Hedge Funds: A Solution to the Collective Action Problem

Posted on by Justin Montis

There is a collective action problem in any system where an informed vote is costly to a shareholder.1 Such a collective action problem is present among shareholders of publicly traded companies in the United States.2 Small shareholders are rationally apathetic in their voting decisions because they assume (usually correctly) that their vote will not change the outcome of a voting decision.3 On the other hand, large shareholders are likely to under-invest in the voting decisions because they receive only a pro rata share of the benefit of an informed outcome.4 Large shareholders are deterred from incurring large monitoring costs to make an informed vote when they bear the brunt of the burden only to realize a disproportional share of the benefit. This has led to a lack of efficiency in the monitoring, management, and overall operation of publicly traded companies in the United States. However, commentators have pointed to hedge funds as a solution to the collective action problem.5

Hedge Funds have emerged as some of the most dynamic and prominent shareholders activists in publicly traded companies.6 Hedge funds in the course of maximizing profits for their own investors, help to overcome the agency problem of publicly held companies by removing underperforming management, challenging ineffective and inefficient strategies, and ensuring that merger and control transactions not only benefit, but also make sense for the shareholders of the company.7 By doing this, hedge funds benefit both their investors and their fellow shareholders.8 This happens mainly because hedge funds have their interests aligned with that of their fellow shareholders.

The incentives for hedge funds to monitor portfolio companies are likely to result in the mutual benefit for shareholders of these public companies because hedge funds benefit directly and substantially from achieving high absolute returns.9 In the 1980s people spoke of mutual funds, pension funds, and insurance companies as being the large sophisticated investors that would solve the collective action problem.10 However, this proved to not be completely true.11

There are a few things that distinguish hedge funds from these other large institutional investors. First, hedge fund managers are highly incentivized to maximize the returns to fund investors.12 Generally, hedge funds charge a base fee of about 2% of the assets under management.13 Along with this base fee, hedge funds charge a large incentive fee, usually around 20% of the profits earned.14 This fee structure gives hedge fund managers a significant stake in the financial success of the fund’s investments.15 This stake is even larger when, as many times is done, hedge fund managers invest a large portion of their own personal wealth into the hedge fund.16 Hedge funds, unlike these other institutional investors, have their interests aligned with shareholders, and have the incentive to maximize profits both in the short term and the long term. The 20% incentive fee gives hedge fund managers a large interest in maximizing profits each year. The 2% fee rewards good hedge fund managers over the long term as more investors choose to invest with the hedge fund, thus giving the manager a larger pool of assets. This larger pool of assets makes the 2% base fee a significant fee in the long term for a hedge fund manager that has successfully maximized his investors’ profits each and every year. This results in hedge fund managers adequately monitoring and regulating the management decisions, strategies, and transactions, of the companies they invest in. This increased monitoring and investment of time into public companies that a hedge fund has invested in, benefits shareholders by ensuring that the company is run efficiently and in the shareholders’ best interests, i.e., maximizing overall profits. Secondly, many hedge funds strive to achieve high absolute returns, rather than returns relative to a benchmark.17 The 20% incentive fee is based on the hedge fund’s absolute performance.18 Therefore, unlike mutual funds, hedge funds have their interests aligned with maximizing shareholder profits.

  1. William T. Allen et al., Commentaries and Cases on the Law of Business Organization 188 (4th ed. 2012). ↩

  2. See id. ↩

  3. See id. ↩

  4. See id. ↩

  5. See id. ↩

  6. Marcel Kahan & Edward B. Rock, Hedge Funds in Corporate Governance and Corporate Control, 155 U. Pa. L. Rev. 1021, 1028 (2007). ↩

  7. See id. ↩

  8. See id. ↩

  9. See id. at 1065. ↩

  10. See id. at 1028. ↩

  11. See id. ↩

  12. Kahan & Rock, supra note 6, at 1064. ↩

  13. See id. ↩

  14. See id. ↩

  15. See id. ↩

  16. See id. ↩

  17. See id. at 1065. ↩

  18. See Kahan & Rock, supra note 6. ↩

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