Getting alpha from activism

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.
However, companies have important stakeholders, notably their employees, with their own interests. Normally, only the interest of the top layer of employees is taken into account and it is rare that the rest is even heard, let alone represented. Also, some companies must take into ‘cost’ in the field of social responsibility in order to be publicly accepted. There would be an outcry if, for example, a best in class oil company would be besieged in order to be sold to much lower performers working at lower cost and responsible for recent major environmental incidents. Such a situation would hurt trust in pension funds if they were seen as approving of the hedge fund action. Hedge funds can avoid such pitfalls where they occur, but they don’t always do so. For this reason, they have acquired a doubtful image, being called locusts in more than one language. Such easy classifications do not do justice to the good hedge funds, though. So, when can a pension fund profit from hedge fund activism?
Hedge fund action is not a good method to effect change. Hedge funds want the company to dissolve, not to repent.However, hedge fund action is an argument in engagement: restructure yourself, or hedge funds will restructure you out of existence.
The advantage of the argument is that it is realistic. The disadvantage is that threats work only if you are prepared to see them through. Hedge funds need pension funds as allies, not the other way around. When they come to you for support you have leverage on their behaviour. You can ask yourself to what extent their goals match yours and how hard they will pull on the leash. Therefore, you can manage the image risk that hedge fund activism brings along. As a shareholder you are implicated in hedge fund action. Therefore, careful planning is required. You’ll want to have a clear position that is often repeated in the media so that your constituency will know where you stand and on what points you are or are not allied with the activist hedge fund. If someone misrepresents your position, you should react, lest people take the misrepresentation for truth. And if you find that your goals and theirs don’t match, you should go actively against them and score points that way.
Peter Kraneveld is an international pensions advisor