In a provocative article, “How Activist Investors Became Respectable,” Harvard Business School Professor Joseph Fuller sketches how the once-hated corporate raiders of the 1980s are now treated as “respectable agents of change.” These corporate raiders, who were “once playing on the margins of the system as reviled villains,” have now become the enforcers of “the world’s dumbest idea”: maximizing shareholder value.
Corporate raiders have joined forces with institutional investors and others in the financial sector and are now “a permanent force at its center” in extracting cash from publicly-owned firms. Worse, they have turned other investors, including institutional investors and pension funds, into vultures.
Carl Icahn Photographer: Victor J. Blue/Bloomberg
How did the corporate raiders like Carl Icahn become respectable? It was not by changing their basic game plan, which still consists of extracting value from hapless corporations and then using their winnings to attack further victims in ever larger and more elaborate raids. Activists now raise huge new sums of money to invest in and attack even the world’s largest and most prestigious companies.
What has changed is that in the 1980s, the corporate raiders were acting by themselves in extracting value from corporations. Now the raiders are leading the whole business world in an unabashed dash for short-term cash in the form of winnings from the raids. "Today,” writes Fuller, “university endowments and state pension funds invest with activists, corporate directors discuss how activists will view their strategy, and the business media even treat them as celebrities.” Even schoolteachers’ pension funds have joined the raids.
A Remarkable Public Relations Turnaround
Fuller suggests that the corporate raiders have pulled off a remarkable public relations triumph. They have engaged a wide array of partners to support the raids in extracting value from corporations. A change in name helped. No longer “corporate raiders,” they have adopted the kinder gentler term, “activist investors,” as if they were high-minded social activists totally devoted to serving the public interest, thus distracting attention from their agenda, which is actually extracting cash for themselves.
The fact that university endowments and state pension funds have been getting into bed with the corporate raiders has helped. These public institutions could hardly tell their stakeholders they were engaged in “corporate raids.” They became co-conspirators with the raiders to change their label to “activist investors.”
The corporate raiders also learned how to present their vulture-like activities in a more positive light. Now they are not engaged in corporate raids or sucking the blood from once valuable corporations. Instead they are merely performing the public service of “unlocking value.”
“Activist investing gained legitimacy and influence,” writes Fuller, “thanks in part to the development of a support system from professional services such a law firms, investment banks, and consultancies that once shunned the practice and from the increasing influence of proxy advisory firms. But it was the many institutional investors who eventually embraced activists in their search for better returns who gave these hedge funds their real clout.”
Today the corporate raids are launched with considerable research and elaborate public relations fanfare. “In many cases, activists have courted both investors and the public with an informative and insightful approach to individual investments. They engage in considerable due diligence and propose specific, accountable strategies to create value for shareholders.”
Dividing The Spoils
But it’s not just a public relations turnaround. Something more fundamental is going on. Instead of keeping all their winnings for themselves, corporate raiders had the brilliant idea of inviting the rest of the world to join their party. Why not share the gains and so gain supporters for their cause? Corporate raiders induced the whole business world to join in their corporate raids and grab the short-term cash. Suddenly there was money for everyone.
Let’s be clear. It’s all about the money. In effect, the raiders are saying to investors: “Why should you as investors bother with the risk of trying to earn boring returns by growing real value over the long-term? Why not help us squeeze money out of these firms and you can become rich like us. Not next year or next decade. Today!” Sadly, institutional investors and pension funds have lost sight of their responsibilities as citizens to invest in long term value and grow the economy. Instead they are increasingly joining the raiders in the rush to grab the short-term money. They are becoming vultures too.
What the institutional investors lose sight of is that the hedge funds have no interest in the long-term welfare of the firm they are raiding or the economy as a whole. For instance, just this Monday, SEC filings revealed the activist investor, Carl Icahn, has sold his entire stake in eBay, after successfullypushingthe company to spin off its PayPal operation. Icahn had no interest in long-term well-being of eBay. His interest was in making a quick buck.
Why did institutional investors become collaborators in these short-term flimflam operations? It’s not the lengthy analytic reports or the elaborate PR that the raiders now put together. It’s the lure of short-term returns. The raiders have persuaded institutional investors that they too can make a quick buck.
The corporate raids are negative-sum games. They extract value from companies for shareholders, rather than create value for customers and the economy. The Economist writes that capitalism “is not just dividing the spoils.” Yet dividing the spoils is precisely what corporate raiders are turning capitalism into: extracting value from companies and dividing the spoils among short-term investors and the C-suite. The raids leave the victims in a weaker state to innovate for the future.
The Supposed Cure Is The Disease
Corporate raiders of course clothe their raids in noble words about “improving management.”
The result of their now pervasive corporate raids is however to induce managers to adopt a short-term time horizon with the same agenda of extracting resources for shareholders—and themselves.
The impact on corporate management of pursuing this agenda is now clear: staff reductions, squeezed operations, cutbacks in investment and R&D, reduced benefits and pensions for employees, mindless mergers, closed factories, off-shoring, and increased debt are all treated as collateral damage and necessary steps in jacking up the share price, returning value to shareholders and making the company attractive for an IPO or sale. Lavish C-suite compensation in stock gives top executives strong financial incentives to become co-conspirators with the corporate raiders. In this way, activist hedge funds turn bad managers into even worse ones.
Corporate raiders thus create a massive distraction for managers from the real task of management, namely, creating value for customers. Successfully fending off attacks requires the full-time attention of the very top management, when they should be focused on creating innovation and running the company. Thus corporate raiders now target not only poorly run companies but increasingly seek to suck value out of even the richer, best-run companies, like Apple. In their campaigns, activists often go to the very edge of what is legal.
This is not to suggest that there are no management problems in the companies that raiders attack. However the management problems are largely the result of the very philosophy that the raiders are touting, namely, the dumbest idea in the world—the idea that the purpose of a corporation is to maximize shareholder value as reflected in the stock price. Once an organization embraces this goal, then cost-cutting, offshoring and share buybacks and the rest become the central preoccupations, while investing in the future is put on a back burner.
When the majority of publicly owned companies act this way, the economic impact is disaastrous: corporate returns on assets are only one quarter of what they were half a century ago, and firms can no longer compete internationally. The economy slides into a state of secular economic stagnation, with increasing and unsustainable economic inequality.
The Rise Of Institutionalized Gambling
“But none of that would matter much,” writes Fuller, “without the growing acceptance of alternative asset classes.” Alternative asset classes are the nooks and crannies of the financial sector into which the “unlocked value” from corporate raids is now flowing.
Thus what do the corporate raiders, shareholders and executives do with the money that they have been able to extract from corporations in these raids? The corporate raiders suggest that the money is invested more productively. But in practice, it’s becoming harder and harder to find healthy investments in new production or innovation, because firms aren’t making enough of those investments. Remember: that's because those firms are busy extracting value for shareholders, not creating value!
So where do these resources go? By and large, the resources flow into various nooks and crannies of the financial sector in an increasingly desperate effort to “make money out of money.” While the real economy remains in a state of “secular economic stagnation,” the financial sector and the stock market experience spectacular growth that has little relation to what is happening to the real economy. The stock market is booming and the financial sector becomes a massive gambling casino.
Now the financial sector is no longer just the circulatory system of the economic body, performing the critical function of keeping the economy alive and healthy by enabling jobs to be created, shops to be built, houses to be bought, investments in the factories and facilities, risks to be offset and so on.
Instead, the financial sector is turned into vast global casino, of zero-sum, and negative-sum, games. Bankers became gamblers wearing pin-stripe suits. As they are gambling with other people’s money, the attractions are enormous. If their gambles pay off, they receive extraordinary compensation. If not, it isn’t their problem, because it isn’t their money that is at risk.
There are now trillions of dollars in off-balance-sheet derivatives, the very things that caused the 2008 global financial meltdown. If—or rather when—the institutional gambling hits a bad patch—analogous to fall of house prices in 2008—no one will know who owes what to whom and so the whole global financial system will once again be at risk. As the same behavior that caused that meltdown is recurring, the risk of another global financial crash is significant. We just don’t know how or where or when it will occur.
The Excessive Financialization Of The Economy
Corporate raiders thus exacerbate the already-excessive financialization of the economy. The “unbalanced power” of the financial sector has had undue influence over management mindsets. The damage caused, as Gautam Mukunda points out in his HBR article, is not only in forcing people to do what activists want, but even more in changing the way managers think, so that the managers now want to do what the activists want.
The cost to the economy of financialization "running amok" is high. According to a recent study by the International Monetary Fund, the direct cost to U.S. economic growth of an over-sized financial sector is 2 percent of GDP per year. In other words, if the financial sector were the proper size, the U.S. economy would be enjoying a normal economic recovery of 3% to 4% per year instead of the dismal 1% to 2% of the last few years. That’s a massive drag on the economy–some $320 billion per year. In effect, by becoming a vast gambling casino, Wall Street has turned itself into a macro-economic problem of the first order.
The Root Cause: The World’s Dumbest Idea
What’s at the root of all these bad behaviors is a single bad idea. It’s what even Jack Welch has called, "the world’s dumbest idea"—maximizing shareholder value. The unthinking acceptance of the notion throughout much of the business world is inducing large numbers of intelligent, well-educated actors to do some very unintelligent things.
Corporate raiders like Icahn are happy to act as the enforcers of the idea and get rich in the process. They couldn’t care less about the damage to jobs and the economy.
Yet the raiders are not the cause of the problem. They are simply symptoms. The real disease is the ideology of maximizing shareholder value. And the main damage is being done by the institutional investors who increasingly buy into the idea and join in the raids aimed at extracting value.
In short, the problem is not just that activist hedge funds are still vultures, feeding off both the healthy and the sick. The real problem is that they are now encouraging the rest of the economy to act like vultures, corrupting those who should know better.
When the main actors in the economy lose sight of their responsibilities to invest in long term value to grow the economy, and instead join with the raiders in the rush for short-term money, and use their winnings in gambling to “make money out of money,” the economy has become a house of cards. It cannot end well.
As a start towards setting things right and rooting out the world’s dumbest idea, maybe it’s time we got back to calling activist hedge funds what they are really are: corporate vultures? In that way, everyone would know what those institutional investors and pension funds who collaborate with them in their raids are up to.
And read also:
The Seven Deadly Sins Of Activist Hedge Funds
The World’s Dumbest Idea: Maximizing Shareholder Value
Why the World’s Dumbest Idea Is Finally Dying
Big Firms Increasingly Resort to Corporate Cocaine
How Corporate America Is Cannibalizing Itself
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