November 23, 2005
Hedge Fund Activism
Posted by Gordon Smith

Today's W$J contains a sobering article on shareholder activism by hedge fund managers. The motivation for activism is that "it is getting tougher to show top-notch returns as more hedge funds pursue similar investment ideas and overall market volatility drops." This is the best argument against shareholder activism that I have seen in a long time. Does anyone (other than a hedge fund manager) believe that hedge fund managers know more about the companies in which they invest than the officers and directors of those companies?

This reminds me of the 1980s:

A chief complaint is that many companies are sitting on oodles of cash earning paltry returns, and it should be returned to shareholders through share buybacks or dividends. Companies in the Standard & Poor's 500-stock index have accumulated more than $650 billion in cash, up from $329 billion five years ago, and almost a third of the nonfinancial stocks in the S&P 500 have more cash than debt. Other companies are sitting on valuable real estate that isn't being appreciated by the market, restive investors argue.

If you need a refresher on the 1980s, I would recommend this article by Michael Jensen, which discusses the adverse incentive effects associated with large free cash flows. Here is the abstract:

The interests and incentives of managers and shareholders conflict over such issues as the optimal size of the firm and the payment of cash to shareholders. These conflicts are especially severe in firms with large free cash flows--more cash than profitable investment opportunities. The theory developed here explains 1) the benefits of debt in reducing agency costs of free cash flows, 2) how debt can substitute for dividends, 3) why diversification programs are more likely to generate losses than takeovers or expansion in the same line of business or liquidation-motivated takeovers, 4) why the factors generating takeover activity in such diverse activities as broadcasting and tobacco are similar to those in oil, and 5) why bidders and some targets tend to perform abnormally well prior to takeover.

I do not intend to condemn the 1980s wholesale, but I believe that the virtues of leverage often were exaggerated, especially at the end of that decade. Perhaps the time is right for an academic defense of cash stockpiles.

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