Responsible Investor

Getting alpha from activism

Can pension funds profit from increasingly aggressive hedge fund strategies?

With a relatively small investment, hedge funds have broken up large companies. When hedge funds take the initiative they need allies to succeed. Their motivation is to make an instant return by breaking up companies, which, for one reason or another, appear grossly undervalued to them, so that the parts would be worth more than the whole. Making a return is also the motivation, which is, of course, the fiduciary duty of a pension fund. But are their interests automatically aligned? Hedge funds are short-term investors. The very best, like Berkshire Hathaway, resemble self-appointed turnaround managers. The very worst destroy significant long-term value for minor short-term profits. Most are in-between. Their main instrument is the General Assembly of Shareholders. If there is one expression to describe their thinking it is shareholder value. Pension funds are long-term investors. By being activist shareholders, they play a vital part that keeps directors on their toes, which is in the best interest, not only of the shareholders, but also of the economy. That, in turn, increases the value of their investments. They have a variety of instruments, ranging from divestment, voting in General Assemblies or dialogue with the companies (engagement). Their thinking may be characterized by the expression continuity.

Being short-term investors, hedge funds have neither the time nor the inclination to be subtle. This causes resistance to their actions even when they have an excellent point. In some cultures, e.g. Japan, it is important to try solving a problem amicably before action is taken. Action makes one party lose face. Pension funds, still single-country organizations, will go with the local culture. Trades unions are often worried about hedge fund actions. Selling the parts of a company separately will often mean creating overlaps in the structure of the buyer. These are solved by firings. As trade unions are very often board members of pension funds, this entails fund governance risks for a pension fund shareholder. If the company is a national champion (a dominating market leader in a country) there may be a political reaction. The mere fact that a company is a national champion should not make it safe from hedge fund activism, but hedge funds should take the status of national champion into account and be diplomatic. Pension funds are subject to government oversight and depend on legislation, so they generally attach value to good relations with the government. The subtlest trap is that hedge fund action can easily be seen as an approach that limits the value of companies to their potential profitability.

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