At the turn of the 20th century, large active shareholders like J.P. Morgan sat on the boards of companies to monitor their performance and to protect their investments—a practice that worked to the benefit of other shareholders as well. The 1980s saw a revival of investor activism in the form of hostile takeovers and the rise of LBOs. According to David Haarmeyer, we are now witnessing another major resurgence of active investing, this time in the remarkable growth of private equity and activist hedge funds.

The need for active monitoring stems from an old problem: the separation of ownership from control in large, publicly traded commercial enterprises. Although there are clear gains from drawing on the expertise of “professional” managers and on the risk-bearing capacity of a public shareholder base, such gains are at least partly offset by the loss in corporate efficiency and value that results from the ineffective control of such managers with, in many cases, negligible ownership stakes.

Active investors like private equity firms and some hedge funds attempt to address both the information and the control problems that confront the absentee owners of publicly traded enterprises. The hallmark of these investors is putting a substantial part of their net worth at stake along with their investors.

Hedge fund activists buy large minority stakes in public companies, and so achieve "influence" and, in some cases, a measure of control. Private equity investors effectively combine ownership and control by purchasing public companies, or their divisions, thereby eliminating the role of public shareholders. The result in either case is an improvement in corporate efficiency and increasing corporate values by reducing the gap between ownership and control. The presence of major shareholders, and oftentimes on boards, means that tough operating and financial decisions are less likely to be avoided or influenced by parties with little or no capital at risk, such as investment banks, “independent” board members, or proxy advisers.

There are at least five reasons why today’s revolution in active investing will have a deeper and more lasting impact than prior waves:

Greater availability of capital: Reflecting positive and sustained historical returns, private equity and activist hedge funds are attracting record amounts of capital from a widening group of investors, including pension funds, endowments, insurance companies, and wealthy individuals.

Deeper industry expertise with extensive deal-making and boardroom experience: Active owners bring to corporate boards a level of oversight and industry expertise that, going well beyond that provided by the part-time, “independent” directors of most public companies, is far more likely to generate productive changes in company performance and governance.

Powerful modeling capabilities to better understand company value drivers: With their owner orientation and growth in assets under management, active investors are in the forefront of thinking about company valuation and adopting faster and better tools to analyze company fundamentals.

Political and boardroom environments have become more receptive: With their growing track record for scrutinizing management and boards, and success in pushing for policies that increase shareholder value, active investors have gained a moderate (though by no means unmixed) degree of public recognition and support as agents for effective corporate governance. At the same time, however, the concentrated ownership of such investors conflicts with the principle of director “independence” embodied in rules such as Sarbanes Oxley—a principle that may be limiting the information and incentive benefits that outside active owners can bring to public companies.

Global competition and technological advances are increasing the need to restructure businesses: Hedge fund activists have been successful in forcing mature companies to sell off non-core assets, return capital to shareholders, and push founders to hand off businesses when the time is right. Swapping debt for equity in a leveraged buyout encourages management to tackle difficult downsizing issues, while the periodic need to return capital to investors and raise additional funds creates an effective discipline and puts a premium on maintaining a reputation for honest dealing.

The trends identified above suggest that the revolution of active investing will continue to grow and shape the corporate landscape. Market forces, and the strong economic winds at their back, are responding to a fundamental problem faced by public companies. The organizational model of private equity and hedge fund activists, which leverages the information and incentives of ownership, and pushes these two types of active investors towards convergence, will likely continue to evolve and become even more successful in their search for value. At the same time, the competitive process will continue to push public companies to adopt an ownership model that takes advantage of the power of outside active investors to stimulate more effective governance. The greatest threat to this process are new legal rules, which, like provisions of Sarbanes Oxley, exchange listing rules, and the Investment Company Act of 1940, restrict the natural and beneficial practice of investors looking after their investments.

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