Rob Swystun, Pristine Advisers
Maybe it’s indicative of our collective attention spans growing shorter or maybe it’s just greed, but companies are increasingly forsaking long-term success for short-term success, specifically those quarterly earnings everyone loves so much.
In fact, senior lecturer at the MIT Sloan School of Management and senior fellow at the Brookings Institution Robert C. Pozen, in a blog post for the CFA Institute, cites a 2004 survey of chief financial officers that says the majority of them would forego spending on long-term projects to avoid missing upcoming quarterly earnings projections. That survey may be over a decade old now, but it’s telling that within that 10 years, short-termism has continued to proliferate.
Critics of this short term thinking have pointed to activist hedge funds that acquire a small portion of stock (typically one or two percent) and then lobby for measures that boost a company’s stock price quickly, but ultimately unsustainably. Typically, these programs will involve raising dividends, increasing stock buybacks or spinning off corporate divisions. They also generally want board seats.
So, how exactly does an activist hedge fund that only holds a smattering of shares enact their grand schemes? They win the support of a major shareholder like mutual funds, pension plans and other institutional investors that own a majority of a given company’s stock.
As these institutional investors are obviously interested in a company’s long-term success, they would easily be able to block any activist hedge fund proposals that weren’t deemed to be for the good of the company.
But, many institutional investors don’t take an outspoken position for or against activist hedge fund proposals. And, despite their minimal holdings of stocks, company executives have been known to cave to activist pressure by adopting new strategies or adding new board members sans shareholder vote.
Pozen cites the example of activist Harry Wilson managing to pressure General Motors (GM) into using $5 billion of its cash to buy back stock, which Pozen points out doesn’t make much sense for the company, as it needs a substantial cash cushion to protect it from possible downturns. But, GM agreed to the activist’s proposal without putting it to a shareholder vote.
Why Institutional Investors Don’t Engage
It should stand to reason that an institutional investor would want to push for corporate reforms that advocate long-term success of the company, but this generally doesn’t happen and Pozen lists the following systematic reasons why he believes this doesn’t happen more often:
- Over 30% of US stock assets under management are held in index mutual funds or exchange-traded funds that are based on indexes and many managers of index funds have no analysts with in-depth knowledge of most stocks in the particular index. Therefore, these index funds are not in a good position to analyze an activist’s program for a specific company.
- Actively managed funds tend not to publicly take a strong position on either side of a proxy fight unless doing so meets a cost–benefit test and the cost of participation is rather high in terms of management time and potential litigation.
- If a fund does use significant resources in supporting or opposing an activist’s program, the fund incurs all the costs of the campaign while most of the benefits go to other shareholders who have not contributed to the costs.
- Some asset managers have effectively turned over their voting decisions to proxy advisory firms, which may or may not have a long-term perspective.
- Activist hedge funds frequently concentrate a large portion of their assets in the stocks of a few target companies and managers of these funds receive an incentive fee equal to 20% of realized gains making the cost-to-benefit ratio in proxy fights much better for concentrated activist funds than for diversified mutual or pension funds.
- Activist hedge funds can control a much higher percentage of proxy votes than their share numbers would indicate because of a practice called empty voting. Asset managers can lend their shares to a hedge fund and then not recall them for a contested proxy vote; or hedge funds can cast a significant portion of the votes in a target company’s election while maintaining an economically neutral position by shorting the target’s stock.
Encouraging Institutional Investors to Engage
To get institutional investors to engage and take more vigorous positions on activist proposals, Pozen suggests:
- Securities regulators, CFA Institute and other relevant organizations should publicly advocate that when an institutional investor is the largest shareholder in a company, it should play a decisive role in determining the outcomes of activist campaigns against the company rather than staying silent on the subject.
- They should study a proposal’s potential impact on the company in the long run and base their decision on how well it would impact the company.
- Regulators across the globe should examine the complexities of empty voting and adopt a well-designed rule against acquiring votes without comparable ownership. Even without any government action on empty voting, institutional investors can include in their stock loans a provision retaining the right to vote the stock in the event of a proxy fight.
- Institutional investors should push for their vision of sustainable long-term growth through engagement with the companies they own.
- Institutional shareholders should be proactive in the process of nominating directors with a long-term approach to corporate growth.
- Institutional investors should reject a company’s compensation plan if it puts too much emphasis on short-term results and should push for a three-year performance period for determining cash bonuses.
If institutional investors are dissatisfied with a company’s performance, they no longer have to choose between selling the stock or opposing management. They can now, as Pozen puts it, start acting like the big owners they are. If they want long-term performance to be a top priority, they can — and should — start using the power they have to make it a top priority.