Last week’s cover of The Economist featured Activist Investors and in a number of articles on the topic, the magazine takes a controversial positive stance on these investors. The Economist article also mentions the controversial shorting of Herbalife as an example of this form of activism. Indeed, since Bill Ackman presented his short thesis on Herbalife on December 20, 2012, and publicly disclosed Pershing Square Capital’s $1 billion short position on the nutrition company, the media has been charting the ups and downs of this investment soap opera and the plot has thickened at every turn.
For those of you who did not follow it, here is a recap: Ackman claimed that Herbalife was not really in the business of selling weight-management products through its multi-level market distribution networks. It was instead in the business of selling entrepreneurial dreams. To put things more prosaically, he argued that Herbalife independent distributors do not get their revenues primarily from selling products but from recruiting new members. And therefore its business was essentially a pyramid scheme, as “participants obtain their monetary benefits primarily from recruitment rather than the sale of goods and services to consumers” (Federal Trade Commission, FTC).
A number of prominent hedge fund managers (Dan Loeb, Carl Icahn, George Soros) took the other side of the trade, smelling the opportunity of a short squeeze, and the news story became yet another case of hedge fund alpha males bucking horns at the expense of hard-working corporations. As these other funds exited the trade (all of them with sizable profits), Ackman’s persistence in raising the public profile of the case led to the opening of an FTC investigation into Herbalife, and to in-depth investigative reporting on the lobbying effort of Ackman to attract regulatory attention.
Could shareholder activism be a form of responsible investing?
When I first heard about the story, I was immediately interested in it but from a different angle. Together with my colleagues Jan Simon and Tom Vandebroek, I wrote a teaching case study on this, which I use with my MBA students to debate whether this form of shareholder activism (shorting) can be considered a form of responsible investing. But, wait a minute, isn´t shorting unpatriotic? Shouldn’t we set strict limits to shorting? And how could billionaire hedge funds be “responsible investors”?
Let´s start with what responsible investment is today. According to the Principles for Responsible Investment (PRI), a United Nations-supported network of investors, “Responsible investment is an approach to investment that explicitly acknowledges the relevance to the investor of environmental, social and governance factors, and of the long-term health and stability of the market as a whole.” (PRI) In this recent IESE video (see below), Prof. Mireia Giné and I introduce the topic of shareholder activism, with a special focus on responsible investing.
So how could Ackman’s short be a form of responsible investing?
- ESG integration. Integrating environmental, social and governance, a.k.a. ESG factors, in the investment process, across asset classes (bonds, equities, PE, real estate) and investment styles, is the core of responsible investing. Therefore shorting a corporation’s stock because its business practices generate a substantial negative impact on society might be considered an instance of integrating a thorough analysis of social factors (the “S”) into the investment process, and therefore within the scope of responsible investing.
- Symmetric treatment of shorting. A common rebuttal to this argument is that shorting limits capital accumulation; it is short-term oriented, and therefore cannot be considered a form of responsible investing. Many finance scholars and some sociologists of finance have convincingly shown that having opportunities to short securities not only improves market efficiency, but also provides a vehicle for contrarian views that could help prevent asset bubbles. What if we had possessed better vehicles for shorting real-estate prices ten years ago? A few contrarians creatively found ways of doing so — and profited handsomely from the collapse of the real-estate market — but by and large investors did not really have a way of shorting that. What if we could short the venture capital deal valuations today in Silicon Valley? Furthermore, if shorting is motivated by environmental and social factors, why would shorting irresponsible companies be more problematic than overweighting more sustainable ones?
- “But he is doing it to profit from it!” Individual motives behind investment decisions should not impact whether or not the investment is considered within the scope of responsible investing. Indeed, PRI signatories are clear about the fact that ESG integration is done within the frame of their fiduciary duty to their beneficiaries. Individual motives should not matter as much as leveraging the power of financial markets to deliver the seeking of truth through valuation.
Just to be clear, I am not claiming here that Ackman is right, and Herbalife is wrong. I am merely outlining why this form of investment might actually be good for the economy, as the degree of transparency required of listed corporations is used by some investors to shed light on whether corporate practices are actually sound, not only in financial terms but also in terms of their impact on society as a whole.
The jury is still out on Herbalife; the investigation will be long, and Ackman’s short might turn out to not be right. The more important thing, however, is that we learn from these experiments and think about how we can leverage the power of financial markets to guide corporations to operate in more sustainable ways.