The past, present, and future of shareholder activism by hedge funds.

• Author: Cheffins, Brian R.

1. Introduction II. Definitional Issues A. What is Shareholder Activism, Hedge Fund-Style? B. Market for Influence vs. Market for Control C. Offensive Shareholder Activism Techniques III. Elements of the Market for Corporate Influence A. When is Offensive Shareholder Activism a Rational Strategy? 1. A Simple Model 2. Costs Associated with Exercising Influence 3. Benefits of Activism Accruing to the Insurgent Shareholder 4. Private Benefits B. Supply Side. 1. "Undervalued" Targets 2. Ownership Structure 3. Shareholder Rights C. Demand Side 1. Financing Costs 2. Transaction Costs 3. Regulation of Collective Investment Vehicles IV. The Rise of Shareholder Activism by Hedge Funds A. Offensive Shareholder Activism During the "Deal Decade" B. The 1990s C. Hedge Funds Move to Center Stage V. Why Was There a Surge in Offensive Activism by Hedge Funds? A. Discounting Potentially Relevant Variables B. Supply Side C. Demand Side VI. The 2008 Financial Crisis and Shareholder Activism by Hedge Funds VII. Hedge Funds and Offensive Shareholder Activism-Likely Future Trends VIII. Conclusion I. INTRODUCTION

   The forthright brand of shareholder activism hedge funds deploy had emerged by the mid-2000s as a major corporate governance phenomenon. In 2007, the New York Times said "activists have captured the center ring and are directing the main event." (1) A Wall Street Journal columnist observed similarly in 2008, "Like a rebel politician declaring victory, shareholders can declare their revolution nearly complete." (2) When the financial crisis of 2008 hit, however, it seemed like it might be a brief corporate governance revolution. The Economist observed in 2009 that "activist funds are on the back foot." (3) The New York Times ran a story the same year entitled "Among Activist Investors, a New Hesitancy." (4) TheStreet.com declared more bluntly, "Activist Investors Sidelined by Brutal Market." (5) Law professor William Bratton concurred. Citing data indicating that the market capitalization of public companies targeted by hedge fund activists fell dramatically in 2009, he concluded "Thus did the sector's financial salience wane under crisis conditions." (6)

   The financial turbulence did not deliver a fatal blow to hedge fund activism, and there were signs this corporate governance tactic would achieve renewed prominence as markets recovered. Schulte Roth & Zabel, a law firm, surveyed both hedge fund activists and senior corporate executives in 2010 and reported that nearly two-thirds of activists and executives anticipated the volume of shareholder activism would increase going forward. (7) The Economist observed as 2010 drew to a close that activist hedge funds were "finding their voices again." (8) The Financial Times declared in February 2011 "Activists are Back and Bolder Than Ever." (9) A New York Times columnist maintained in August 2011 that "[a]ctivist investors [were] escalating their fight for change," (10) a claim borne out by press reports of hedge fund activism campaigns affecting Fortune 500 constituents Kraft Foods Inc. and McGraw-Hill Companies. (11)

   What does the future in fact hold? Was the brand of shareholder activism associated with hedge funds a mid-2000s flash in the pan? Or did the financial crisis merely deliver a temporary setback for practitioners of the controversial form of shareholder engagement in which hedge funds engage? In other words, is hedge fund activism likely to be an important part of the U.S. corporate governance landscape going forward?

   These are questions of considerable importance. Law professor Jonathan Macey argued in 2008 that hedge funds, together with private equity, "are the newest big thing in corporate governance and are likely to remain an important and controversial feature of the financial and legal landscape for some time to come." (12) The extent to which this prediction comes true will do much to shape manager/shareholder interaction in U.S. public companies going forward. Advocates of hedge fund activism argue that interventions which occur typically generate improved shareholder returns by prompting companies to manage assets better. (13) On the other hand, hedge fund engagement can be highly disruptive for targeted firms. As Damien Park, founding and managing partner of Hedge Fund Solutions, a shareholder activist advisory firm, said in 2010 of companies where activists had declared they owned a sizeable stake, "It wreaks havoc. Now you have to manage a lot of other components that you didn't before, and it's all-consuming--none of which adds real value." (14)

   When shareholder activism by hedge funds rose to prominence in the 2000s, a series of academic papers addressed various important questions about this corporate governance tactic. For instance, which public companies are targeted? (15) What changes do hedge funds seek to promote? (16) Do they achieve their stated objectives? (17) What is the time horizon of hedge funds that engage in shareholder activism? (18) Does hedge fund activism improve the share price performance of targets? (19) Do activist hedge funds have a counterproductive, self-serving agenda--a "dark side"--that necessitates a regulatory response? (20)

   While academics responded expeditiously to the rise of hedge fund driven shareholder activism and provided valuable evidence on key aspects of the phenomenon, the relevant literature glosses over various important contextual questions. For instance, what motivates investors to step forward in the manner hedge funds have done? In other words, given that activism is costly in terms of time, effort, and diversification forsaken, how is it that, at least for some investors, the perceived benefits outweigh the costs? Why did activism by hedge funds achieve particular prominence in the mid-2000s? Was the brand of shareholder engagement in which hedge funds specialize carried out by other investors before then? If not, why not?

   This Article answers each of these important background questions, deploying the heuristic of a "market for corporate influence" to facilitate matters. The analysis of the past and present in turn provides the departure point for predictions about the future of hedge fund activism. The Article draws upon the points made to show that key changes to market and regulatory structures that helped to bring hedge fund activism to the forefront should endure and ensure the brand of shareholder activism in which hedge funds engage will play an important part in U.S. corporate governance going forward.

   The Article acknowledges that the 2008 financial crisis was a setback for hedge fund activism, but points out that interventions continued to occur with some regularity in the midst of the market turmoil. While regulatory changes introduced in the wake of the financial crisis could impinge upon the business model of hedge fund activists to some degree, it is unlikely that reforms undertaken will undermine fundamentally the hedge fund sector or the operations of the sub-set of hedge funds that engage in shareholder activism. Correspondingly, absent a fresh shock to the financial system, hedge fund activism should be a central feature of the corporate governance landscape for some time to come.

   The Article proceeds as follows. Part II identifies the key characteristics of the form of shareholder activism in which hedge funds engage. It explains what is distinctive about the operations of hedge funds in the shareholder activism context by distinguishing between "offensive" and "defensive" interventions. Hedge funds specialize in the former while traditionally dominant "mainstream" institutional shareholders, such as pension funds and mutual funds, tend only to engage in the latter, in the sense they will only step forward to protect or enhance the value of pre-existing holdings. Part II then explains how offensive shareholder activism differs from interventions designed to achieve full voting control by introducing the market for corporate influence concept and by distinguishing it from its well-known counterpart, the market for corporate control. Part II concludes by summarizing the tactics hedge funds deploy when they engage in offensive shareholder activism.

   Part III of the Article identifies the "demand" and "supply" factors that shape the market for corporate influence and in so doing outlines the variables likely to determine levels of offensive shareholder activism over time. Part IV describes the emergence of hedge funds as the dominant practitioners of offensive shareholder activism in U.S. corporate governance. It identifies antecedents from the 1980s and 1990s but emphasizes hedge funds did not move to the forefront until the 2000s. Part V draws upon Part III's assessment of the costs and benefits of offensive shareholder activism to explain why hedge funds stepped forward when they did.

   Part VI of the Article focuses on the 2008 financial crisis, drawing attention to features of the crisis that discouraged hedge fund activism but providing empirical evidence showing that hedge fund interventions continued to occur despite the market turmoil. Part VII offers predictions for the future, arguing that regulatory changes introduced in the wake of the financial crisis could well be a net liability for hedge fund activism but maintaining that the bold interventions for which hedge funds have become known will continue to be a significant aspect of corporate governance going forward. Part VIII concludes.

2. DEFINITIONAL ISSUES

   1. What is Shareholder Activism, Hedge Fund-Style?

      Shareholder activism has been described as "the exercise and enforcement of rights by minority shareholders with the objective of enhancing shareholder value over the long term." (21) While defining shareholder activism by reference to the use of shareholder rights to enhance shareholder value delineates the basic parameters of this corporate governance tactic, the formulation is too general in nature to...