Hedge Funds in Corporate Governance and Corporate Control.

Abstract:     
Hedge funds have become critical players in both corporate governance and corporate control. In this article, we document and examine the nature of hedge fund activism, how and why it differs from activism by traditional institutional investors, andits implications for corporate governance and regulatory reform. We argue that hedge fund activism differs from activism by traditional institutions in several ways: it is directed at significant changes in individual companies (rather than small, systemic changes), it entails higher costs, and it is strategic and ex ante (rather thanintermittent and ex post). The reasons for these differences may lie in the incentive structures of hedge fund managers as well as in the fact that traditional institutions face regulatory barriers, political constraints, or conflicts of interest that make activism less profitable than it is for hedge funds. But the differences may also be due to the fact that traditional institutions pursue a diversification strategy that is difficult to combine with strategicactivism.Although hedge funds hold great promise as active shareholders, their intense involvement in corporate governance and control also potentially raises two kinds ofproblems: The interests of hedge funds sometimes diverge from those of their fellowshareholders; and the intensity of hedge fund activism imposes substantial stress that theregulatory system may not be able to withstand. The resulting problems, however, are relatively isolated and narrow, do not broadly undermine the value of hedge fundactivism as a whole, and do not warrant major additional regulatory interventions.The sharpest accusation leveled against activist funds is that activism is designedto achieve a short-term payoff at the expense of long-term profitability. Although weconsider this a potentially serious problem that arguably pervades hedge fund activism,we conclude that a sufficient case for legal intervention has not been made. Thisconclusion results from the uncertainties about whether short-termism is in fact a realproblem and how much hedge fund activism is driven by excessive short-termism. But,most importantly, it stems from our view that market forces and adaptive devices taken by companies individually are better designed than regulation to deal with the potentialnegative effects of hedge fund short-termism while preserving the positive effects ofhedge-fund activism.

Number of Pages in PDF File: 58

working papers series