When Hedge Funds Become ‘Bodyguards,’ Do They Avoid the ‘Dark Side’?

Researchers looked at the potential for “corrupt relational investing” when companies pay stakeholders to protect them.

Illustration by II

Illustration by II

Hedge funds may pocket side payments when providing “bodyguard” services to companies whose strategies and management are under siege in the market. But becoming so-called validation capital could come with “a dark side,” according to new research.

Side payments to hedge funds holding a significant block of shares may include “preferential investment terms upon entry; a premium upon exit; extra compensation for directors; and even inflated reimbursement for proxy expenses,” New York University’s Edward Rock, Duke University’s Alon Brav, and the University of Southern California’s Dorothy Lund said in their paper.

While validation capital can be helpful, investors who shield a company from other shareholders might in “sad” cases entrench underperforming management from “outside interference” that would benefit stockholders, according to the paper. But “corrupt relational investing” is rare, the researchers found.

“Although side payments are relatively common, they tend to be small, and not of the magnitude necessary to induce corruption,” they said in the paper. “The legal regime governing disclosure and external market forces appear to be adequately protecting investors, at least when it comes to side payments made to activist hedge funds at U.S. public companies.”

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Sometimes an investor such as Warren Buffett will validate a company’s management simply by buying and holding its stock, the authors said. But hedge fund managers who provide validation capital may take on a more active role in protecting management.


They might secure inside information through a board seat or become an “anchor” investor by advertising their alignment with management through public statements and conversations with other shareholders, the researchers explained. “This support ultimately allows management to execute on its plans without the distraction of a proxy contest,” they said.

The researchers cited Trian Fund Management as an example of an activist hedge fund that has acted as a validation capital provider. In 2014, Trian “surprised the banking world” with a billion-dollar investment in Bank of New York Mellon Corp. that amounted to a 2.5 percent stake, according to the paper.

“Trian had engaged in several hard-fought proxy contests at blue chip companies since its founding in 2005 and so the investment might have signaled the beginning of a battle,” the researchers said. “But from the start, Trian sought management’s cooperation: Trian’s founder Nelson Peltz declared early on that the fund was only interested in attempting a constructive dialogue with the bank.”

At first, Bank of New York Mellon rebuffed Trian’s advances, only grudgingly offering a board seat to the hedge fund firm’s chief investment officer Ed Garden after it threatened a proxy battle, according to the researchers. “But ultimately, Trian would prove to be a boon to management.”

Trian’s Garden supported management when hedge fund firm Marcato Capital Management took a “much less collaborative” stance in buying a 1.6 percent stake in the bank. Marcato sought to shake up the management team, making “disparaging” statements about the bank’s chief executive offer at the time, according to the researchers. But the backing from Trian helped Bank of New York Mellon avoid “a potentially bitter” proxy contest, they said.

“Trian’s validation came in exchange for management and the board’s commitment to execute on proposed changes that had been contemplated for some time,” the authors of the paper wrote. Trian says on its website that the firm exited its position in BNY Mellon last year, and that the bank’s profitability increased during its investment period.

Spokespeople for Trian and BNY Mellon declined to comment on the research paper, while Marcato didn’t reply to an email seeking comment. Reuters reported in December 2019 that Marcato, an activist hedge fund firm backed by Blackstone Group and billionaire investor Bill Ackman, was shutting down.

The academics said they examined the “likelihood of virtuous and corrupt variants” in validation capital amid a proliferation of investors who are increasingly engaged in active governance roles. Side payments made by publicly-traded companies to their “bloc holders” will generally be disclosed under federal securities law, while markets forces provide a “key constraint” to corruption, according to the paper.

Hedge fund managers who act as a shield must consider their reputational risk as well as their returns as shareholders, the authors explained. Bodyguard services provided by investors with a significant block of shares may be “rational” when the payment covers expected losses from the decline in stock price, according to the paper.

“This is not to suggest that corrupt relational investing is impossible, only that we expect that it is rare, especially among experienced hedge fund activists that regularly launch campaigns,” the researchers said.