Common Ownership and Hedge Fund Activism: An Unholy Alliance?

Zohar Goshen is Jerome L. Greene Professor of Transactional Law at Columbia Law School, and Doron Levit is Marion B. Ingersoll Endowed Professor of Finance and Business Economics at the University of Washington Foster School of Business. This post is based on their recent working paper.

In our recent article titled “Common Ownership and Hedge Fund Activism: An Unholy Alliance?” we propose a novel mechanism linking common ownership to anticompetitive outcomes. While hedge fund activism can be beneficial to society in a competitive market, we highlight a symbiotic relationship between common owners and activist hedge funds that may be detrimental to society.

In our model, multiple firms face the decision to invest in new projects or increase payouts to shareholders. Investment requires resources, acquired in a competitive market—with labor being the primary resource of focus. The firm’s governance structure, initially set by shareholders, determines control over investment decisions. In a “weak” governance structure, like dual-class firms with outside shareholders owning non-voting shares, managers are shielded from shareholder discipline, and investment decisions rest with the manager. Disloyal managers may either overinvest (e.g., “empire-building” aspirations) or underinvest (e.g., “quiet life” motives) relative to the shareholder value-maximizing policies. The nature and severity of these “agent costs” vary across firms. A “strong” governance structure, found in firms without staggered boards and poison pills, enables shareholders to hold managers accountable through the empowerment of hedge fund activism. While activist interventions alleviate agent costs, they also impose non-trivial “principal costs,” stemming from their potential mistakes or conflicts with other shareholders. These principal costs manifest as excessive pressure on managers to increase payouts which inevitably leads to missed profitable investment opportunities. A stronger governance structure may either boost or diminish a firm’s investment and share value in our framework.

As a benchmark, we consider a competitive market with separate ownership. In this market, each firm is owned by different investors, and the governance structure of each firm is set to maximize its share value. We show that the interplay between employees’ wages and governance structure creates a feedback loop, culminating in an equilibrium where the balance between firms’ agent and principal costs determines both control and labor allocation. Notably, this equilibrium is socially efficient

We then consider a market with common ownership, where multiple firms are owned by the same investors (e.g., the Big Three asset managers), and the governance structures of all firms are set to maximize the aggregate portfolio value. Common ownership breaks the feedback loop between wages and governance. In equilibrium, common owners exert market power indirectly by delegating control rights to other shareholders through broad implementation of “strong” governance structures across their portfolio firms. That is, more firms adopt strong governance under common ownership. These delegated control rights are then leveraged by activists, which pressure managers of their target firms to reduce investments. The aggregate effect of lower investments reduces the demand for labor and lowers wages. Importantly, even though activist hedge funds do not internalize externalities across firms, the cumulative impact of their interventions contributes to anticompetitive outcomes. Effectively, common owners establish a labor market monopsony without resorting to collusion among firms. Consequently, the symbiotic relationship between common owners and hedge fund activists is detrimental to society.

It is important to note that common owners need not consciously act as a monopsony or a cartel. The anticompetitive effects follow naturally from common owners’ push for strong governance. The conventional wisdom praises institutional investors for strengthening corporate governance as it mitigates agency costs (Jensen and Meckling 1976). And indeed, institutional investors are consistently pushing toward strong governance structures for publicly traded firms. However, this perspective often overlooks the principal costs inflicted by activist hedge funds. Consequently, common owners who push for strong governance and bolster hedge fund activism, might mistakenly attribute the realized positive returns on their portfolios to the benefits of reduced agency costs rather than acknowledging the role of labor monopsony at play. In other words, the commonly held naive view that strong governance unequivocally enhances shareholder value by reducing agency costs could explain the anticompetitive impact of common ownership.

In our model, activist hedge funds are the vehicle through which common ownership thrusts anticompetitive outcomes, which raises the question of whether hedge fund activism is inherently detrimental or if its potential harm is contingent on the alliance with common ownership.

We show that in a competitive equilibrium under separate ownership, hedge fund activism increases social welfare as long as weak governance structures sufficiently insulate managers from market pressure. This condition holds, for instance, when dual-class structures or anti-activist poison pills can be adopted by shareholders. This result is noteworthy as it holds even when activist hedge funds do not aim to maximize shareholder value. Intuitively, if managers in weak governance firms are adequately insulated, activist hedge funds mostly influence strong governance firms. Shareholders of these firms chose strong governance structures because, from their standpoint, the advantages of activism outweigh the associated costs. Consequently, as exposure to hedge fund activism intensifies, the valuation of these firms increases, and as a result, social welfare as well.

Under common ownership, hedge fund activism is detrimental to society compared to separate ownership. Two insights stand behind this result. First, given the lower wages under common ownership, the impact of overinvestment by managers is less significant, resulting in a smaller benefit from activist interventions aimed at mitigating this agency cost. Second, common ownership compels certain firms to adopt strong governance structures, even when these structures may not align with maximizing shareholder value for those specific firms. Owing to their common ownership, these firms remain exposed to hedge fund activism, which in turn diminishes their individual valuations. These negative effects on the valuation of these firms can turn the aggregate positive impact of hedge fund activism into a negative one under common ownership.

Overall, our theory establishes a novel linkage between several recently documented trends: the rise in common ownership, widespread adoption of shareholder-friendly governance policies, surge in hedge fund activism, decline in aggregate investment, decline of employment by US public firms, and decline in labor share.

The paper is available here: Common Ownership and Hedge Fund Activism: An Unholy Alliance?.

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