New Financial Instruments and Institutions: Opportunities and Policy Challenges

Chapter 4: Gap Filling, Hedge Funds, and Financial Innovation

101 Gap Filling, Hedge Funds, and Financial Innovation 4 During the early 1980s, corporate raiders represented a potentially important monitoring mechanism of corporate management in the United States. They bought large stakes in target companies and caused significant restructuring of U.S. businesses. Many companies responded to this hostile takeover wave by adopting stronger defenses; others implemented managementsponsored leveraged buyouts. The bulk of financial innovation during this period was defensive in nature. During the 1990s, institutional investors moved to the forefront and accumulated increasing shares of U.S. equity securities. Much ink was spilled over how this shift in ownership structure would lead managers to adopt more shareholderfriendly corporate governance structures. Yet, after twenty-five years, institutional shareholder activism appears to have had relatively little impact on U.S. corporate governance. Instead, a new player has emerged: the activist hedge fund. Hedge funds recently have shaken up boardrooms and forced radical changes at many publicly traded firms by leveraging their large pools of capital to push successfully for restructurings, sales, increased dividend payments, and other corporate actions that have directly benefited hedge funds and other shareholders. This hedge fund “activism,” while in evidence for several years, reached a crescendo in the period 2005–06 with an unprecedented flood of funds directed at a broad spectrum of corporate targets. At the same time, financial innovation shifted from defense to frank partnoy randall thomas offense. Today’s hedge funds use novel financial techniques that were unknown to corporate raiders in the 1980s. In this paper, we begin by documenting the successes and failures of “institutional shareholder activism” in recent years. In the first section, we focus on those areas in which shareholders are most able to exert influence: voting, litigation, and change-of-control transactions. We find that on balance institutional activism has been of marginal importance at targeted firms and that many institutions, such as mutual funds and pension funds, have not been as successful as some commentators initially had predicted. The second section contrasts institutional shareholder activism with the more aggressive recent activism of the hedge fund managers. We cover a range of issues related to the recent growth of hedge funds and discuss the costs and benefits of hedge fund activism for each of four broad strategies that these funds have pursued: information asymmetry and convergence trades; capital structure– motivated trades; merger and risk arbitrage; and, most controversially, governance and strategy. Our analysis shows that, although there are major benefits derived from hedge fund activism, there are clear costs as well. In the third section, we turn to the challenges presented by hedge funds and their innovative financial strategies in the areas of voting, litigation, and changeof -control transactions. We conclude that, although hedge funds have better incentives than do other institutions to play an activist role in these areas, their activism also raises novel challenges for regulators. The Traditional Institutional Investor Role In the early 1990s, shareholder activism by large institutional investors was praised as a promising means of reducing the agency costs arising out of the separation of ownership and control at American public corporations.1 The theory was straightforward : Shareholder monitoring was an important method of limiting managers’ divergence from the goal of maximization of shareholder wealth, and institutional shareholders were well positioned to act as effective monitors. Institutions held larger blocks of stock than most other investors and collectively held well over 50 percent of the stock of most large public companies. Acting collectively, these shareholders would have the power and the incentives to push for good corporate governance and to nudge managers to pursue wealth-maximizing strategies. The idea captured the attention of federal regulators. To facilitate shareholder collective action, the SEC made two major changes to the proxy voting system 102 frank partnoy and randall thomas 1. Black (1990); Roe (1991). that favored efforts of institutional investor voting. First, in 1992 the SEC adopted several rule changes that had the effect of making it easier for institutional investors to act collectively in opposition to management proposals or in favor of shareholder proposals.2 Later, in January 2003, the SEC mandated that mutual funds disclose how they were voting their proxies at firms in which they held shares. This change was meant to lead mutual funds to be more even handed in their voting practices by exposing potential conflicts of interest of funds that had closer ties...