This DealBook article about the new alliances between activist hedge funds and long-only institutional shareholders is full of enjoyable oddities; here is my favorite part:
“Periodically, we are approached by large institutions who are disappointed with the performance of companies they are invested in to see if we would be interested in playing an active role in effectuating change,” said William A. Ackman, founder of the $13 billion hedge fund Pershing Square Capital, who is best known for his positions on J. C. Penney and Herbalife. Institutional investors even have an informal term for this: R.F.A., or request for activist.
Also good are T. Rowe Price's and BlackRock's vague non-denials that they issue R.F.A.'s, and a proxy solicitor's statement that "Institutional investors want to share the sick children in their portfolio with someone who can help make them better."
Lazard's delightfully titled "head of corporate preparedness" is quoted saying, "This is the biggest shift in the battle for corporate control since private equity was invented in the 1980s," and it's worth thinking about it in the larger context of the separation of ownership and control.1 Companies are let us just say "owned" by their shareholders,2 but typically individual shareholders don't have much control over the companies they "own." Their main rights are to vote for directors -- normally a one-party affair where your only option is to vote for the directors nominated by the board, or just vote for no one -- and to sell their stock if they're unhappy.
So an individual shareholder should value her control rights at basically zero. On the other hand, a big mutual fund that's a shareholder has some real control rights. It can, in theory, do the monitoring and cajoling and proxy-fighting work to actually force changes in management. But this is a lot of work and arguably away from its core expertise as a passive investor.
So, more efficiently, it can just issue an R.F.A., have an activist firm do the work, and vote for the activist. The mutual fund's main way of getting control is by making the one-party state of most corporations into a two-party state: You can't get anything you want, but you can get the choice between, say, Tim Cook and Carl Icahn. And as a big shareholder, you have some ability to influence the activists who are, after all, campaigning for your vote.
And, usefully, an individual shareholder in a mutual fund has some control rights in that mutual fund. Most notably, she can just take her money elsewhere if the mutual fund underperforms. This is very different from selling your shares in an underperforming company, because withdrawing from a mutual fund leaves the fund with less money. Selling your shares of a bad company doesn't affect the company; it just leaves the shares in the hands of some other schlub.3
Also, it is easy for her to see if the mutual fund is underperforming. A mutual fund's whole job is to provide investment returns, and that is easily measurable against some market benchmark. How do you measure if a company is doing its job? What even is its job? Stock price appreciation is one relevant measure (over what period?), but not the only one. Maybe it's net income. Maybe it's revenue growth. Maybe it's active monthly users. Shareholder bamboozlement is easier for the manager of a company that makes things than it is for the manager of a fund that just makes money.
So big mutual funds pulling activist strings are a way to aggregate and simplify control of corporations in a way that give some control rights back, ultimately, to the individuals who own the residual claims on corporate earnings. It goes like this:
Instead of like this:
Financial innovation: Adding value!
Or at least redistributing it. Obviously there is counter-innovation, and I guess your priors will determine how you interpret the recent wave of public offerings in which shareholders have reduced control rights. Are they just self-interested management entrenchment? Are they a way to preserve companies' ability to pursue long-term value in the face of shareholders who are overly focused on immediate returns? Is the notion that shareholders should control corporations sort of passé anyway?
Those have long been fun theoretical questions; for myself, I'm a big fan of the notion that companies should be able to choose exactly what rights go in the bundle that shareholders get, and what level of care and catering they promise to shareholders. But the new world of an activist (or three) in every stock, and passive-shareholder support for and use of activists, makes these issues a lot more practically relevant. Companies will need to figure out if they're run for the purpose of providing financial returns to shareholders, or for some other higher/lower/more self-interested purpose. If they don't, their shareholders might figure it out for them.
1 That link is to the official-looking JSTOR page for the 1983 Fama and Jensen classic, "Separation of Ownership and Control." Here is what seems to be a free version.
2 Those scare quotes are because it's not true, come on. Shareholders provide capital to a corporation in exchange for a bundle of rights defined by state law and the corporation's charter and bylaws. That bundle of rights has certain similarities to "ownership," but that doesn't make it ownership.
3 An obvious exaggeration: Selling your shares tends to lower the stock price, affecting stock-price-based executive pay, capital-raising ability, prospects of being taken over, etc. But the mechanism with mutual funds is more direct.
By the way this is all loosely from Fama & Jensen:
For the purpose of decision control, the unique characteristic of the residual claims of mutuals is that they are redeemable on demand. ... The decision of the claim holder to withdraw resources is a form of partial takeover or liquidation which deprives management of control over assets. This control right can be exercised independently by each claim holder. It does not require a proxy fight, a tender offer, or any other concerted takeover bid. In contrast, customer decisions in open non-financial corporations and the repricing of the corporation's securities in the capital market provide signals about the performance of its decision agents. Without further action, however, either internal or from the market for takeovers, the judgments of customers and of the capital market leave the assets of the open nonfinancial corporation under the control of the managers.
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