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Why Wall Street's campaign to enrich shareholders could be bad for everyone else

Billionaire investor Carl Icahn is one of Wall Street's most powerful activist shareholders.
Billionaire investor Carl Icahn is one of Wall Street's most powerful activist shareholders.
Adam Jeffery/CNBC/NBCU Photo Bank via Getty Images

The media had a field day last year when the investment firm Starboard Value wrote what amounted to an epic one-star Yelp review of the Olive Garden.

In a 300-page slide deck, Starboard investor Jeff Smith argued that the middlebrow Italian chain served too many of its famous unlimited breadsticks at a time, allowing the leftovers to grow cold and contributing to food waste.

Starboard had other gripes, too. It complained that the Olive Garden wasn't salting its pasta water, producing a "mushy, unappealing product." It declared that the restaurant's combination of vegetarian lasagna with grilled chicken not only "doesn't make any sense" (if you want meat, you'll get the meat lasagna), but was also poorly prepared. And it said that the "crispy parmesan asparagus" was "anything but."

The stakes were higher than cold breadsticks and mushy pasta, though. The presentation, which also delved into the company's financial performance and business strategy, was part of an ambitious campaign to oust the management of the Olive Garden's parent company, Darden Restaurants. Starboard succeeded a few weeks later, when shareholders elected a new board of directors that went on to implement many of Starboard's ideas. Since then, Darden's stock price has soared. That has earned Starboard — which owned a 5 percent stake in the company — millions in profits.

Starboard's strategy — known as activist investing — has been getting more popular in recent years. And some people see that as an ominous trend.

"Activists have become toxic to the tech community," says Peter Levine, a partner at the prominent venture capital firm Andreessen Horowitz. Levine argues that activists pressure companies to focus on short-term financial results at the expense of long-term investments in company growth. In his view, that's a disaster for Silicon Valley firms that need to keep their products on the cutting edge.

But defenders point out that when activists target a new company, its stock price usually rises — and it generally stays high even after the activists leave the scene. They see activist investors as a benign force in corporate America, helping to ensure companies are run well.

The debate makes more sense when you reframe the argument. The larger question is: run well for whom? The goal of activists is to enrich shareholders, but pro-shareholder moves won't necessarily be good for a company's creditors, employees, and customers. Pressure from activists can discourage companies from making long-term investments that can produce broad social benefits. The big shareholder payouts activists often seek can drain companies of financial reserves, making layoffs or bankruptcies more likely in the event of an economic downturn.

In short, activists' laser-like focus on economic efficiency might — ironically — be making the economy as a whole less productive.

Activists can be effective shareholder advocates

Bruce Gifford / Getty

If some of your retirement savings are invested in stocks (and they should be!), then you have a personal financial stake in how America's public companies are run. Better corporate performance means higher profits, which will ultimately mean a larger nest egg when you reach retirement age.

In most companies, shareholders elect a board of directors to represent their interests. The board, in turn, hires the CEO and then tries to make sure he or she runs the company well.

That can be harder than it sounds, according to Ronald Gilson, a legal scholar at Columbia University. Modern companies have become so large and complex that even sophisticated board members struggle to understand what they're up to.

"The bulk of the information that the board gets comes through management," Gilson says. CEOs have staffs of people who can prepare briefing materials reflecting the CEO's point of view. Board members generally don't have the time or staff to do much independent research.

For ordinary shareholders, this is a problem; for activist investors, it's an opportunity. Activist firms have enough money to buy a big stake in a company — usually between 5 and 10 percent. And they have the resources to do their own research and develop proposals for improving performance and boosting returns. If they succeed, it pushes up the stock price and makes the activist — and all the company's other shareholders — more money.

This was Starboard's strategy in the Olive Garden fight. "In effect," Gilson argues, "the activists provide a parade of McKinseys" — that is business consultants like the ones you can hire at McKinsey & Company — "who come into the board saying, 'We've got a better idea.'"

"You can't run the company anymore"

A "parade of McKinseys" might sound great if you're a shareholder concerned that the company's CEO might be doing a bad job. But if you're the CEO, activists can be pretty disruptive.

"When you have an activist come on your board, you can't run the company anymore because all you're doing is dealing with the activist," Levine says. "It's crippling until these campaigns are over with."

Levine argues that the demands of the activists — who often launch their campaigns after only owning shares for a few months — may not be good for shareholders who are investing for the long term. Activists, Levine says, are "very interested in returning money to shareholders, changing management teams, selling the company." But they're often not interested in making acquisitions or investing in research and development — activities that help the company grow and prosper over the long term.

There's not much evidence that activists are bad for shareholders

Tim Cook, CEO of Apple, has boosted shareholder payouts to $200 billion under pressure from activist investor Carl Icahn.
Paul Morigi/WireImage/Getty

If it's true that activist investors are forcing CEOs to think short term and forgo promising investment opportunities, stocks ought drop after activist campaigns start.

But the data shows the opposite. An influential study by Harvard legal scholar Lucian Bebchuk, Duke's Alon Brav, and Columbia's Wei Jiang found that when an activist firm announces it has taken a position in a company, the company's stock price usually rises — suggesting that other shareholders view the news positively. And increases aren't transitory, either. Five years after the start of an activist campaign, companies targeted in activist campaigns still tend to outperform similar companies that have not been targeted.

The increases observed in their study were not statistically significant, so it's possible that they were the result of random chance. But the data certainly doesn't support the fears that having an activist target a particular company is bad for that company's shareholders.

This makes sense because the activist strategy depends on support from other shareholders. As Gilson stressed to me, activists only succeed if other shareholders buy into their proposals. The activists themselves typically buy just 5 or 10 percent of a company's shares. They need other shareholders to agree with them to achieve a majority and force a change in strategy or management. An activist firm that mostly pushed ideas that were bad for shareholders wouldn't stay in business very long.

What's good for shareholders might be bad for everyone else

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The fact that activists seem to be good for shareholders doesn't necessarily mean that their campaigns are good for companies, to say nothing of the economy as a whole.

Take McDonald's, for example. Earlier this year, activist investors began a campaign to pressure McDonald's to pay out larger dividends to shareholders. McDonald's recently capitulated to their demands, announcing that it would borrow $10 billion to help finance $30 billion in payments to shareholders. The whole company is only worth about $100 billion, so that represents a large fraction of the company's value.

The move might enrich shareholders, but it's going to make McDonald's as a company a lot weaker. Major credit ratings agencies immediately downgraded the company's debt, and it's not hard to see why. In recent years, McDonald's has struggled to find its footing as consumer tastes have shifted to healthier and more upscale options. Sending $30 billion out the door will greatly reduce the company's margin for error. In the coming years, McDonald's will have less money on hand to invest in expansion and a smaller cash cushion to help it ride out future economic downturns.

This is bad for everyone associated with McDonald's other than the shareholders. It's bad for lenders, who face a slightly lower likelihood of getting their loans paid back. It's bad for McDonald's workers, who are more likely to lose their jobs in the next recession. And it's bad for customers who may see the quality of McDonald's products decline — or may even see their local McDonald's forced to close.

A lot of shareholder payouts aren't getting reinvested

In 2013, Safeway announced it was boosting buybacks by $2 billion under pressure from activist hedge fund Jana Partners.
Connie J. Spinardi / Getty

The McDonald's case is not an isolated incident. A Wall Street Journal analysis of 71 recent activist campaigns found that more than 20 of them successfully pressured target companies to buy back shares, boosting share prices and weakening companies' balance sheets.

Companies forced to disgorge money to shareholders in recent years include Apple, Safeway, Dow Chemical, Yahoo, McGraw-Hill, and State Street bank. And, of course, worries about unwanted attention from activists have likely motivated other companies to proactively return cash to shareholders.

Ideally, shareholders would reinvest the cash they receive from established companies in ways that help newer, smaller companies grow. But in recent years, that mostly hasn't been happening.

A recent paper from the Roosevelt Institute found that in 2014, companies paid out $1.2 trillion in dividends and buybacks. Yet the paper's author, J.W. Mason, estimates that less than $200 billion of those payouts were ultimately reinvested at other companies in Silicon Valley or elsewhere. The other $1 trillion was either used to buy existing stocks (which drives up share prices but doesn't increase investment spending) or simply went into the pockets of mostly wealthy shareholders.

So what's going on here? Mason's interpretation is that pressure from shareholders — and activists in particular — is forcing companies to take a myopically short-term point of view. In his view, companies would be more profitable in the long run if they spent more to build factories and infrastructure, buy equipment, and develop new products and services. But instead, shareholders are forcing CEOs to devote most of their profits to paying dividends and buying back shares.

More investment might be bad for shareholders but good for society

Facebook founder and CEO Mark Zuckerberg personally controls a majority of voting rights in the company, insulating him from Wall Street pressures.
Lluis Gene/AFP/Getty Images

Another possibility, however, is that there just aren't that many opportunities for investment. The most innovative sector of the economy — high tech — is notable for not requiring vast quantities of capital investment (Facebook, after all, was launched from a college dorm room), and $1.2 trillion is a lot of money.

Mason readily admits that this might be part of the explanation for the recent decline in investment spending. But he still argues that aggressive shareholder demands have had a detrimental impact.

"A lot of technological innovation happens as a spillover from investment," he says. When a company invests in growth, it doesn't just benefit its own bottom line; it makes the broader society richer. For example, inventing the iPhone has obviously made Apple a lot of money, but it's made lots of other people better off, too. Thousands of people have gotten jobs selling iPhone apps, iPhone accessories, iPhone cases, and so forth. Apple's innovations were quickly copied by rivals such as Google and Microsoft, making smartphones better for everyone. And so forth.

So even if — perhaps especially if — activists are effectively advancing the interests of shareholders, that doesn't necessarily mean that their efforts are good for the economy as a whole. The economy as a whole might be better off if companies invested more aggressively — even if many of the investments don't quite pay off for the company making them. Ironically, activists' efforts to boost the returns companies pay to shareholders may be making the economy as a whole less innovative.

This might explain a recent trend in Silicon Valley. Some of the most successful Silicon Valley founders have become convinced that pressure from Wall Street is so toxic that they're better off avoiding public markets altogether. Companies like Uber and Airbnb have stayed private despite being much larger than previous generations of technology companies were at the time they first offered their shares to the public. Others, including Google and Facebook, have adopted structures that give their founders control even though they only own a minority of the shares.

"I think there's really an overvaluation of people who work on Wall Street — an exaggeration of their talents relative to everyone else," Mason says. In his view, Wall Street's obsession with boosting shareholder returns is myopic. In the long run, we might all be better off if companies faced less pressure to generate returns for shareholders — and more incentive to invest in the next generation of great products.