Agency Theory in Practice: a Qualitative Study of Hedge Fund Activism in Japan

• Author: Dominic Heesang Chai,John Buchanan,Simon Deakin
• Date: 01 July 2014
• DOI: http://doi.org/10.1111/corg.12047
• Published date: 01 July 2014

Agency Theory in Practice: a Qualitative Study

of Hedge Fund Activism in Japan

John Buchanan, Dominic Heesang Chai*, and Simon Deakin

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: We look at the reaction to hedge fund activism of managers and shareholders in Japanese firms

and explore the implications of our findings for agency theory.

Research Findings/Insights: Confrontational shareholder activism of the kind practiced by American and British hedge

funds in Japan during the 2000s failedto gain acceptance from Japanese investors and managers or to alterthe internal focus

of corporate governance practices in Japanese firms.

Theoretical/Academic Implications: We use a qualitative research design which treats the standard agency-theoretical

model of the firm as only one possible approach to understanding corporate governance, to be tested through empirical

research, rather than as an assumption built into the analysis. We find that Japanese managers do not generally regard

themselves as the shareholders’ agents and that, conversely, shareholders in Japanese firms do not generally behave as

principals. Our findings suggest that the standard principal-agent model may be a weak fit for firms in certain national

contexts.

Practitioner/Policy Implications: For policymakers, our work demonstrates the importance of understanding the distinc-

tive features of national-level corporate governance arrangements. For practitioners, it cautions against the view that

nationalcorporate governance systems are converging around the model of shareholder primacy and directs attentionto the

need for investors to be informed of the diversity of practices across different countries.

Keywords: Corporate Governance, Agency Theory, Japan, Hedge Funds, Shareholder Activism

INTRODUCTION

Hedge fund activism is a relatively new phenomenon

which has attracted growing interest from corporate

governance researchers and practitioners. From the late

1980s, hedge fund activists in the United States pioneered

focused forms of engagement with listed companies, pub-

licly confronting their boards with proposals to release

shareholder value through dividend increases, share repur-

chases, corporate restructurings, and asset sales. Theconsen-

sus of opinion among researchers was that these methods

contributed to the realignment of managerial and share-

holder interests, and consequent reduction of agency costs

(Macey, 2008: 272). Although some studies found evidence

of losses for bondholders (Klein & Zur, 2011), along with

unclear implications for firm performance beyond a one- or

two-year time horizon (Klein & Zur, 2009), others claimed to

identify improved returns for shareholders and higher firm

valuesover both the short and medium term (Bebchuk, Brav,

& Jiang, 2013; Brav, Jiang, Partnoy, & Thomas, 2008). Hedge

fund activism subsequently spread to Europe, albeit in a

somewhat less confrontational form (Becht, Franks, & Grant,

2010).

After the United States and Europe, Japan was the third

main site of hedge fund activism during the 2000s. In this

paper we report qualitative evidence on the experience of

hedge fund activism in Japan with the focus on the period

up to 2008, when the full onset of the global financial crisis

led the more prominent activist funds to wind down a

number of their Japanese investments. By that stage, a

mixture of managerial resistance and shareholder indiffer-

ence was already making it hard for the funds to replicate

the impact they had achieved elsewhere.

We use our account of the activist hedge fund episode in

Japan to reassess the value of agency theory as the dominant

frame of reference for corporate governance research.

*Address for correspondence: 1 Gwanak-ro, Gwanak-gu, Seoul, 151-916, Korea. Tel:

+82-2-880-5832; E-mail: dchai@snu.ac.kr

This is an open access article under the terms of the Creative Commons Attribution

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the original work is properly cited.

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Corporate Governance: An International Review, 2014, 22(4): 296–311

© 2014 TheAuthors. Corporate Governance:An International Review published by John Wiley & Sons Ltd.

doi:10.1111/corg.12047

Agency theory “asserts that principals (owners) must

monitor and control agents (managers) to protect the

owners’ residual claims from the excesses of self-interested

agents” (Bansal, 2013: 127). The practice of hedge fund activ-

ism is premised on this belief and on the related claim that,

through such activism, the efficiency of the corporate sector

of the economy will be enhanced. This was one of the main

justifications offered for hedge fund activism in Japan

during the 2000s: as an activist hedge fund manager put it to

us in early 2008, “hopefullyJapan will see for itself that there

is a lot of bottled-up inefficiency, capital inefficiency, oper-

ating inefficiency and that if it really wants a good future for

its grandchildren, they need to change.”

However, despite this activism, neither management

practice nor the practice of corporate governance changed

greatly in Japan during the 2000s (Whittaker & Deakin,

2009). This was in large part because expectations generated

by the application of agency theory to the Japanese case

failed to materialize. As we shall see, the activists encoun-

tered managers who did not behave as agents, and share-

holders who did not act as principals.

Our findings pose the question: if the standard agency

model does not well describe the Japanese firm, what does?

We will argue that certain features of the Japanese model, in

particular the internalist orientation of its corporate gover-

nance arrangements (Buchanan, 2007), go a long way to

explaining the limited success of activist hedge fund tactics

in the Japanese context, and point to continuing Japanese

divergence from the practice of “shareholder primacy”

(Hansmann & Kraakman, 2001) as it is recognized in the

United States and, to a lesser degree, Europe.

In developing our argument, we first present some con-

textual information on hedge fund activism, briefly charting

its origins in the United States in the late 1980s and its

diffusion to Europe and Japan in the course of the 2000s.

Next we consider theoretical perspectives on hedge fund

activism, focusing on the principal-agent model which is the

main lens through which not just researchers but also many

practitioners have viewed this phenomenon. Then we

discuss our methodology and present the case for using

qualitative research in this context. In the following section

we present our findings, focusing on two high-profile hedge

fund interventions in Japan, Steel Partners’ targeting of Bull-

Dog Sauce and TCI’s targeting of J-Power, and drawing on

our interview material to probe actors’ perceptions and

interpretations of hedge fund activism in these and other

instances. The final section provides an assessment of our

results.

CONTEXT: THE ORIGINS AND DIFFUSION

OF HEDGE FUND ACTIVISM

A hedge fund is an investment club governed by private

contract and therefore beyond the scope of many regulatory

requirements. Investors who accept increased market risk

and an initial restriction on early withdrawal mandate fund

managers, whose remuneration is linked to performance

through bonuses, to exploit any legitimate opportunities

for exceptional gains over an agreed benchmark, usually

through a pre-advised investment strategy which may

include borrowing or use of derivative instruments. Activist

hedge funds are a distinct group within the hedge fund

sector as a whole and, in terms of investment volume, were

thought to constitute around 5 percent of the total in a J.P

Morgan report dated 2006 (Kahan & Rock, 2007: 1046). Exact

figures are difficult to calculate because funds can vary

their strategies over time and do not disclose outstanding

asset profiles. Moreover there is sometimes only a fine

line between “value funds” that amass shareholdings in

expectation of predicted returns and “activists” who try

to precipitate those returns. The Alternative Investment

Management Association (AIMA), for example, generally

avoids the expression “activist” in its 2008 survey of the

hedge fund sector and its strategies (AIMA, 2008). Never-

theless, we cite J.P. Morgan’s 5 percent figure as a plausible

estimate that is probably still accurate: most hedge funds are

not activists.

Activist hedge funds first emerged in the United States in

the late 1980s. The literature on the US experience (see

Bratton, 2007; Brav et al., 2008; Clifford, 2008; Greenwood &

Schor, 2009; Kahan & Rock, 2007; Klein & Zur, 2009, 2011;

Xu & Li, 2010) suggests that they typically operate by taking

large but not controlling stakes in financially healthy and

relatively small target companies, and then engaging

directly with management on matters which include busi-

ness strategy, capital structure, asset sales, and adherence to

corporate governance standards. They are not short-term

investors: holdings of up to four years are common. They

call for the return of cash surpluses to shareholders in the

form of increased dividends and share buy-backs, and

encourage firms to increase their leverage. Because they do

not normally seek control of their targets through hostile

takeover bids, their strategy depends for its success on

gaining the cooperation of management or that of other

shareholders, or a combination of the two.They often seek to

precipitate takeover bids by others (Greenwood & Schor,

2009).

The scale of hedge fund activism in the US context is

significant, particularly in terms of the volume of interven-

tions. In the most comprehensive study so far, Bebchuk et al.

(2013), building on an earlier database assembled by Brav et

al. (2008), examined 2,040 activist interventions in the

United States between 1994 and 2007, but this is only a

sample drawn from a larger population of interventions, not

all of which can be tracked precisely because of limits on

disclosure rules and difficulties in distinguishing between

activist hedge funds and more passive value funds. After a

brief lull following the onset of the global financial crisis,

activist tactics have resumed with a new level of intensity in

the US context, with public confrontations between hedge

funds and boards occurring at companies including Apple,

T-Mobile, and Hess in the first few months of 2013 (Priluck,

2013).

The scale of hedge fund activism in Europe is more

limited than in the United States; using a mixture of public

and proprietary data, Becht et al. (2010) analyze 362 inter-

ventions by activist shareholders of variouskinds, including

activist hedge funds, focus funds, and other activists in 15

European countries, including the UK, between 2000 and

2008. There were some high profile and controversial cases

of interventions leading to takeovers and associated

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