Money Stuff: ESG Isn’t Passive Anymore

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One reason to buy stock in a company is that you think the company is good, you like its management, and you think the stock will go up. This is probably the most normal reason to buy stock. It is sometimes called buying stock for “investment purposes.” It is also sometimes called being a “passive investor,” though that terminology is confusing. Here it means that your relationship with the company is passive: You’re not trying to change things and are just along for the ride. (People often use “passive” to refer to index investing, where you don’t make active choices about which stocks to buy, but that is not the sense in which I am using it here.)

Another reason to buy stock in a company is that you think something is wrong at the company and you would like to see some changes. By buying stock, you become an owner of the company, [1]  and as an owner you can call the company up and demand changes. Your relationship to the company is active.

This covers a range of possibilities. The maximal form is: You buy all the shares of the company, take it over, fire the executives, install yourself as chief executive officer, change the company’s name and strategy and generally treat the company as your business, because you own it.

The minimal form is: You buy one share of the company so that, if you have some sort of customer service complaint, you can call investor relations rather than the general customer service line. [2]

An important intermediate form is: You run an activist hedge fund, and you are in the business of acquiring stakes in companies, agitating for changes in management or strategy or capital allocation, and running proxy fights if the companies don’t give you what you want. You don’t want to own the whole company yourself, but you want a seat in the boardroom and a say in the strategy. You think that the company has good assets and a good business, but management is making some important mistakes, and you would like to correct them so that the stock becomes more valuable.

Another important intermediate form is: You think the company is great, you trust management to run the business, but you have just a few general notes. “You’re doing a great job,” you tell management, “but could you keep an eye on your carbon emissions? Maybe emit less, or buy cleaner electricity, or buy carbon credits to offset the flights you take?” Or: “You’re doing a great job, but some of your governance policies are pretty shareholder-unfriendly. You’ve got a staggered (or ‘classified’) board, where one-third of the directors are elected each year to three-year terms, so if an activist hedge fund wins a proxy fight it can’t immediately take over the board. Now of course I am not an activist hedge fund, I have no specific complaints, and I have no desire to replace the board. But I think that it is good practice to elect all the directors every year: It forces some accountability, and it signals that you care about shareholders. Why don’t you declassify the board so that I can feel better about your governance?”

These sorts of criticisms are sometimes lumped under the heading of “ESG,” environmental, social and governance investing. They are also sometimes described as “systemic stewardship.” You have a general, systemic idea of how companies ought to be run — they should be concerned with climate change, they should have shareholder-friendly governance — and you tend to push it on all companies. There is a sort of economy of scale here: If you own the stocks of a lot of companies, it takes a lot of work to get up to speed on all of their businesses, but it’s relatively easy to conclude that staggered boards are always bad for accountability so companies should all get rid of them.

You could have a ranking of how active a shareholder might be, from most passive to most active:

1. Pure passive investing, just owning the stock and never talking to the company.
2. Occasional customer service calls.
3. Meeting with management to suggest ESG-type improvements.
4. “Activist” investing, pushing specific strategic or management changes, and running proxy fights if the company says no.
5. Actual takeover.

The edges of those categories are blurry, and sometimes investors shift from one category to another; it is all a continuum.

Except that, for a lot of legal purposes, there is a sharp dividing line between “activist” and “passive,” or between “trying to control a company” and “buying stock solely for investment purposes.” If you are trying to take over a company, for instance, you need to get approval from antitrust regulators; if you are just a passive investor, you don’t. If you are buying some stock and making some suggestions to management, you might think “ehh I’m just an investor, no antitrust problem here,” but the antitrust regulators might disagree. Activist hedge funds, and also Ryan Cohen, sometimes get in trouble over this sort of misunderstanding.

I think it is fair to say that for most legal purposes in the US, for most of the last few decades, the dividing line has been roughly between my Categories 3 (ESG) and 4 (activism): Activist hedge funds and actual takeover attempts are lumped in as “trying to control a company” and are heavily regulated, while occasionally meeting with management to suggest better governance is lumped in as passive investing and is not particularly heavily regulated.

The intuition is that some people — acquirers, corporate raiders, activist hedge funds — are in the business of making drastic changes to companies, and they seek the sorts of control that implicate regulatory concerns. But every investor — or at least every big, engaged, professional asset manager with a fiduciary duty to its clients — might sometimes want to meet with the managers of the companies that it owns and give some feedback. It would be irresponsible for managers to refuse to listen to their shareholders, and it would be irresponsible for professional asset managers not to keep an eye on the companies they invest in. Having those meetings doesn’t mean that you control the company; it just means that you are an engaged shareholder. 

And then the big development over the last few years is that the line is shifting; increasingly it is between my Categories 2 and 3. Institutional shareholders who meet with managers to discuss business or governance or climate policies are now often viewed as trying to control the company, and they are subject to more regulation.

Part of the shift is that big institutional investors have gotten bigger, and there is more awareness of their power. The “Big Three” index fund firms (BlackRock, Vanguard, State Street) now own huge chunks of every US public company, so it just seems like they have a lot of control over companies and the economy; it feels increasingly weird to just treat them as passive investors.

But part of the shift is a political backlash, in the US, to ESG investing: There is a sense among Republicans that big investment managers are too “woke,” and that their preferred environmental and social policies are too left-wing. [3] Regulating how investment managers meet with the companies they invest in is a way to discourage ESG policies.

So we have talked about various arguments that big institutional investors should be subject to antitrust regulation if they meet with companies and advocate for policies. And we talked last year about arguments that those investors should be subject to more bank regulation. If you own more than 10% of a bank’s stock, you are normally treated as a controlling owner of the bank and are subject to a lot of onerous regulation. Traditionally big asset management firms got exemptions from those rules, because they were obviously just running index funds, not building banking empires. But that is no longer so clear, and the Big Three’s “passivity agreements” with bank regulators are now more hotly negotiated.

And then there’s the US Securities and Exchange Commission. The SEC draws the dividing line between active and passive using two disclosure forms, Schedule 13G and Schedule 13D. If you’re an activist — if you are trying to take over a company, or run a proxy fight, or push for big management and strategy changes — you file a Schedule 13D when you acquire more than 5% of a company’s stock. You have to file that within five business days of acquiring the stock, and you have to disclose your intentions, your trades, your sources of financing, etc. If you are coordinating with other activists, you are treated as a “group” and subject to restrictions on your trading.

Meanwhile if you are a passive investor, your disclosure is not particularly detailed or real-time: You file a much shorter Schedule 13G, and you generally get to wait until 45 days after the end of the quarter in which you buy the stock. 

Traditionally takeover bidders and activist hedge funds file 13Ds, and big index fund managers file 13Gs. And the big index fund managers meet with companies and make suggestions, but are nonetheless not treated as activists by the SEC.

Last week that changed. The SEC put out new staff guidance, in the form of a questions-and-answers page, saying that too much ESG advocacy makes you activist:

Generally, a shareholder who discusses with management its views on a particular topic and how its views may inform its voting decisions, without more, would not be disqualified from reporting on a Schedule 13G. A shareholder who goes beyond such a discussion, however, and exerts pressure on management to implement specific measures or changes to a policy may be “influencing” control over the issuer. For example, Schedule 13G may be unavailable to a shareholder who:

recommends that the issuer remove its staggered board, switch to a majority voting standard in uncontested director elections, eliminate its poison pill plan, change its executive compensation practices, or undertake specific actions on a social, environmental, or political policy and, as a means of pressuring the issuer to adopt the recommendation, explicitly or implicitly conditions its support of one or more of the issuer’s director nominees at the next director election on the issuer’s adoption of its recommendation.

And this week the Financial Times reports:

BlackRock has cancelled meetings with companies in the middle of shareholder battles because it fears that it could violate guidance on investor activism that the US Securities and Exchange Commission issued last week.

BlackRock and other asset managers typically talk with companies about voting ahead of activism campaigns and also about routine proxy ballot issues at annual shareholder meetings.

But that practice has been called into question by the SEC’s guidance, which has been widely interpreted as an attack on using environmental, social and governance (ESG) factors in investing. The change imposes more onerous regulatory requirements on fund managers that may be seeking to influence corporate behaviour.

“This guidance exploded like a grenade in the middle of pending proxy fights last week,” said Kai Liekefett, a partner at Sidley who is representing companies in activist fights that will vote imminently.

BlackRock, the world’s largest asset manager, temporarily paused “stewardship” meetings to assess what the SEC rule change meant, one person familiar with the matter said. Semafor first reported on BlackRock’s move to halt the meetings.

The theory, I suppose, is that even regular non-activist institutional shareholders, if they are big enough, have too much control over companies to be treated as purely passive. So the new SEC wants to cut back their ability to pressure companies, and particularly their ability to pressure companies to do ESG.

I for one have enjoyed Bill Ackman’s recent attempts run an investment fund that trades at a premium. Ackman’s thesis appears to be:

1. I am a very good investor.
2. Therefore, people should pay a premium for an investment vehicle that I manage, particularly if I charge low fees. If you invest $100 with me, that $100 should be worth $120, because I am investing it.

Not a crazy thesis, really. [4] So last year Ackman tried to launch a new closed-end fund that would trade at a premium. This did not work: Investors did not want to buy it at a premium, so it fell apart. “It requires a significant leap of faith and ultimately careful analysis and judgment for investors to recognize that this closed end company will trade at a premium after the IPO when very few in history have done so,” Ackman said, but they never took that leap.

What must particularly sting here is that Ackman has a good record of launching innovative hedge fund vehicles. He was early to the idea of “permanent capital vehicles” for hedge funds, with his Europe-listed Pershing Square Holdings, and he did stuff with special purpose acquisition companies that would bring a tear to your eye. He is a guy who sits down with the best advisers and comes up with clever ways to structure fund investments, but he can’t crack the code of launching a fund that trades at a premium.

Meanwhile all sorts of random people do it without even trying! Fund managers, sometimes; we have talked about the Destiny Tech100 fund, which has traded at a huge premium to the value of its holdings of private tech companies. But there has also been a vogue for “Bitcoin treasury companies,” particularly MicroStrategy Inc. [5]  but also various imitators, where the idea is:

1. You take a public company.
2. That company spends its money buying Bitcoin (or, sometimes, a different cryptocurrency).
3. Investors get excited and pay more for the company’s stock than the underlying Bitcoin is worth. [6]

Also Warren Buffett. Warren Buffett, famously, took control of a mediocre textile company called Berkshire Hathaway Inc. in the 1960s, and used it as a platform to make investments. If you buy a share of Berkshire Hathaway, what you are getting is roughly a share in Warren Buffett’s investment vehicle. Those shares have often traded at a premium to net asset value, [7] because Warren Buffett has a good track record, so investors like to give him money.

What do they all have that Bill Ackman doesn’t? You can be like “well Warren Buffett is pretty special,” but all the chief executive officers of the Bitcoin treasury companies can’t be that special, so that can’t be it. A reasonable answer — the answer that Ackman seems to have hit upon — is: They all run regular public companies. It is hard to get a thing that is technically an investment fund to trade at a premium to net asset value, for a combination of psychological and technical reasons. But if you take a textile company and use it as an investment vehicle, there is nothing to anchor its stock price to its net asset value, so maybe people will pay up for it.

It doesn’t have to be a textile company. It’s more or less completely arbitrary: Berkshire Hathaway started in textiles; MicroStrategy makes software; we talked once about Ryan Cohen maybe trying to turn GameStop Corp., a video game retailer, into his investment vehicle. [8]  Take any company — ideally not a bank or financial company, just a regular boring normal company — put some money into it, use the money to make investments, and maybe the stock of the company will trade for more than the value of the investments. Ideally the company you start with would itself be a good investment — if you’re going to acquire control of a public company to showcase your investing skills, you might as well find a good one — but it’s not strictly necessary and wasn’t really true of Berkshire Hathaway. 

Anyway we talked about all of this last month when Ackman proposed to acquire control of Howard Hughes Holdings Inc., the real estate developer, pretty much explicitly to turn it into his Berkshire Hathaway. Yesterday Ackman was on X teasing his next Berkshire Hathaway:

At 4pm, we are going to announce a potential transaction which, if completed, will provide me and my firm with the opportunity to create our own, you might say, modern-day version of Berkshire. Fortunately, our starting base of assets won't be a dying textile company, but a very good business.

We will adopt similar, long-term, shareholder-oriented principles to Berkshire, and we intend to hold the stock forever.

It turns out it was Howard Hughes again:

Bill Ackman’s Pershing Square revised its offer to buy Howard Hughes Holdings Inc. as the hedge fund founder forges ahead with his pursuit of the real estate company.

As part of the offer, Pershing Square would acquire 10 million of newly issued Howard Hughes shares for $90 apiece, according to a statement Tuesday.

“The $900 million cash infusion will enable HHH to immediately begin to pursue the acquisition of controlling interests in public and private companies as part of its new strategy of becoming a diversified holding company,” Pershing Square said in the statement.

A Howard Hughes spokesperson didn’t immediately respond to a request for comment.

Ackman has been on the hunt to secure a deal with Howard Hughes for months. 

I joked on X, and also kind of believe, that the right move here would be to use GameStop as a platform, because you get a valuation premium and meme-stock retail investors automatically, but I guess that makes it an unattractive entry point. (Plus Cohen already has dibs on GameStop.) Someone else on X suggested that Ackman should take control of Herbalife Ltd. as his platform, which is honestly a very good and funny idea. Again, the “starting base of assets” is kind of arbitrary and doesn’t matter that much; it’s nice for it to be “a very good business,” but having it be a very funny joke is almost as good. The point is both to do good investments and to have the stock trade at a premium, and good memes are almost as good for the trading premium as a good investing track record.

Arguably there are two slightly conflicting ways to measure the success of a hedge fund manager:

1. There are annual league tables of hedge-fund performance, and you want to be at the top of them. So for instance Bloomberg publishes an “annual list of the best-paid hedge fund founders,” and being on that list is an obvious sign of success.
2. As I wrote last year, “the ultimate goal of running a hedge fund is to make enough money that you can replace the investors’ money with your own.” You start out with a little of your own money and a lot of outside investors’ money, you have years of good returns, and over time (1) you collect 20% (or more) of the investors’ returns as your fee and reinvest it in the fund and (2) you return a lot of outside investor capital. Eventually the fund is all your money and you close it to outside capital, become a family office and focus on growing your own money rather than working for outside investors.

But if you become a family office, you will probably stop sending out investor letters to outside investors, and you might fall off the league tables, and what is the point of making a billion dollars for yourself if nobody hears about it?

I am not sure that there is a good theoretical solution to this problem, but there is a decent practical solution, which is that you do not automatically and instantly drop off the league table just by closing your fund to outside investors. Today Bloomberg published its 2024 ranking of best-paid hedge fund managers, and it’s not like literally all of them run hedge funds. The top three — Izzy Englander of Millennium, Ken Griffin of Citadel and Steve Cohen of Point72 — do in fact run three of the biggest multistrategy hedge funds, so it makes sense to find them at the top of the rankings. 

But No. 5 in the rankings is David Tepper of Appaloosa Management. The managers’ earnings are broken down into (1) capital appreciation on the manager’s own money in his fund and (2) the manager’s share of fee earnings from running the fund, and Tepper is unusual in that essentially all of his earnings are capital appreciation: $1.7 billion return on capital versus only $20 million of fees. Why do his investors pay him so little? Well, here is a 2019 article about Appaloosa closing to outside investors and converting into a family office: It is apparently not quite done, and Bloomberg’s methodology says that “hedge funds must manage funds for external clients to be included on the list.” But Tepper seems to get the best of both worlds, mostly running a family office but also appearing on the hedge fund league tables.

Meanwhile Renaissance Technologies’ main fund has been closed to outside investors since 2005, but its founder Jim Simons is at No. 7 on the list, even though he died last May. Not exactly the best of both worlds.

This is dumb, but here’s a thing I have never understood about X, Elon Musk’s social media company that was formerly known as Twitter Inc. In 2022, Musk bought Twitter for, let’s say, $44 billion. That is, he paid about $44 billion for the equity of Twitter, which did not at the time have much debt. But he added some debt: He borrowed about $13 billion to pay for Twitter, with the remaining $31 billion or so coming in the form of equity investments from him and a few co-investors. So at the closing of the deal, Twitter (soon renamed X) had an enterprise value of about $44 billion, but its equity value, post-buyout, was less than that. Its equity value was like $31 billion: It was the same company, but it had a lot more debt, so there was less equity.

Actually its equity value post-buyout was much less than $31 billion, because the market for social media companies had deteriorated between signing and closing, and because Musk actually did a lot to tank the value of Twitter specifically. But then his co-investors would periodically go around marking down the value of their shares, and I was always like: from what? If Twitter’s value was “down 50%” from the buyout, did that mean that the equity was marked at $22 billion (actually down 30%) or at $15.5 billion? Meanwhile there was talk about the banks who loaned him the $13 billion also marking down the value of their debt significantly, which implied a very low valuation for the equity.

But recently those banks have been selling the debt at around par, and now here’s this:

Elon Musk’s X is in talks to raise money from investors at a $44 billion valuation, according to people familiar with the matter. That is the same price that Musk paid for the social media company in 2022, when it was called Twitter.

The funding round would be a remarkable turn of fortunes for the company after Musk’s takeover and overhaul caused many users and advertisers to flee. In December, prior to the current deal talks, Fidelity Investments had marked down its Twitter stake by about 70% from the 2022 sale price.

I assume that’s a $44 billion enterprise value — flat to what he paid for it — but if the equity that he bought for $31 billion is now worth $44 billion, that’s a good trade. It would be reductive to say “with his $44 billion purchase of Twitter, Elon Musk secured absolute control over the US government,” but even if you think that that is, like, 1% true, it’s probably worth $44 billion.

There are two typical ways to get financial advice in the US. You can go to a broker, who will give you some suggestions on what stocks or mutual funds to buy, and who will typically get paid out of commissions (you pay her some money each time you trade) and/or by the companies whose products she sells. Or you can go to a financial adviser, who will generally provide comprehensive investment advice and typically charge you an annual fee that is some percentage of your assets, often 1%. Historically financial advisers had a fiduciary duty to act in your best interests, while brokers could be pretty mercenary, but since 2019 retail brokers also have an obligation to act in your best interest when they recommend investments. 

Still, there is a lingering stereotype that brokers are out to make as much money as possible off of you, while fiduciary advisers are looking out for you and happy with their 1%. If your broker is calling you up every week with some new complicated structured product, putting you into new trades constantly, and charging fees each time, she is probably making more than 1% per year off of you. On the other hand, if you are just in some index funds, and your broker calls you once a month with a trade idea and you say “no thanks, I’m good with my index funds,” she is probably making less than 1% per year.

And so if (1) you are boring and steady and (2) your broker is greedy, there is a natural trade for your broker. The trade is: Become your financial adviser and start charging you 1% per year. [9]  There are problems with this trade, though:

1. You have to agree to it, and “pay me 1% of your account every year for the same service you’re getting now” is a tough sell. The broker might have to hide that in the fine print.
2. Your broker does have some obligation to act in your best interests (before and after you convert to an advisory account), and “pay me 1% of your account every year for the same service” does not seem to be in your best interests? 

Anyway on Jan. 21 I wrote “what if the US Securities and Exchange Commission never brings another enforcement case,” and I wasn’t that serious, but I was a little serious. But here is the first SEC enforcement press release of the second Trump administration [10] :

The Securities and Exchange Commission [Friday] filed settled charges against New York-based registered investment adviser One Oak Capital Management LLC, and former One Oak investment adviser representative, Michael DeRosa, for misconduct related to advisory services provided to their retail clients.

According to the SEC’s order, from approximately June 2020 through October 2023, One Oak and DeRosa recommended that DeRosa’s customers at an unaffiliated broker-dealer, at which he was simultaneously employed, convert more than 180 brokerage accounts to advisory accounts at One Oak. Most of these customers were elderly and had been long-time customers of DeRosa’s at the broker-dealer, which charged the customers on a commission basis. According to the order, One Oak and DeRosa ignored their fiduciary duty and failed to adequately disclose that the conversions from brokerage accounts to advisory accounts would result in significantly higher fees for the clients and increased compensation for DeRosa; nor did they disclose the resulting conflict of interest. The order finds that the change in fee structure resulted in significantly increased costs, but the clients generally received no additional services or benefits. The order further finds that One Oak and DeRosa failed to adequately consider whether it was in their clients’ best interests to convert their brokerage accounts to advisory accounts, and in fact, many of the accounts were not suitable to be advisory accounts.

From the SEC’s order:

For example, the accounts converted in 2020 and 2021 incurred a more than seven-fold increase in fees and costs on average, and some clients paid more than ten times in advisory fees to One Oak as they had paid in commissions to the broker-dealer over a similar time period. 

Despite the higher fees charged to the Converted Accounts, DeRosa did not significantly alter the trading activity of the accounts following the conversions to advisory accounts, or generally provide additional services to these accounts. While the accounts were brokerage accounts at the broker-dealer, DeRosa had discretionary authority to trade in the accounts, and he executed relatively few trades—approximately one transaction per two months per account, on average. After the conversions to advisory accounts, DeRosa did not significantly increase the trading activity in the Converted Accounts. In some instances, the number of transactions post-conversion decreased significantly because DeRosa did not obtain the necessary authorizations from clients to execute options trading strategies he had previously employed at the broker-dealer. Many of the Converted Accounts had few, if any, trades for more than a year after their conversion to advisory accounts.

Well, yes, right, the best accounts for a broker are the ones that trade a lot, and the best accounts for a financial adviser are the ones that never trade. For the customer, it’s the opposite.

First-Day IPO Trading Flops Threaten Next Wave of US Debuts. Anglo American Sells Nickel Business for Up to $500 Million. Nikola, Once a Darling of Green Investment, Files for Bankruptcy. Lingering Question at Coinbase: Who Really Owns the Customers’ Crypto? Who is the bad art adviser? Milei Crypto Scandal Widens With Allegations Against His Sister. 

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