By John C. Alexander Jr., Ph.D.

Breazeale Professor of Investments and Professor of Finance, College of Business and Behavioral Science

Long/short equity hedge funds have the ability to hold both long and short allocations in public equity. If the markets move as a fund manager hopes, the long shares of equity will increase in value and the short shares of equity will fall in value. Therefore, a successful manager not only has a fundamental view of how they expect share prices to move in the future, but they also have a view on the right price at which to reverse the position.

Recently, though, we have seen a new breed of shareholder activists emerge in the long/short equity space.

For example, Pershing Square Capital Management has stated in a number of different venues that its management thinks that the Herbalife Corporation — in which they hold a substantial short position — is a fraud. And yet, since that declaration, well-known activists such as Carl Icahn and George Soros have taken an opposing view and purchased long stakes in Herbalife.

Pershing Square’s activism has gone even further than the accusation of fraud. According to a Reuters report, they have agreed to pay one whistleblower from within the Herbalife Corporation as much as $3.6 million if he lost his job in helping Pershing Square substantiate their fraud claim. In addition, other whistleblowers have been offered indemnities to cover legal fees and damages if they are sued by Herbalife. To date, Pershing Square has spent roughly $20 million on a campaign to substantiate their claim.

It causes me to wonder just who benefits from such a public display of activism. And, more specifically, are there less dramatic ways to bring the shortcomings of a company strategy or a lack of managerial talent to the attention of analysts and investors, rather than public indictments made to the press?

We must keep in mind the following: Among the important aspects of a long/short equity strategy is the ability to be agile and neutral. The ability to reverse a position once the share price has achieved its target is an important part of this strategy. Once an activist fund such as Pershing Square makes a public accusation of a fraud, do they lose some of that agility and neutrality? Do they become enamored with winning the debate and, as a result, hold on too tightly to a position?

Unfortunately, the issues do not end there. An additional aspect that has been largely ignored is the matter of who bears the cost if Pershing Square Capital Management is wrong, or if they have pursued the discussion in the wrong manner. More specifically, when one organization accuses another of fraud, they incur a legal liability. If they are wrong, they can be taken to court. Further, the compensation to a whistleblower is something that may get the attention of the Securities and Exchange Commission. If the SEC decides to investigate Pershing Square, who bears the cost of that investigation?

The offering documents of Pershing Square Capital Management make it clear that “the fund” bears any legal costs, or costs arising from an SEC investigation. Of course, these costs would reduce the fund returns. So who benefits from this activism? If Herbalife is a fraud, the markets will likely discover it, and its shares could eventually fall in price to fractions of a dollar. Any investor who was short Herbalife shares, benefits from this price movement. Of course, the Pershing Square investors would also benefit, but possibly less due to the potential legal and investigative costs that the company could incur in the process of being public activists.

It seems clear that the management of Pershing Square may benefit from the attention of the press, and its possibility of being right, therefore winning the debate. Not only could this bring a sense of pride to Pershing management, but it could also bring more potential investors, which in turn would increase the fees to Pershing Square management.

Does the Pershing Square activism raise an additional issue relative to institutional due diligence? Do we need a new metric to evaluate activist funds? Possibly, in addition to measuring net returns, we may also want to evaluate the legal and investigative costs associated with an activist fund compared to a non-activist fund. Does the form of shareholder activism cause the fund to lose flexibility and adeptness in adding value to the fund? Are there cost efficiencies in the way a fund pursues activist strategies? Could these cost efficiencies be used as a metric in deciding among funds?

Indeed, we may have entered into a new type of activism. The benefits and the costs associated with this new type of activism, however, are yet to be fully understood.


John.AlexanderJohn C. Alexander, Jr., Ph.D. Is the Breazeale Professor of Investments and a Professor of Finance at Clemson University’s College of Business and Behavioral Science. He earned his bachelor and master’s of business administration from Florida’s Stetson University, and his doctor of philosophy in finance from Florida State University. He has won numerous awards, including the Cote Fellow Award for Excellence in Teaching and Service, and in Research and Scholarship, as well as the NationsBank Faculty Research Award. He is actively involved in research and has been published in several prestigious journals. He has also been a frequent speaker at professional meetings and a guest lecturer at other colleges and universities within the United States and abroad.