Loving Critics or Critical Lovers?

If you are the executive leader of a public company, you probably assume that the benefits of being public are in the strategic best interests of your company: benefits such as the ability to go to the public market to raise capital when you need it, having the liquidity and the flexibility that capital markets provide, and—last but not least—having the enhanced respect and reputation that goes with being part of a market system that values your company. Aside from the increased expenses of being public due to governmental regulations stemming from the Sarbanes-Oxley Act, being public is generally a win-win situation for companies and their shareholders.

And most of the time, even when outstanding shares are held by institutional investors, such as private-equity funds, pension funds, and hedge funds, the managers of these funds tend to be more passive investors and allow company management to be in control. If fund managers aren’t happy with the company’s results or its direction, they generally “vote with their feet” by selling their shares and moving on.

However, it’s not unusual for a handful of institutional investors to control the majority of the outstanding voting stock. A growing number of activist fund managers are attempting to get institutional investors to join with them in order to influence a company’s decisions and get the best returns for their fund investors. Sometimes, that tactic isn’t in the best long-term interests of the company or its other shareholders.

Trends in Extreme-Value Investing

Let’s examine hedge fund managers more closely, because they are the fastest-growing group—it’s a $1.5 trillion industry—of activist fund managers. The number of hedge fund managers who are activists is still a minority, but it seems to be a trend that’s here to stay because of their success in getting healthy returns for their investors.

Unlike the corporate raiders of the 1980s, who generally took controlling interests in their targets, today’s hedge fund managers take relatively small positions in companies to maintain the diversification their investors seek. However, they flex their muscles by gaining seats on the boards of directors of companies, soliciting and aligning other institutional investors with them, and pushing for change that will quickly boost the company’s stock price. Their goal is to force the company to make a highly visible strategic move, such as a change in management, sale of assets, or a large stock buyback or dividend, which creates a short-term increase in the company’s stock value.

Most of the time, activist fund managers will work behind the scenes to pressure management to make the change they are seeking. Occasionally, their efforts are more visible, such as those of hedge fund manager Carl Icahn of Icahn Partners, who took out a full-page ad in the Wall Street Journal in May asking Motorola shareholders to vote him onto its board because current management had a “critical failure in oversight and leadership.”

Some activist fund managers have been successful at making money for their investors. According to a recent study led by Duke University, when news of potential fund manager activism hits the headlines, a company’s stock price can jump 5 to 7 percent, with no apparent reversal of the trend for a year after the fund announces its intentions.

A larger force in the market than hedge funds are the approximately 8,000 mutual funds, which make up an $8.5 trillion industry. Yet mutual fund managers are traditionally a quiet force in the boardroom because of strict rules on a fund’s ability to influence companies. I believe mutual fund managers are afraid of being perceived as nasty, headline-grabbing activist investors. But some are beginning to say that mutual fund managers act like renters instead of owners, and should be more aggressive on behalf of their investors. So we may be seeing more activist mutual fund managers, too.