For those hoping for a return of a vibrant market for corporate control (last seen in the 1980s) and the discipline it brings to corporate governance, hope may be on the way. First, some background:
The fact pattern for my exam in Corporations last year was Oliver Stone’s fabulous movie “Wall Street.” This isn’t as cute as it seems. The movie, despite being sloppy with the law and largely mixing up the villains and the heroes, is a perfect snapshot of the market for corporate control that prevailed in the 1980s. From 1982 until the collapse of the high-yield (“junk”) bond market in 1989, approximately 60% of large U.S. firms were either takeover targets or restructured on their own. While all LBOs, MBOs, and corporate takeovers did not succeed, the threat of a hostile raider was so real and so scary for management, that it provided unprecedented discipline on managerial behavior. Executives no longer sought to build empires, like the synergy-free conglomerates slapped together in the 1970s, and executive compensation, instead of being based on firm size, became linked to shareholder value through the use of options and other equity compensation. A related outgrowth of this takeover activity was the creation of shareholder activist organizations and movements, such as Council of Institutional Investors and Institutional Shareholder Services. Very often, the public motives of these “good guy” activist groups and the “bad guy” raiders were aligned. Just take one example from the movie that mimics reality: Gordon Gekko’s speech to the board and management of Teldar Paper at its annual stockholders’ meeting. Gekko—the supposed villain—rips the executives for wasting the shareholders’ money on country club memberships, hundreds of do-nothing vice presidents, excessive compensation, and “golden parachutes.” One can imagine CII or ISS making these same arguments then and now.
Critics of the corporate raiders—like Mr. Stone—criticized the self-interested motives of the raiders, pointing out that very often raiders were looking for side payments to go away (“greenmail”) or were looking to get in, get rich, and get out, without any long-term plan for the firm. Some raiders used these strategies to be sure, but the criticism is misplaced, because, as Adam Smith pointed out centuries ago, it is precisely reliance on the self-interest of the baker to which we owe our daily bread. The critics mistakenly indict the entire practice by impugning the motives of the actors instead of looking at the consequences of those actions. (They also conveniently ignore the fact that the “good guys” (CII, ISS, and CALPers, just to name a few) are acting in their own self-interest as well.) This is not to say that the ends always justify the means in these cases, but merely that ends and means should both be relevant to any assessment of the value of raider behavior.
Takeovers, at least the hostile kind with its attendant disciplining effects on businesses as a whole, largely disappeared in the 1990s. One of the chief culprits was the invention of so-called “shareholders’ rights plans,” better known as poison pills. Pills, along with other takeover defenses, such as staggered boards, and government regulation of takeover activity (largely through the Williams Act) enabled management to raise the cost of hostile takeovers sufficiently to all but drive them out of existence. So if the 1980s was the era of raider-imposed discipline, the 1990s saw the return of management power.
This change produced a cottage industry of critics, many of whom ironically complained about the tactics of corporate raiders. There criticisms can still be heard today. Read any newspaper, or listen to any news program on the radio or TV, and you will hear a Gekko-like refrain coming from today’s ivory tower corporate activists. They argue that managers are exploiting the separation of ownership (shareholders) and control (executives), and that the solution is a greater role for shareholders in some firm decision making. Lucian Bebchuk and Jesse Fried (law professors at Harvard and Berkeley, respectively) just published a book on executive compensation that makes just this argument, and the SEC is considering a new rule that would allow shareholders the power to propose directors for election under certain conditions.
There are serious doubts about whether these reforms will resurrect the discipline we saw from a vibrant market for corporate control. While a full critique requires more space and time, let me just mention a few obvious objections. For one, it is not at all clear that a few minority directors would be able to bring any significant changes to a board of directors. The more likely consequence is that these directors will be marginalized (e.g., in terms of information) because they will bear the stigma of dissidents. In fact, they may end up disrupting board functioning by creating warring camps within the board, all of which are vying for the favor of management. In addition, it is doubtful that empowering shareholders will result in substantial changes in executive compensation and other areas of concern for activists. As I show in a forthcoming paper, reuniting ownership and control (in going private transactions, MBOs, and chapter 11 restructurings) does not result in changes in compensation practices, suggesting that empowered boards or shareholders are unlikely to be the saviors they are made out to be.
A better solution would be a return of market discipline. Activists recognize this to some extent, since they urge government regulation to limit takeover defenses (such as poison pills and staggered boards). But any regulatory solution is likely to sweep too broad since it will prevent the use of takeover defenses even when they are legitimately invoked and will maximize firm value. Thankfully, there may be a true market-based solution on the horizon – a return of the corporate raiders of the 1980s.
Who are the new raiders? In short, hedge funds. Today there are more than 8000 funds with more than $1 trillion in assets under management, and these funds have the potential to revolutionize corporate governance. (In fact, the Wall Street Journal called funds the “new corporate activists” and investors like Carl Ichan wear the mantle proudly.) Hedge funds are uniquely positioned to recreate the discipline of the market for corporate control for several reasons related to the unique nature of hedge funds.
First, hedge funds are, by virtue of their ability to employ a broad range of investment strategies, able to move quickly to exploit arbitrage opportunities created by inefficient managers. One of these investment strategies employed by “event-driven” funds, involves destabilization and takeover efforts of firms that are mismanaged. An example of a destabilization campaign is Carl Ichan’s recent criticism of TimeWarner management; an example of a takeover effort is Eddie Lampert’s recent purchase of Kmart and Sears. In each of these cases, hedge funds employed their capital in a focused and leveraged manner in an attempt to wrest control of key day-to-day business decisions from existing management. Other firms with questionable balance sheets and strategies are taking note.
Second, funds are able to avoid the bite of many takeover defenses by using parallel investing techniques – funds follow each other’s investments and support each other’s initiatives at target firms. This tacit cooperation—independent decisions by investors with similar goals—allows hedge funds to avoid being treated as a “group” under the securities laws, which would trigger disclosure obligations that raise the costs of takeover activities. It also allows funds to create a “wolf pack” that can exercise effective control over target firms without reaching ownership thresholds that would trigger a firm’s poison pill. To cite just one recent example, consider the play for Beverly Enterprises. Hedge fund Formation Capital announced that it had acquired 8.8% of Beverly's stock and was proposing an acquisition of Beverly. Within hours of this announcement, almost 50% of Beverly's shares were in the hands of hedge funds and arbitrageurs who were aligned with Formation’s strategy for taking control. Formation and its tacit partners were thus able to make a credible play for control without jumping over any of the normal regulatory or contractual hurdles.
A third characteristic is the vast amounts of equity capital that funds can deploy quickly and at low cost. While the raiders of the 1980s relied on junk bonds and other third-party financing to make takeover threats credible (using so called “highly confident letters” invented by Michael Milken), hedge funds have their own cash to spend. Moreover, they can multiply their influence by deploying leverage ratios of up to 25:1 provided by investment banks. The lower cost and increased threat enables funds to be far more potent than raiders of the 1980s.
While it is too early to tell whether event-driven funds (about $120 billion out of the $1 trillion market) will bring market discipline to firms in general and over the long term, the possibility is sufficient to suggest caution in regulatory efforts that may have the unintended consequence of killing the nascent market for corporate control. For example, in an article in Legal Affairs, David Skeel criticized hedge funds for occasionally engaging in transactions that separate economic and voting interests in takeover targets, in effect allowing the fund to lock in a profit if a deal goes though even if shareholders might lose as a result of the transaction. This practice might warrant some regulatory attention, a subject I’ll return to in future papers and posts, but any criticism of hedge funds’ self-interested actions should bear in mind Adam Smith’s wisdom and the likely benefits that funds’ unimpeded actions in the aggregate may have on corporate governance.