Equity funds are now giving hedge funds a run for their money as the pariahs of international corporate governance. Rather than acquiring companies and slowly revamping them, as in the past, many have saddled their acquisitions with new debt, then used the proceeds to make huge cash distributions to themselves. With some companies, such as Nellson Nutraceutical, Inc, which makes energy bars, the equity fund got its money and the company’s creditors are now left to pick over what is left in bankruptcy.
If this latest corporate crisis is anything like its predecessors, there will soon be calls for regulatory intervention. But not all corporate and financial cris de coeurs are created equal. In the 1960s, when hostile tender offers were young, critics denounced bidders as “white collar pirates”. Harrison Williams, the New Jersey senator after whom the Williams Act tender offer regulations of 1968 are named, accused the new bidders of assaulting “proud old companies”, stripping them down to “corporate shells” and keeping “the loot” from the sale of their assets; but a careful empirical study showed that most takeovers did nothing of the kind. In reality, many simply undid the cumbersome conglomerates so prevalent in the 1960s. When takeovers really took off in the 1980s, thanks to deregulation, more relaxed antitrust enforcement and Michael Milken’s junk bonds, the new raiders were once again denounced as destroying proud old American companies. Some of the claimed excesses, as portrayed in Oliver Stone’s movie Wall Street, were real (even now, it is hard to defend Ivan Boesky). But the complaints were once again exaggerated.
With the corporate scandals of the early 2000s, by contrast, both the complaints and the initial diagnoses were far more accurate. Chief executives whose compensation was heavily based on stock options had enormous incentives to pump up the company’s stock price. And conflicts of interest in accounting firms and with securities analysts ensured that companies cutting accounting corners were unlikely to be caught.
As critics howl about the recent equity fund acquisitions, the question is whether the funds’ buy-and-borrow games constitute a real crisis, as with the corporate scandals, or merely the growing pains of markets in transition, as with the takeover waves of the 1960s and 1980s. The answer surely is the latter. To the extent there are problems, existing regulation is adequate. A bundle of long-established provisions limit a fund’s ability to take the money and run. A company cannot make dividends if it is insolvent, for instance, and other tricks for taking cash out of a company can be challenged under fraudulent conveyance law if they are abusive.
Moreover, if equity funds are buying companies cheaply and taking money out, the company’s shareholders can simply reject the low-ball bid at the outset, when the equity fund first comes calling. Shareholders of several companies have done exactly this, and recently forced Kohlberg Kravis Roberts & Co, the US private equity firm, to up its bid for VNU, the Dutch media company.
The contrast with hedge funds, the other bogeyman of the marketplace, is instructive. (Whereas equity funds generally require investors to keep their money in the fund for several years, hedge funds allow much quicker withdrawal). Hedge funds provide many benefits to the markets, such as the more efficient pricing that results from their efforts to identify and profit from market inefficiencies. But they have worrisome qualities as well. A hedge fund manager usually receives 20 per cent of the fund’s profits, plus 1-2 per cent of its assets under management. These fees, together with funds’ lavish claims about performance, create the same kinds of incentives that led to corporate scandals. The reward for success is huge, the penalty for failure comparatively minuscule, and the earnings targets necessary to attract investors often difficult to achieve by legitimate means. It is not accidental that hedge funds were at the heart of the mutual fund scandal several years ago. These problems suggest the need for more disclosure, especially after the new Securities and Exchange Commission registration rule was struck down by a federal court of appeals this year.
With the recent equity fund acquisitions, by contrast, there is nothing hidden or deceptive. The real lesson is not that the funds should be reined in. It is that the financial markets are undergoing a radical transformation. The reason we hear so much about equity funds and hedge funds is that they are the ghosts of the market’s future. As money that might once have gone to mutual funds pours into equity funds and hedge funds, these funds will play a central role in international corporate governance. Even more momentously, they may increasingly assume many of the functions traditionally handled by banks. With a wide array of financial instruments now available to hedge the kinds of risks (such as the risk of interest rate changes) traditionally borne by banks, there is nothing to stop hedge and equity funds from serving as lender as well as acquirer.
In retrospect, we are not likely to look back on the equity funds’ new buy-and-borrow trick as evidence of a crisis in corporate finance. Instead, it will look like another signpost on the way to a new financial order that we can barely even recognise right now.
The writer, a professor of law at the University of Pennsylvania, is author of Icarus in the Boardroom: The Fundamental Flaws in Corporate America and Where They Came From (OUP 2005)