As the Financial Times observed today in a piece about “gathering confidence” in the hedge fund industry, “The role of hedge funds in the rebuilding of Wall Street is still being written.”
While this may sound like empty cheer leading, the hedge fund model might actually have a lot to contribute to the success of US corporations – this according to an interesting article by University of Oregon professor Robert Illig (published in the Fall 2008 Alabama Law Review).
Illig argues that the corporate oversight role often ascribed to institutional investors is not being adequately fulfilled since institutional investors (mutual and pension funds) are unable to charge performance fees:
“If institutional fund managers were permitted to adopt a similar compensation scheme [as private equity and hedge funds], their interests and the interests of their investors would merge. As a result, they would be transformed into ideal servants of shareholder interests, capable of bringing much-needed discipline to corporate America.”
Illig laments that despite their shared interest in corporate profits, institutional investors remain “largely passive” and generally elect to just sell their stakes in under performers rather that stick it out and vote for fundamental corporate changes (what other academics have termed “rationally apathetic”).
He says that such an approach is tantamount to a game of “whack-a-mole” where agency costs suppressed through corporate governance can reincarnate themselves as agency costs at the institutional investor level.
As hedge funds often charge, the chief business objective of traditional fund managers is often to grow assets and that performance is a critical, but indirect, way of achieve this. By having a direct stake in fund performance, Illig says that fund managers’ interests would better align with those of their investors.
“They could be trusted in the role of ultimate watcher because their interests would dovetail with investor interests. Agency costs would be reduced to their theoretical minimum because corporate ownership and control would be effectively integrated.”
That 70’s Compensation
The Obama administration might be interested in Illig’s comments on changing nature of executive compensation over the past 30 years and how the hedge fund model might mitigate recent problems. He says that prior to 1980, executive compensation was tied to rank, not performance per se. But the introduction of stock options in the 1980’s changed this. And in 1992, the US Congress took measures that actually penalized compensation that was not performance-based.
But Illig says that stock-options have had a “muted and perverse” effect since they offer little downside risk for under performing managers. Plus, they benefit executives who just happen to be in hot sectors – even if they are relative laggards.
Compounding this problem is the fact that many boards are actually picked by the CEO. This has, of course, led to the growing “say on pay” movement that would empower shareholders when it came to executive comp issues.
The bottom line, concludes Illig, is that options showed promise, but still haven’t aligned management’s interests with those of shareholders:
“Though incentive-compensation schemes show promise, political realities are such that management has been able to subvert their impact. Rather than discipline underperforming managers, options in fact reward all managers and encourage them to manipulate their financial results.”
Asleep at the switch?
So whither the institutional investors – often touted as a watchdog of corporate malfeasance? Illig concludes that public equity funds “appear ill-suited to play the role” of the ultimate overseers of corporate governance since they “have little incentive to fervently pursue excellence on behalf of their investors.” As a result, fund managers themselves are exposed to various agency costs (e.g. the drive to increase fund size).
The solution according to Illig is to adopt a performance-based model not just at the management level, but at the fund management level. He argues that this would reduce agency costs and prevent the kind of “empire building” that beset management teams prior to 1980.
But hold the phone. Critics of hedge fund and private equity compensation have charged that a “carried interest” is asymmetric in the manager’s favour. The manager can’t lose; they can only win. So wouldn’t an institutional investor with a carried interest simply advocate for high-risk corporate strategies in the hopes that they would get a bonus?
Possible, but not likely, according to Illig, who contends that manager co-investment would mitigate such conflicts. Besides, he says, the mere fact that hedge fund assets have grown over the past decade shows that investors feel that their interests are sufficiently aligned with those of the fund manager.
What about the common accusation that private equity managers are short-termist? Illlig cites extensive research showing that private equity-owned companies tend to perform well not just in the short term, but also in the long term. In fact, he argues that private equity funds are “exemplers of good governance.”
Convergence and Fee Deregulation
How long will it be before traditional fund management adopts alternative investment practices? Illig says that institutional investors have already begun to adopt HF/PE models:
“…the lines separating public and private equity have begun to blur as the two camps seek to emulate one another’s strengths. Private equity funds have begun to tap the deep pool of retail dollars now available only to public equity funds, while public equity funds seek to garner a share of the profits to be made from active monitoring.”
He concludes that allowing public equity funds to charge performance fee would lead to a process of creative destruction very familiar to private equity players where “bottom-tier companies are acquired, refurbished and then sold as middle or top-tier companies.”
Institutional ownership of public equities exploded in the past 20 years. But as critics of executive compensation are now painfully aware, this has apparently not led to better corporate governance. The knee-jerk policy reaction to this has been to advocate greater regulation of executive comp. But Illig’s suggestion that fund managers be incentivized to actually make corporate changes may be a better solution since it is market-based. Ironically, that would entail less regulation (of the fund management fee regime) not more.