Op-Ed: Activist Hedge Funds — Saviors or Vultures?

Activist hedge fund manager Bill Ackman,

Wall Street titan and billionaire investor Bill Ackman is being investigated for allegedly manipulating the stock price of nutrition company Herbalife.  For people like Ackman, dealing with legal controversy is all part of the job. What exactly is that job?

Specialized hedge fund managers or investors like Ackman will secretly buy up shares of a public corporation. Upon accumulating a sizeable chunk of a company, these investors will then contact said company’s CEO, threatening to fire him or her unless shareholders receive a cash payout from the company’s coffers. In an earlier age, Ackman would have been referred to as a corporate raider. Today, these raiders prefer the more euphemistic moniker “activist investor”.

Many view activist investors as no more than the schoolyard bullies of corporate America. Meanwhile, activists view themselves as value creators representing the ultimate evolutionary stage of capitalism. In reality, activist investors are just symptoms of a free market: amoral profit seekers whose immense power can sometimes be used to benefit society, but more often than not achieve the opposite.

Activists have deposed the CEOs of enormous corporations ranging from Proctor & Gamble to Microsoft. Even the world’s most successful companies such as Apple have not been able to avoid attacks. Alarmingly, the popularity of activist investing has surged in recent years. The cumulative size of activist funds has increased by fivefold over the past decade to over $120 billion.

Of course, activism entails a little more nuance than simply stripping cash from helpless companies. After all, the goal of the activist is to increase a company’s share price, which should theoretically benefit all shareholders as well as the company itself. Activists acquire shares in companies they believe to be undervalued for whatever reasons. They will then publicly argue for changes that they believe will help the company’s share price reflect its full potential. Among the most popular requests are: management changes (i.e. firing an incompetent CEO), cutting costs, merging the company with another, or implementing share buybacks. In general, activist investors do boost company’s share prices, at least temporarily.

The problem with activists though is their time horizon: often, the changes that activists seek are short-term fixes that cause a momentary pop in stock prices, after which the activists can quickly dump their shares and slink away with their profits.

There certainly are cases in which incompetent management or poor strategy can cause a company to be undervalued. Activists can thus play a useful role by keeping managers on their toes. However, the same financial motivations are present, and arguably stronger for activists to attack perfectly healthy companies. For example, a solid performer like Apple is a ripe target for activists simply because it is sitting on an enormous pile of cash that could be used to pay shareholders in the form of dividends or stock buybacks. However, any cash that is paid to shareholders comes at the expense of a company’s long-term investments. Thus, although fulfilling an activist’s request to pay shareholders may increase stock prices in the near term, doing so would likely be detrimental to the true value of a company.

When activists target healthy companies and demand payouts, they essentially reallocate wealth from the company to the hands of short-term shareholders, contributing a negligible or even a negative net value to the economy. As activism grows in popularity, the number of unhealthy companies for activists to target will decrease, and these activists will inevitably begin preying on healthy companies.

Society should strive to discourage activities that contribute a negative net economic value, and oftentimes, activist hedge funds do just that. Unfortunately, there are no easy fixes to discourage “bad” activism. Any additional regulations would raise a new crop of issues. For example, one option would be to modify the time horizons of activists by tying shareholder votes to the length of time a certain shareholder has held a stock. This would discourage activists seeking short-term gains. However, restrictions on the free exchange of a company’s stock reduce liquidity, and thus run contrary to the very purposes of a public corporation.

Instead of creating new rules, authorities should focus on prosecuting those activists whom already use legally dubious maneuvers to influence stock prices, as in Ackman’s case. However, the best way to address activism will not be solely regulatory. In addition to calling for the prosecution of market manipulators, qualified intellectuals in the academic, legal, and financial world need to openly criticize those activists that focus on short-term gains at the expense of long-term growth. Investors avoid controversy, and a hedge fund is nothing without its investors. This kind of public dialogue can steer investors away from “bad” hedge funds and towards funds with solid track records of achieving long-term price gains. Through this process, activist investors can hopefully gain some social awareness and focus on meaningful, cooperative exchanges with corporations that result in true contributions to the public good.