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The Social Role of Hedge Funds

Activists, interventionists, hedge funds are often perceived as the destroyers of capitalism. What is the real role of hedge funds?

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Many people who do not work in the finance world, have probably never heard of Mutual Funds, as opposed to Hedge Funds. The main reason being that the term Hedge Funds is often used by politicians, who reveal their ignorance of the subject. What distinguishes Hedge Funds from “standard” funds (Mutual Funds) is the degree of regulation. As Hedge Funds are not handed out to small investors but rather to the very wealthy, they are not subject to standard fund regulation. No need to protect the rich! Yet this allows for the implementation of more aggressive investment strategies, via short sales and an increased leverage. That said, the main problem among politicians is what is known as Hedge Funds activism, that is, the fact that politicians take the “power” in companies in order to impose their strategic choices and short term assumptions. Yet, a recent research article on this subject revealed results which contradicted the delivery of some so-called right-thinking political figures.

This long-term study examines strategic, operational and financial interventions that Hedge Funds implement in targeted companies. In order to analyse the positive or negative impact of activism, researchers carry out what is called event studies. These studies analyse the positive or negative variations in stock prices around the time of specific events. In this respect, the article shows that the market generally reacts in a positive way when the Hedge Funds applies activism strategies. The increase in the return rate of shares of target companies during the period prior to and after the announce of an increased position in capital would be on average 7%, and this return would persist during the year following the intervention. This would keep pace with the almost-systematic improvement of the company?s performance, unlike what one can observe with institutional investor shares, traditional investments funds and pension funds. This is due to the slightest of degree of regulation that hedge funds face and this allows them to implement more efficient activist policies.

What is more interesting, at least from a social point of view, is that these funds seem to play a real role in income distribution. During the years that followed their interventions, the income of CEOs in target companies dropped by a million dollars on average. Clearly, politicians are not able to do this - that is, limit salaries and poor management - the Hedge Funds do it! Their interventions are praised in two thirds of the case, while the shares that they possess are fairly limited. During 40% of the time, the success is complete in the sense that the main objectives have been reached, while they are only partial in a quarter of the cases, in which major concessions are obtained on behalf of target companies. With regards to the percentage of the parts held by the target company, for the majority of the cases it varies between 5,4 and 8,8%. This seems to confirm the hypothesis that Hedge Funds do not try to take control in itself, but rather aim to incite companies to set up growth policies of their market value.

What types of companies do hedge funds target? First of all, companies of value, that is companies whose own fund?s book value is superior to their market value. These companies would be underestimated, particularly for managerial reasons. Indeed, companies in question do not seem to suffer from operational problems and seem profitable at first sight. However, this does not imply that managers maximize the creation of value. The problems which these companies face stem from the governance and control of managers. Targeted companies generally distribute a weak dividend in relation to the average of the market, in spite of its profitability. Besides, companies would be too diversified, indicating attempts of "empire building” on behalf of the managers. Governance improvement further to the activism of Hedge Funds would allow for an increase the companies? worth.

Why are Hedge Funds more efficient in their activism than standard funds? First of all, Hedge Fund managers are financially more inclined to increase the value of their portfolio shares as their remuneration often includes a performance fee, that is a remuneration of 20% of the annual profit exceeding a certain threshold. Mutual Fund managers are remunerated only according to managed shares, or Management Fees. Moreover they would be more flexible in the implementation of their political investment as they would not face constraints of a political nature : accounting standards to be respected, limitation of the degree of portfolio diversification or limitation part redemption. This allows them to concentrate on target companies.

Due to this freedom of action, Hedge Funds seem to act as a real vector of the governing of a company. Their simple presence and potential of intervention seem to exercise a strong disciplinary pressure on company managers in the sense that they are forced to give the priority to shareholders wealth. Yet is this valuable transfer towards the shareholders not made at the creditors expense? The effect of activism finds itself between the internal surveillance by majority shareholders and the external monitoring by famous corporate raiders.

Michel Verlaine , April 2008

Article also available in : English EN | français FR

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