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Introductory remarks

Stefano Micossi

Director general of Assonime [1] and member of the board of EALIC [2]


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First a general remark on alternative investment vehicle, or better, activist investors, which I take to be the real focus of today’s hearing. Hedge funds and private equity funds are quite different intermediaries: the former typically do not take controlling stakes in their target companies while the latter do it as their core business [3]. However, they share the fact of buying stakes in companies that appear under-performing, and then taking action to improve their performance. Hedge funds, in particular, display a higher risk exposure, trade more actively than many other market participants and often use leverage significantly, so that their market clout is larger than the size of their balance sheets – suggesting at least that good understanding of the way they operate by policy makers is in order.

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As rightly noted in a recent report by the OECD [4], of which I am sure this Committee is aware, with “perfect” capital markets there would be little room for specialist investors like hedge and private equity funds. However, in a financial world dominated by large information asymmetries and institutional investors that adopt passive investment strategies – more index-tracking than stock-picking – and that in addition notoriously have little incentive to monitor individual company performance, activist investors with strong incentives to exercise their shareholder rights can play a valuable role in improving corporate governance, the market for corporate control, capital market efficiency and overall economic performance.

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Activist investors, notably hedge funds, are often accused of seeking short-term gains and not considering the long term interests of companies and their shareholders. This belief is not supported by either theory or empirical evidence. Financial theorists have shown that the presence in capital markets of a small pool of active investors looking at the fundamental prospects of individual companies are key to capital market efficiency. And empirical evidence confirms that activist investors typically target under-performing companies, notably lacking long term strategies and displaying poor management and corporate governance, and that performance is most often improved after activist funds’ interventions. Shareholders typically gain from their actions; the picture is more mixed for other stakeholders, such as creditors and employees, but here the outcomes may well depend above all on the company’s underlying strengths and weaknesses rather than solely on activists funds’ actions.

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Therefore, I share the view expressed in the rapporteur working document, where it is stated that we need to preserve their benefits and indeed make sure that Europe’s capital markets offer a favourable environment for their continuing expansion. To this end, it is important that we manage to avoid excessive or unnecessary regulation and, moreover, that whatever action is taken by regulators, it is taken at the Union’s level.  

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Let me add that available evidence on the recent phase of financial turmoil does not indicate that hedge funds and private equity funds have contributed to increasing instability or amplifying systemic risks; in fact, hedge funds may have played a stabilising role, since they have continued to absorb risky instruments in their portfolios and have taken sizeable losses without much repercussions on capital markets. Thus, reference to previous events in the nineties – e.g. the LTCM crisis – may be misleading, and hedge funds seem to have learnt their lessons.

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As to the regulatory approach, there seems to be a broad consensus among regulators that in the main there is no need for specific rules on hedge funds and private equity firms, and that the best way to address any policy concern regarding the risks involved with these intermediaries is to focus on investors’ and counterparties’ capital and risk management procedures, rather than on these entities themselves. However, self-regulation and transparency rules may help improve understanding of the distribution of risk bearing and the potential effects on market liquidity in distress situations.  

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In particular, there is room to improve disclosure of investment policies of activist funds to the public as well as their clients, regards their voting policies, the actual size of their shareholding on the occasion of proxy fights and other key moments of company life, such as annual meetings. Our main concern here is with ensuring the integrity and transparency of the voting process by shareholders. More precisely, we are concerned with practices whereby activist investors can temporarily increase their votes through derivative operations or share lending. This may lead to alter outcomes of proxy fights or general meetings, not necessarily to the benefit of shareholders.

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A problem that may arise in connection with using derivatives to gain voting rights is “empty voting”, with attendant potential conflicts of interest. For instance, it is possible for a hedge fund to purchase shares in two companies, one bidding to acquire the other, and then to hedge away the risk of shares in the acquiring company, and to vote in favour of the proposed acquisition at an abnormally high price in the general meeting of the target company. In this example, the investor’s behaviour may damage the shareholders of the acquiring company. As to share lending, it may lead both to over-voting, i.e. the possibility that the same share votes twice, and to under-voting, i.e. a reduction in participation in shareholders’ general meetings: in both cases, the normal course of shareholders’ deliberations may be altered in an undesirable manner.  

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Let me recall in this regard that the OECD principles of corporate governance already demand that institutional investors provide full disclosure on their own corporate governance, and in particular on voting policies with respect to their investments, including the procedures that they have in place for deciding on their use of their voting rights. Regulators have a role to play here: rather than by imposing new rules, by using their discretionary powers to strengthen disclosure obligations on all transactions that affect voting rights, especially around the time of proxy fights and general meetings of shareholders.

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On the other hand, we do not consider it necessary nor appropriate to impose on activist funds detailed disclosure to the public on their investment and financing techniques and the expected gains from specific operations; care should be exercised in order not to place these funds at a competitive disadvantage to rivals in other jurisdictions. In this connection, it may be recalled that activist investors already must comply with capital market rules regarding their transactions in publicly listed shares, including the obligation to disclose share purchased beyond certain thresholds. However, greater disclosure may be in order on the investor’s intentions and plans when a private equity firm announces a deal, such as a takeover of a publicly listed or private company. Furthermore, as foreseen Mr. Lehne’s draft report, investment companies may be required to disclose a full account of their portfolio compositions and overall investment strategies once a year with their annual accounts.  

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Concerning the specific question on the private equity business model, let me note that available evidence does not indicate generalised practices of asset stripping or other forms of company looting, such as overloading a company with debt and then selling it at a large gain – although this has happened on occasion. The OECD report mentioned above indicates that – while it is true that average indebtedness increase after takeover by a private equity fund – these funds normally invest in businesses already displaying higher-than-average default probability, and that after the fund’s entry performances often improve, in some instances (including large deals) greatly improves. Moreover, a study of public-to-private deals where the target company is later returned to listing, shows that after the IPO the private equity funds often retain a stake in the company, typically in the order of 30-35 per cent of capital. New mandatory rules in this domain would in all likelihood undermine the very possibility of retaining private equity business in the Union. On the other hand, the adoption by private equity firms of Codes of conduct on transparency and governance – such as proposed recently by the Walker Report [5] – could help consolidate confidence on these intermediaries.

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As to the possibility of encouraging alternative investment vehicle to use organised markets for their transactions, two separate issues seem at stake here. One issue is whether or not to limit activist investors’ freedom of manoeuvre in arranging their transactions: on this our view is that any such limitation is unnecessary and would especially damage the private equity business. A different issue is what to do about “customised” structured products traded over the counter and the need for improved transparency of their valuation and pricing models: on this, personally I rather like the idea of trying to channel trades of these instruments through organised exchanges or, even better, clearing houses – which would provide the twin benefit of fostering standardisation of key features of structured products, and imposing margin requirements on operations in these instruments. The big question is one of feasibility: how to do it, and how to avoid that affected operations simply move out of the Union. Rather than thinking about new binding rules, we need to reflect on how to establish the right institutional incentives for private behaviour: for instance, rating agencies could be encouraged to take into account, in their scores of structured financial instruments, the extra security offered when clearing is done through a clearing house.

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