dual-class shares. Dual-class shares, however, cannot be introduced after the company has gone public, unless they are presented as loyalty shares that formally do not discriminate between shareholders. Unfortunately, loyalty shares can be introduced opportunistically by the management or a dominant shareholder. This circumstance may explain why the EU legislator ultimately dropped the idea to enable them in all member states. As I argue in a companion paper, loyalty shares could be used to engineer dual-class recapitalizations, which can be efficient so long as institutional investors retain veto rights on them.

The goal of the revised SRD may be bigger than fighting short-termism in corporate governance. Interestingly, the Directive encourages asset managers to match the long maturity of their liabilities with their investment strategy. This may make sense from a financial stability perspective. Institutional investors undermine financial stability for they have too little of their portfolios invested in equities and too much in short-term safe assets. Overproduction of safe assets depends on a negative externality, which calls for regulation. Nevertheless, corporate governance seems to be the wrong tool to address this negative externality. On the one hand, it may be ineffective to the extent that institutional investors can opt out of the call for long-termism. On the other hand, a bias towards long-term management is undesirable for a number of companies, particularly those that must react to a fast-changing environment.

The complete paper is available for download here.

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