In a sweeping proposal from the Securities and Exchange Commission, the US regulator has signaled its intent to rein in private financial markets. Hedge funds and private equity firms have grown very rapidly since the financial crisis. The whole alternative investments industry has $18 trillion in gross assets under management (Masters, 2022). This has happened thanks to large institutional investors, like pension funds, that have been funneling increasing amounts of capital into alternative assets on the backdrop of eclipsing opportunities for returns in public markets. Specifically, via the proposed rule changes the SEC aims to increase transparency and oversight of hedge fund and private equity shops. Under this slate of changes, hedge funds would have to agree to annual audits, disclose quarterly performance and fees charged. Additionally, hedge funds will be required to disclose significant stakes in US publicly listed companies in half the time they currently have to. Hedge funds currently have a period of 10 days where they can withhold the fact that they have amassed a stake at company that crosses the 5% threshold. These proposed rule changes will make it substantially harder for activist investors to amass secret stakes in firms and consequently profit from them. SEC chair Gary Gensler states that by halving the time to disclosure they can curb hedge funds from using market-moving information “which creates an information asymmetry between these investors and other shareholders”. Even though these disclosure rules have been in place since the 70s to protect publicly listed companies from corporate raiders, Gensler’s comments seem to imply that these changes are not spurred by the need to protect listed companies but rather more focused on other investors. Despite the SEC chair’s intent to increase transparency and level the playing field for the Main Street economy, detractors of these proposed changes point to the free rider problem that arises from reducing the disclosure window to five days down from ten. Yale law school professor Jonathan Macey argues that this “allows people sitting on the sidelines to free ride and pile on and start buying shares in [a] company on the basis of other people’s research” (Masters, 2022). He contends that attempting to create a level playing field between investors without considering differences in research conducted by finance professionals at private funds and other less sophisticated investors is not sound public policy. As with every part of the economy, shareholder activism experienced a slowdown because of Covid-19, in the US “activists launched 34% fewer campaigns and targeted 25% fewer companies in 2020 than they had the previous year” (PWC, 2021). Despite this, there is evidence that activist investing has bounced back in 2021, with 55 new campaigns launched, 31% higher than in 2020 (PWC, 2021). Hence, how do hedge fund activists unlock value by amassing these secret stakes in publicly listed firms? They typically look for companies that are ineffectively or inefficiently managed. Hedge fund activists recognize a potential “new capital allocation strategy or changes in operations that will increase share value.” (PWC, 2021) If they fail to engage with executives on their ideas, they then begin to amass their stake in these firms to get a representative on the board of directors to try and achieve their goal. Hedge fund activists are most likely to utilize the most aggressive tactic of shareholder activism which is a proxy contest (PWC, 2021). A proxy contest is “an attempt to replace some or all of a company’s board with directors nominated by the shareholder activist” (PWC, 2021). Proxy fights are typically drawn out and cause target companies to burn through cash. Although success isn’t assured, companies and activists often reach a settlement to avoid such a costly contest.
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