Corporate Governance and Hedge Fund Activism

Introduction

Corporate governance can be defined as a system of norms and rules implemented to control how a company is managed. Boards of directors play a primary role in corporate governance. According to Tricker, their main duties include but are not limited to the selection of chief executive officers (CEOs), the enforcement of stakeholder accountability, and the procuring of financial transparency, as well as ethical leadership needed to improve shareholder value.1 Although corporate governance implies the setting of strategic aims based on values promoted by the board, it is substantially different from regular operational management. It is possible to say that its main purpose is the creation and enhancement of accountability structures in corporations.

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The intervention of governance activities through challenging board independence, information disclosure, CEO removal, and so forth is one of the possible objectives of activist hedge funds. In the definition of Leblanc, “activist” means an individual or a group of individuals who “use shareholder rights to effect change at a company.”2 From the perspective of corporate governance, such an approach to intervention in organizational strategies and culture may be beneficial as it may direct more ethical and accountable behaviors of managers and other important corporate actors in target companies.

Nevertheless, there is an ongoing debate regarding the effects of hedge fund activism among scholars, policymakers, and management practitioners. Some of them consider that activist investors are nothing but “short-term opportunists” and are “detrimental to long-term value creation” in corporations. 3 As Babchuk et al. note, this observation is especially relevant to activists with short investment horizons because it is in their interest to encourage the changes associated with short-term profitability objectives while ignoring the long-term needs of firms and shareholders with longer investment horizons.4 At the same time, supporters of hedge funds believe that activist interventions may also be realized in such a way that would benefit organizations in terms of both short- and long-term value creation. 5 Considering this, the present report aims to investigate the potential positive and negative effects of hedge fund activism on companies in the context of the corporate governance framework. It is argued that not only can constructivist hedge funds that focus on collaboration with management improve corporate governance activities in the short run but also lead to an extensive range of prolonged, favorable effects.

Problem Statement and Background

A traditional perspective on the corporate governance system implies that shareholders have a long-term stake in the interests of the firm or, in other words, they own their shares directly, for their benefit, and extended periods. Hedge fund activism inherently poses a significant threat to such a system. As stated by Strine, activists usually have no substantial interest in the target organization’s well-being and usually become shareholders merely after a decision to change an unfavorable state of affairs there. 6 At the same time, activist shareholders often tend to be the most vocal members of the board and often aggressively push changes.

However, a primary concern of the opponents of hedge fund activism is its narrow focus on the short-term improvement of financial performance. The first main reason for this is a significant, historical prevalence of activists who held their positions in target companies for just one or two years.7 Secondly, activist hedge funds usually invest in firms not because they like them but because they know ways to enhance companies’ stock prices. Thus, Strine notes that activists typically target those companies, which are “fundamentally profitable, but undervalued.” 8 In support of this statement, evidence provided by Brav, Jiang, and Kim demonstrate that activists whose major goal is to maximize shareholder value comprise approximately 59% of the total number of 2,624 activism events.9 At the same time, activists that see governance interventions (for example, encouragement of changes in executive compensation or representation of board members) as their primary goals constitute only 31% of the same sample.10 It is apparent that if the first group of activist hedge funds is not involved in the target organization for a longer time and uses aggressive tactics to boost value maximization, some detrimental effects on particular organizational aspects can be induced by their actions. A thorough analysis of both potentially favorable and adverse impacts of activist hedge funds with limited investment horizons will be provided in the following section.

Problem Analysis

Culture and Integrity

A narrow focus on financial metrics of performance implies task- and result-orientation in the general management approach. According to Popadak, “increases in shareholder governance [through hedge fund activism] lead to statistically significant increases in results-orientation and statistically significant decreases in customer-orientation, integrity, and collaboration.” 11 It means that by focusing on performance outcomes as essential short-term objectives, managers often neglect intangible assets and their role in business sustainability. It is valid to assert that corporate culture may be considered one of the most important assets for achieving excellent long-term results.

In general, organizational culture defines the patterns of employee interaction, which values they share, and which behavioral norms they comply with. As stated by McClain, values are the basic units of corporate culture as they demonstrate the aspirations of the company.12 At the same time, it is difficult to look at financial success and an increase in the firms’ stock prices as a value in itself. The traditional leadership style framework suggests that the focus on outcomes is a core feature of transactional or autocratic leadership approaches.13 One of the advantages of such a managerial style is the maximization of performance efficiency in the short run through the imposition of rules and regulations, which often involve some form of punishment of disobedience, leading to desired outcomes.14 In this situation, employees are frequently not involved in decision-making, and their needs and interests may be ignored. As a result, an incapability to add employee values entails reduced job satisfaction and motivation, which consequently deteriorates the overall workplace climate and productivity.

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The findings provided by Popadak and Brav et al. support the suggestion that activist hedge funds centering their interventions on financial metrics and short-term objectives are detrimental to the cultural integrity of target companies and, therefore, undermine their long-term sustainability. For example, Brav et al. task-oriented management approach is linked to greater scrutiny over wages, whereas possible efficiency interventions may significantly reduce the level of wages that are above the industry average.15 Statistical data also shows that increased governance is associated with decreases in goodwill and customer satisfaction, and it consequently results in a 1.4% decline in firm value in up to five years after intervention.16 Considering that intangible assets, such as culture and employee motivation systems, are important variables in generating company value and maintaining business sustainability, short-term hedge fund activism interventions that do not take them into account can harm target firms.

Regulatory Aspects

Due to the perceived negative effects of hedge fund activism, policymakers and leaders of corporations aim to reduce their involvement through various regulations. As Bebchuk et al. state, the arguments about long-term costs of activist hedge funds were used for “limiting the rights of shareholders with short holding periods, tightening the rules governing the disclosure of stock accumulations by hedge fund activists, and corporate boards’ taking on an adversarial approach toward activists.”17 These policies are meant to control the so-called “wolf pack,” predatory, raider behaviors of activists when they start to accumulate shares before going public while influencing other “wolves” to move into the stock at the same time.18 As a result, the main activist or “alpha wolf” manages to reap a significant portion of profits, while the rest of the wolves in the pack grab some chunks to themselves as well.19 This form of aggressive takeovers is most likely to leave the company burdened with the long-term costs of hedge fund activism.

The imposition of a stake disclosure regime under Section 13(d), which forces activists to disclose their stake-related information to the public, may thus be regarded as a good preventive measure needed to minimize the risk of harm to long-term shareholders. Paces note that in the United States, “ownership disclosure is triggered by the crossing of a five per cent beneficial ownership threshold, after which the shareholder has 10 days to disclose its stake.”20 However, Paces argues against such strict regulations and suggests that low thresholds and a short period to disclose information are detrimental to activist hedge funds as they prevent them from gaining profit by buying undervalued stock. 21 It is possible to say that the potentially negative effects of these regulations on hedge fund activities may be especially evident when activists focus on governance interventions and sustainable improvements rather than maximizing financial gains alone. The problem is that current regulations do not allow discerning the type of hedge fund activism. By providing companies and their shareholders with an opportunity to choose the best disclosure regime based on individual characteristics of hedge funds, it would be possible to benefit them more.

Technology

As it was partially described above, many studies demonstrate that activist hedge funds induce improvements in productivity and efficiency. For example, Bebchuk et al. state that activists’ interventions usually lead to long-term performance improvements rather than performance declines.22 Brown comes to a similar conclusion and states that such interventions are “actually beneficial for companies in the long-term.” 23 It is possible to assert that one of the possible ways through which such results may be attained is the improvement of companies’ technological capabilities and innovativeness.

Research evidence makes it clear that hedge fund activism may increase company value by improving efficiency and productivity in the context of research and development (R&D). According to Wang and Zhao, it happens because many activists encourage their target firms to allocate resources to higher-quality and potentially more lucrative projects and to learn from other innovative enterprises included in their investment portfolio. 24 In this situation, the history of R&D activities and orientation toward innovation becomes the main prerequisite for successful technology interventions. As stated by He, Qiu, and Tang, “activist hedge funds tend to target industry-specific firms with low innovation output, which experiences a substantial increase upon active intervention.” 25 Moreover, it is observed that it is typical for activists to regard R&D as a form of investment and to link it with organizational competencies. 26 In this way, activists’ interventions can potentially enhance technological capabilities, as well as innovation quality and quality of a technology firm.

There is a substantial pool of evidence in support of observation regarding the links between innovativeness and the market value of companies. According to Berzkalne and Zelgalve, corporation value is closely associated with knowledge assets, as well as various patent measures.27 Nevertheless, in the case of hedge fund activism, there is also a chance for failure because many activist interventions involve previously untested approaches and the overall technological environment is abundant with risks that a difficult to foresee.28 Berzkalne and Zelgalve also not that too much innovativeness may have counterproductive effects and lead to a decline in market value.29 Therefore, environmental factors along with the overall managerial objectives and tactics must be considered by the board when choosing methods and investment projects aimed at the maximization of firm value.

Moral and Social Dimensions

As the findings of the literature review show, hedge fund activism has multiple ethical implications. According to Strine, a significant number of Americans “have their wealth invested indirectly in equity and debt capital markets through a more traditional means–a pension plan.” 30 It means that their welfare is dependent on the ability to receive high work payment, as well as the stability and soundness of pension funding. With this in mind, Strine suggests that a corporate governance system that fosters investments in the development of useful services and products is in the interest of human investors (namely, members of the US society, as well as any other community) because it ultimately leads to sustainable profits and wealth.31 The focus on short-term results at the expense of long-term advantages has contrary effects. It means that hedge fund activists that are not accountable for the long-time implications of their interventions may diminish social welfare and, in this way, their actions may not be considered ethical.

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At the same time, shareholder activism can be used as a primary tool to realize corporate social responsibility (CSR) strategies. In her article, Fortado notes that a greater number of hedge funds are now preoccupied with environmental, social, and governance practices, which constitute the core of the CSR framework, to boost organizational performance. 32 Not only do such initiatives help enhance organizational culture and encourage the adaption of more ethical leadership approaches but also can stimulate profitability. For example, the findings by Dimson, Karakaş, and Li reveal that “CSR engagements generate a cumulative abnormal return of +1.8% over the year following the initial engagement.”33 Similar results are reported by Fortado who notes that organizations showing more ethical behaviors are usually valued more than their rivals.34 However, it is worth noticing that activist shareholders often hold positions in target firms for a longer time than regular equities hedge funds and take relatively large stakes in them.35 Such an approach provides more opportunities for productive cooperation with managers and members of the board, and should thus be considered as one of the effective ways to maximize shareholder value.

Recommendations

The problem analysis results demonstrate that there are different types of hedge fund activism and they may be associated with distinct effects on organizations. Considering the potential ethical implications of activist interventions, it was observed that short-term interventions could undermine the corporate culture and decrease stakeholder accountability. Therefore, it is possible to suggest for the board of directors to utilize a more constructive activism approach, which has the purpose of increasing company value through active cooperation with managers. When speaking of the regulatory and legal situation about hedge fund activism, it seems that current policies can reduce the influence of activist shareholders. Therefore, it may be recommended to consider longer investment horizons with a greater stake in the target company.

These recommendations are based on recent research evidence and scholars’ statements. For instance, Strine claims that “the more successful activist funds are the ones more likely to take a fiduciary position, by seating a representative on the target board and hold their investments for five to ten years.”36 Additionally, Wang and Zhao note that by having a larger stake in the target firm and by having a direct interest in its long-term success, activists become able to engage in the managerial decision-making process more effectively.37 The establishment of long, deep, and transformative relationships among investors and their target companies also correspond with the framework of virtue ethics in which the generation of maximum benefits for all involved parties is a primary element. 38 When all these conditions are considered by investors, shareholder activism is likely to have favorable impacts on both corporate governance and organizational performance.

While preferring collaboration and constructive dialog with managers, members of the board can also consider using the socially responsible investment (SRI) tactics. According to Dyck et al., the growing popularity of this method among institutional investors worldwide is predetermined by both financial and social motivations.39 First, SRIs protect against event risks and foster product differentiation.40 Secondly, they are regarded as a means to address current social pressures and develop a corporate culture that would meet stakeholder interests better.41 Additionally, Hong and Liskovich note that CSR adds value to the company by creating a positive corporate image.42 Based on this, it is possible to say that long-term SRIs aimed at collaborating with managers can help avoid the deficiencies linked to the task-oriented leadership style, which leads to negative impacts on intangible assets of the firm. On the contrary, in line with the CSR framework, this form of shareholder activism allows enhancing corporate culture and consequently contributes to the development of social and financial capital.

Since it was mentioned above that a lot of ordinary Americans may depend on the success of hedge fund interventions, especially when activists take funds from pension funds and similar public entities, shareholder activists need to ensure full disclosure of information to establish trust. In case members of the board do not take a fiduciary position in a hedge fund but the only vote for or against proposed interventions, they should insist on transparency as per the CSR framework. According to Strine, “disclosure about average and median holding periods for particular investments would be illuminating, by giving investors and regulators reliable information about portfolio turnover and how much a fund deviates from a buy and hold strategy.”43 This type of transparency will help better understand intervention performance and its effects on various shareholders. Moreover, such disclosures can discourage wolf-pack behaviors among activists.

Summary

Based on the results of the literature review conducted in the present report, it is possible to conclude that investors’ intentions and relations with the target company largely determine the nature of hedge fund interventions, as well as the effects they may have. Many scholars and practitioners in the field of management oppose hedge fund activists, perceiving them as raiders and referring to the potential detrimental impacts of their involvement on organizational performance in the long term. Nevertheless, evidence shows that activist interventions often affect organizations positively, especially in terms of production and technology efficiency, as well as the enhancement of the overall company value. At the same time, depreciation of intangible assets is identified as one of the negative effects of short-term, outcome-oriented activist interventions. It is observed that this factor can ultimately lead to a decline in productivity and firm value. The best way to minimize these risks is to realize activist hedge fund strategies with long investment horizons and a focus on CSR. It was demonstrated that SRIs help meets the interests and needs of various stakeholders including institutional and human shareholders who benefit from the sustainable growth of companies.

Lastly, the analysis of regulatory aspects associated with hedge fund activism made it clear that current laws requiring disclosure under lower thresholds and within shorter windows can reduce the influence of activist shareholders. Investments for a longer period and with a greater stake in the company can help resolve the problem of limited engagement in decision making. At the same time, the requirement for disclosure of information may be regarded as a CSR tool because transparency is associated with a favorable investment philosophy and helps establish trust with stakeholders.

Bibliography

Alford, Helen, and Silvana Signori. “Brief Considerations on the Effectiveness of Shareholder Activism.” Electronic Journal of Management, no. 3 (2014): 1-10.

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Allaire, Yvan and François Dauphin. “The Game of ‘Activist’ Hedge Funds: Cui Bono?” International Journal of Disclosure and Governance 13, no. 4 (2016): 279-308.

Bebchuk, Lucian A., Alon Brav, and Wei Jiang. “The Long-Term Effects of Hedge Fund Activism.” NBER Working Paper Series. Web.

Berzkalne, Irina, and Elvira Zelgalve. “Innovation and Company Value: Evidence from the Baltic Countries.” Regional Formation and Development Studies 11, no. 3 (2014): 39-51.

Brav, Alon, Wei Jiang, and Hyunseob Kim. “Hedge Fund Activism: A Review.” SSRN. Web.

Brav, Alon, Wei Jiang, Song Ma, and Xuan Tian. “Shareholder Power and Corporate Innovation: Evidence from Hedge Fund Activism.” SSRN. Web.

Brown, Jason Michael. “Analyzing the Long-Term Performance of Activist Targets.” Yale University. Web.

Dimson, Elroy, Oğuzhan Karakaş, and Xi Li. “Active Ownership.” Harvard Business School. Web.

Dyck, Alexander, Karl V. Lins, Lukas Roth, and Hannes F. Wagner. “Do institutional investors drive corporate social responsibility? International evidence.” Journal of Financial Economics (2018): 1-22.

Fortado, Lindsay. “Why activists are cheerleaders for corporate social responsibility.” Financial Times, Web.

Giltinane, Charlotte Louise. “Leadership styles and theories.” Nursing Standard 27, no. 41 (2013): 35-39.

He, Zhongzhi, Jiaping Qiu, and Tingfeng Tang. “Hedge Fund Activism and Corporate Innovation.” UTS. Web.

Hong, Harrison, and Inessa Liskovich. “Crime, Punishment and the Value of Corporate Social Responsibility.” SSRN. Web.

Leblanc, Richard. The Handbook of Board Governance: A Comprehensive Guide for Public, Private and Not-For-Profit Board Members. Hoboken: John Wiley & Sons, 2016.

McClain, Mark. “How Corporate Culture Can Make (Or Break) Your Organization.” Forbes, Web.

Paces, Alessio M. “Law and Economics of Hedge Fund Activism.” Ethical Boardroom. Web.

Popadak, Jillian. “A Corporate Culture Channel: How Increased Shareholder Governance Reduces Firm Value.” UCLAAnderson. Web.

Strine, Leo E. “Who Bleeds When the Wolves Bite?: A Flesh-And-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System.” Yale Law Journal 126, no. 6 (2017): 1870-1970.

Tricker, Bob. Corporate Governance: Principles, Policies and Practices. Oxford: Oxford University Press, 2015.

Wang, Ying, and Jing Zhao. “Hedge Funds and Corporate Innovation.” Financial Management 44, no. 2 (2015): 353-385.

Footnotes

  1. Bob Tricker, Corporate Governance: Principles, Policies, and Practices (Oxford: Oxford University Press, 2015), 3.
  2. Richard Leblanc, The Handbook of Board Governance: A Comprehensive Guide for Public, Private and Not-For-Profit Board Members (Hoboken: John Wiley & Sons, 2016), 410.
  3. Lucian A. Bebchuk, Alon Brav, and Wei Jiang, “The Long-Term Effects of Hedge Fund Activism,” NBER Working Paper Series, Web.
  4. Ibid.
  5. Richard Leblanc, The Handbook of Board Governance: A Comprehensive Guide for Public, Private and Not-For-Profit Board Members, 410.
  6. Leo E. Strine, “Who Bleeds When the Wolves Bite?: A Flesh-And-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System,” Yale Law Journal 126, no. 6 (2017): 1872.
  7. Ibid., 1892.
  8. Ibid., 1891.
  9. Alon Brav, Wei Jiang, and Hyunseob Kim, “Hedge Fund Activism: A Review”, SSRN, Web.
  10. Ibid.
  11. Jillian Popadak, “A Corporate Culture Channel: How Increased Shareholder Governance Reduces Firm Value,” UCLA Anderson, Web.
  12. Mark McClain, “How Corporate Culture Can Make (Or Break) Your Organization,” Forbes, Web.
  13. Charlotte Louise Giltinane, “Leadership styles and theories,” Nursing Standard 27, no. 41 (2013): 36.
  14. Ibid., 36.
  15. Alon Brav, Wei Jiang, and Hyunseob Kim, “Hedge Fund Activism: A Review.”
  16. Jillian Popadak, “A Corporate Culture Channel: How Increased Shareholder Governance Reduces Firm Value,” 38.
  17. Lucian A. Bebchuk, Alon Brav, and Wei Jiang, “The Long-Term Effects of Hedge Fund Activism,” 17.
  18. Leo E. Strine, “Who Bleeds When the Wolves Bite?: A Flesh-And-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System,” 1896.
  19. Ibid., 1896.
  20. Alessio M. Paces, “Law and Economics of Hedge Fund Activism,” Ethical Boardroom, Web.
  21. Ibid.
  22. Lucian A. Bebchuk, Alon Brav, and Wei Jiang, “The Long-Term Effects of Hedge Fund Activism,” 76.
  23. Jason Michael Brown, “Analyzing the Long-Term Performance of Activist Targets,” Yale University, Web.
  24. Ying Wang, and Jing Zhao. “Hedge Funds and Corporate Innovation,” Financial Management 44, no. 2 (2015): 354.
  25. Zhongzhi He, Jiaping Qiu, and Tingfeng Tang, “Hedge Fund Activism and Corporate Innovation,” UTS, Web.
  26. Yvan Allaire, and François Dauphin, “The Game of ‘Activist’ Hedge Funds: Cui Bono?,” International Journal of Disclosure and Governance 13, no. 4 (2016): 305.
  27. Irina Berzkalne, and Elvira Zelgalve, “Innovation and Company Value: Evidence from the Baltic Countries,” Regional Formation and Development Studies 11, no. 3 (2014): 40.
  28. Alon Brav et al., “Shareholder Power and Corporate Innovation: Evidence from Hedge Fund Activism,” SSRN, Web.
  29. Irina Berzkalne, and Elvira Zelgalve, “Innovation and Company Value: Evidence from the Baltic Countries,” 40.
  30. Leo E. Strine, “Who Bleeds When the Wolves Bite?: A Flesh-And-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System,” 1882.
  31. Leo E. Strine, “Who Bleeds When the Wolves Bite?: A Flesh-And-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System,” 1884.
  32. Lindsay Fortado, “Why activists are cheerleaders for corporate social responsibility,” Financial Times, Web.
  33. Elroy Dimson, Oğuzhan Karakaş, and Xi Li, “Active Ownership,” Harvard Business School, Web.
  34. Lindsay Fortado, “Why activists are cheerleaders for corporate social responsibility.”
  35. Ibid.
  36. Leo E. Strine, “Who Bleeds When the Wolves Bite?: A Flesh-And-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System,” 1892.
  37. Ying Wang, and Jing Zhao. “Hedge Funds and Corporate Innovation,” 354.
  38. Helen Alford, and Silvana Signori, “Brief Considerations on the Effectiveness of Shareholder Activism,” Electronic Journal of Management, no. 3 (2014): 5.
  39. Alexander Dyck et al., “Do institutional investors drive corporate social responsibility? International evidence,” Journal of Financial Economics (2018): 11.
  40. Ibid., 11.
  41. Ibid., 11.
  42. Harrison Hong, and Inessa Liskovich, “Crime, Punishment and the Value of Corporate Social Responsibility,” SSRN, Web.
  43. Leo E. Strine, “Who Bleeds When the Wolves Bite?: A Flesh-And-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System,” 1958.
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