The Wolf at the Door: The Impact of Hedge Fund Activism on Corporate Governance

Hedge fund activism has recently spiked, almost hyperbolically. No one disputes this, and most view it as a significant change. But, their reasons differ. Some see activist hedge funds as the natural champions of dispersed and diversified shareholders, who are less capable of collective action in their own interest. A key fact about activist hedge funds is that they are undiversified and typically hold significant stakes in the companies that comprise their portfolios. Given their larger stakes and focused holdings, they are less subject to the “rational apathy” that characterizes more diversified and even indexed investors, such as pension and mutual funds, who hold smaller stakes in many more companies. So viewed, hedge fund activism can bridge the separation of ownership and control to hold managements accountable. Others, however, believe that activist hedge funds have interests that differ materially from those of other shareholders. Presidential contender Hillary Clinton has criticized them as “hit-and-run activists whose goal is to force an immediate payout,” and this theme of an excessively short-term orientation has its own history of academic support. From this perspective, the rise of activist funds to power implies that creditors, employees, and other corporate constituencies will be compelled to make wealth transfers to shareholders. This Article explores this debate in which one side views hedge funds as the natural leaders of shareholders and the other side as short-term predators, intent on a quick raid to boost the stock price and then exit before the long-term costs are felt. We are not comfortable with either polar characterization and thus begin with a different question: Why now? What has caused activism to peak over the last decade at a time when the level of institutional ownership has slightly subsided? Here, we answer with a two-part explanation for increased activism. First, the costs of activism have declined, in part because of changes in SEC rules, in part because of changes in corporate governance norms (for example, the sharp decline in staggered boards), and in part because of the new power of proxy advisors (which is in turn a product both of legal rules and the fact that some institutional investors have effectively outsourced their proxy voting decisions to these advisors). Second, activist hedge funds have recently developed a new tactic – “the wolf pack” – that effectively enables them to escape old corporate defenses (most notably the poison pill) and to reap high profits at seemingly low risk. Unsurprisingly, the number of such funds, and the assets under their management, has correspondingly skyrocketed. If the costs go down and the profits go up, it is predictable that activism will surge, which it has. But that does not answer the broader question of whether externalities are associated with this new activism