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The Case for a New Super Hedge Fund
Meet the Super Hedge Fund
The investment world has a love-hate relationship with activist hedge funds. Some activist funds have achieved impressive results over the years by shaking up sleepy corporations, extracting results for shareholders and kicking out ineffective management. On the other hand, other activist funds have caused more trouble than they are worth by entering a position, shaking up a business to draw out every drop of profit and then moving on with little regard to employee welfare and company longevity.
Hedge fund activism isn’t perfect, but in some cases, activists are needed to help a company realize its full potential. Furthermore, hedge fund activism can rally institutional investors to promote certain operational goals at major US companies although it is a highly indirect mechanism for institutional investors to wield their power.
Dean and Professor of Law at Tel Aviv University Faculty of Law, Sharon Hannes believes there is a way to achieve the goal of corporate activism and producing the best results for shareholders while at the same time enacting changes that are in the best interests of a company and its employees.
The Case For A New Super Hedge Fund
In a research paper first published in the Delaware Journal of Corporate Law (DJCL), Vol. 40, No. 1, 2015, Hannes looks at the idea of a “Super Hedge Fund”, which would ideally maintain the benefits of hedge fund activism, while curbing its downsides.
This non-traditional hedge fund would not really be a fund but rather “a contractual arrangement among a broad group of institutional investors and a task force of financial experts.”
Hannes described this further in a Harvard Law School Forum on Corporate Governance and Financial Regulation column:
“Imagine that an organization gathers teams of experts to form independent task forces for each market sector or a well-defined group of corporations. This initial recruitment of experts for the task forces would become unnecessary once the task forces gained reputations in their own right. The organization would also draft a standard agreement to be signed between each task force and as many institutional investors as possible.”
Rather than raising funding from private investors to finance activist activity, once the task force has begun to zero in on a potential target, it would be allowed to make a so-called “capital call” from institutional investors with shares in the target, pro rata to their holdings. Those institutional investors that are past the task force but do not hold shares in the target would not be asked for funding. Such a funding structure is, according to Hannes “crucial in creating the task force’s direct accountability as an activism agent to the institutional investors of the specific target in question.” Moreover, to “minimize the “free-riding risk,” the standard agreement would also include a provision that allows the task force to engage a target only if the aggregate holdings of the parties to the agreement top certain threshold, perhaps 25%.”
Fully funded, the task force would actively engage the target and push it towards the goal. Any action that requires the vote of institutional investors, including proxy fights would not be fought by the task force, but instead, the Super Hedge Fund would hold an advisory role in relation to the institutional shareholders.
Hannes goes on to suggest that there would be two key ways of monitoring the Super Hedge Fund to ensure its actions remain relevant. First of all contracts with institutional investors would have to be renewed periodically and a “financing reload” would be required after a certain number of campaigns. Secondly, the standard contract between task force members may stipulate that “certain actions require the consent of the relevant institutional shareholders, even if such actions do not require a shareholder vote.”
By bringing in this theoretical “super hedge fund” Hannes believes it is possible to eliminate four common flaws of activist hedge funds. These include enormous transaction costs as a hedge fund trades in and out of a position, a lack of long-term duties to shareholders, disproportionate wealth creation and a lack of significant ownership to drive long-lasting change. Activist hedge funds generally own a small slice of public businesses giving them less leverage over institutional investors. A Super Hedge Fund should remedy this problem.
This article was originally published in ValueWalk.