Hedge Fund Activism Creates Shareholder Value

Sir William Davenant wrote “Actions rare and sudden, do commonly Proceed from fierce necessity” (Hale 10). One can argue that recent hedge fund activism (“HFA”) constitutes poetic justice with reference to top managers and directors who cause agency problems within publicly-traded firms. HFA achieves its goal of creating value for shareholders according to the preponderance of the evidence.16 Some evidence “suggests that hedge funds participating in private placements practice more intense activism” (30).17 What are hedge funds and how are they different from other institutional investors? 

Hedge funds typically organize as limited partnerships. The general partner manages the entity, and the limited partners invest their capital but remain passive so as to avoid liability above their investments (Brav et al. 1735). Although hedge fund activists are a “small sliver of the hedge-fund world, their assets have “risen by a factor of five over the past decade” (Economist 21-24).18 Hedge fund activists routinely charge fees to their investors of 2% of assets under management plus 20% of the profit of each deal.19 Clifford points out that hedge funds enjoy a lack of regulation compared to mutual funds and pension funds, and this lack of transparency coupled with their unique organizational features provides “an interesting laboratory to study shareholder activism” (325). Besides a strong personal financial incentive and lack of regulation, a hedge fund does not face the “political barriers that limit the effectiveness of traditional institutional investors” (Brav et al. 1773).

Unless activists choose to announce their initial purchase, they generally remain under the “radar screen” until their ownership exceeds a 5% threshold (Boyson and Mooradian 7).20 After entry the hedge fund activists ordinarily begin their interactions with top managers and directors. George and Lorsch assert that HFA compels directors and managers to focus upon “short-termism and excessive attention to financial metrics” (90). Top managers and directors need a strategic focus and tactical maneuvers in order to either “fend off activist advances or use them to improve their organizations” (George and Lorsch 90). George and Lorsch outline some strategy and tactics as follows: “meeting performance goals, lining up external advisers, building board chemistry and considering activist ideas” (91). Brav et al. report that hedge funds have caused some targets to convert executive compensation salaries into pay-forperformance agreements; and have even provoked some boards of directors to replace lackluster CEOs (1770).21 Activists want CEOs to be substantial shareholders. The research evidence on HFA reveals positive long term effects that overshadow any validity for what some critics of shareholder activism describe as cases of short-termism.22 Brav et al. explain that their data show that HFA is not as short-term as the critics of activism contend (1740).23

Clifford documents that activists earn larger stock returns on targeted firms “at the filing window” (335), and “significant positive wealth effects in the target firms” (324). Brav et al. find positive returns at announcement, and these positive returns are unabated “during the 1-year period subsequent to the release” (1730).24 Bebchuk, Brav, and Jang track performance for five years after the intervention, and “find no evidence that [. . .] short-term gains come at the expense of subsequent long-term declines in operating performance” (1117). Using regression analysis the buy-and-hold returns stay positive for the three and five year holding periods (Bebchuk, Brav, and Jang 1126).25 Brav, Jiang and Kim note that HFA creates long-term value for shareholders so it is not just an over-reaction to news that an activist bought a position (221). And the evidence shows that HFA generates value not because activists are good stock pickers, 26 but because they “commit upfront to intervene in target firms on behalf of shareholders, and then follow through on their commitments” (Brav et al. 1773).27 When a hedge fund exits after its intervention failed to effect positive shareholder results, targeted firms’ prices customarily decline; thereby indicating that positive announcement returns reflect the market’s expectation for the success of HFA (Brav et al. 1731). The Economist analyzes the 50 largest activist positions taken since 2009, and finds that “in most cases profits, capital investment, and R&D have risen” (23). Gillan and Starks state that recent HFA has provided more evidence of gains from activism, but the long-term effects are unknown and warrant more research (69). HFA generates other consequences within target firms, rivals (peers), and the overall market. 

Aslan and Kumar observe spillover effects after announcement on the product market performance of rivals with respect to their “productivity, capital investment, and operational returns” (2-3). The authors “control for the peers’ performance based on timevarying investment opportunities and industry specific fixed effects” yet still find that HFA “significantly affects the product market performance” (Aslan and Kumar 27). Their findings indicate that financial markets expect HFA to result in product market improvements and greater productivity and efficiencies among targets and their rivals (Aslan and Kumar 3)

Another way HFA enhances firm values involves innovation-especially the quantity and quality of patent grants. Wang and Zhao find hedge fund ownership increases innovation (385). If a hedge fund holding represents a significant portion of the fund’s assets under management, then such holding likely nourishes more innovation by the target (Wang and Zhao 369). Hedge funds foster patent innovation because these activists believe high quality projects-based upon secure patent protection-generate free cash flows for years to come (Wang and Zhao 377-378). Other effects on hedge funds generally, and activists, particularly, include fund size and fund age, “new vote buying,”28 and takeovers. 

Historically, small and young hedge funds actively and nimbly move into positions that oftentimes older and larger hedge funds refrain from taking because they become somewhat passive with age and size-unless these funds are taking positions in largely capitalized target firms (Boyson 27).29 Boyson finds on a sample of hedge funds from 1994-2004 as follows: “A portfolio of young, small, good past performers outperformed a portfolio of old, large, poor past performers by nearly 10 percentage points per year” (42). 

Hedge funds may decouple economic ownership and the voting right. Leading activists engineer new vote buying by short selling (borrowing securities in the process), and deploying complex equity derivative securities (Hu and Black 363). Sometimes the activist fund decouples, and thereby votes more shares than it economically controls (empty voting), and on other occasions via decoupling, it controls more economic benefits than the traditional one vote for one share protocol (hidden ownership). Once regulators better understand new vote buying they may need to more fully regulate disclosure of empty voting (Hu and Black 363).

Researchers of HFA discover different sets of target firms depending upon the date ranges and other parameters. Nevertheless, takeovers are surely germane to the overall activist menu. Activist intervention creates auction opportunity, and increases the probability that a target firm will be acquired (Greenwood and Schor 372). Greenwood and Schor point out that activists search for small undervalued firms that can be taken over (374). These authors disclose the “returns are highest for targets that are acquired within 18 months of the activist filing” (374).

Activists intervene in a small number of firms, and then reach out to other large shareholders-index funds and money managers-for support of their agendas (Economist 24).30 Activist agendas also include larger asset divestitures (spinoffs) than those incurred under “passivist blockholders” (Clifford 331). HFA does not always coincide with the interests of other shareholders. HFA reins in top managers and directors who have become more bureaucratic and less entrepreneurial by bringing them to task for past actions and forcing them to declare future goals. Hedge fund activists spend considerable funds to invest, and then seek changes within their targeted firms. One can argue that other shareholders are “free riders” to the positive results of HFA. Brav et al. believe HFA “might remain a staple of corporate governance [. . . .]” (1774). 

Activists confront the regulatory agencies, and surprisingly, are still relatively unregulated (Kahan and Rock 1021). One can hope that if regulation comes it will not squeeze out activists who are helpful to most shareholders. Kahan and Rock believe that companies can make the necessary changes to thwart rogue activist maneuvers (1021). Recent HFA has not used “greenmail and other unsavory tactics” (Kahan and Rock 1090). In the final analysis, activists are minority shareholders-typically controlling 2-10% of the votes-so they cannot exercise control without vital partnering with other large shareholder blocks. 

Footnotes:

16 The Wall Street Journal reports on October 6, 2015 about 71 activist campaigns since 2009 taking on large U.S. companies “with market capitalizations of more than $5 billion” and finds mixed results, but the companies are more likely to “outperform stocks among their industry peers” ( Benoit and Monga A1, A6). 

17 The authors found that 80% of hedge fund activists acquire investment funds by way of private placements. See Boyson and Mooradian 16. These authors write that these funds “induce better long term firm performance, and reap the benefits from higher stock prices, both short and long term, and better long term operating performance” (30). 

18 The Economist reports that of about “8,000 hedge funds activists number 71-less than 1%.” However, “at $120 billion under management the activists account for about 4%” of the assets under management (21-24).

 19 Activist hedge funds lock in their investors’ money for one to two years whereas the average hedge fund, a few months (Economist 21-24).

20 They must file 13D forms with the Securities and Exchange Commission within 10 days of the date the threshold is met (7). All institutional managers are subject to the disclosure requirements of section 13F of the Securities Exchange Act (Kahan and Rock 1063). Hu and Black argue that 13F rules “provide little disclosure of either empty voting or hidden (morphable) ownership [. . . .]” (359-361). 

21 Brav et al. find that HFA is “associated with an almost immediate increase in payout [dividends and stock buybacks], heightened CEO discipline, and an improvement in analyst sentiment” (1773). 

22 Kahan and Rock express that the “pressure for short-term results over more valuable long-term benefits is the most severe attack leveled on hedge fund activism” (1021, 1087). 

23 The authors stress that the upper 25% of the deals offer more upside than the corresponding downside of the lower 25% (1760).

24 “An explanation for the high abnormal return is a temporary price impact caused by buying pressure from the filing hedge fund or other hedge funds” (Brav et al. 1760). 

25 The authors did not find evidence those interventions “involve ‘sacrificing the future for a quick buck’” (1114). 

26 The authors disclose that a “small portion of positive abnormal return might be due to stock picking” (1766). 

27 Results show that the credit worthiness of debt claims improves for target firms after activist intervention. See Brav, Jiang and Kim 226.

28 This term appears in Hu and Black 343. 

29 “General Electric, Microsoft, and Apple are all massive companies that have come into activist investors’ sights” (Reilly C6).

30 Bebchuk, Brav, and Jang write “activists do not generally target well-performing companies” (1117).

Works Cited 

“Activist funds: An investor calls.” ECONOMIST 7 Feb. 2015: 21-24. Aslan, Hadiye and Praveen Kumar. 

“The Product Market Effects of Hedge Fund Activism.” Journal of Financial Economics accepted manuscript, in press (2015, September): 1-41. Bebchuk, Lucian, Alon Brav, and Wai Jang. 

“The Long-term Effects of Hedge Fund Activism.” Columbia Law Review 115.5 (2015, June): 1085-1155. Benoit, David and Vipal Monga. 

“Activist Campaigns Yield Mixed Results.” The Wall Street Journal 6 Oct. 2015: A1. Boyson, Nicole M. 

“Hedge Fund Performance Persistence: A New Approach.” Financial Analysts Journal 64.6 (2008): 27-44. Boyson, Nicole M. and Robert M. Mooradian. 

“Intense Hedge Fund Activists.” (October 12, 2009) (unpublished manuscript), available at http://ssrn.com/abstract=1492641. Brav, Alon et al. 

“Hedge Fund Activism, Corporate Governance, and Firm Performance.” The Journal of Finance LXIII.4 (2008, August): 1729-1775. Brav, Alon, Wei Jiang, and Hyunseob Kim. 

“Hedge Fund Activism: A Review.” Foundations and Trends in Finance 4.3 (2009): 185-246. Clifford, Christopher. 

“Value creation and destruction? Hedge funds as shareholder activists.” Journal of Corporate Finance 14 (20080: 323-336. Gantchev, Nickolay, Oleg Gredil, and Chotibhak Jotikasthira. 

“Governance under the Gun: Spillover Effects of Hedge Fund Activism.” 1-52 (Jan. 2015) (unpublished manuscript), available at http://ssrn.com/abstract=2356544 (on file with Columbia Law Review). Greenwood, Robin and Michael Schor. 

“Investor activism and takeovers.” Journal of Financial Economics 92 (2009): 362-375. George, Bill and Jay W. Lorsch. 

“How to Outsmart Activist Investors.” Harvard Business Review May 2014: 89-95. Gillan, Stuart L. and Laura T. Starks. 

“The Evolution of Shareholder Activism in the United States.” Journal of Applied Corporate Finance 19.1 (2007, Winter): 55-73. Hale, Sarah Josepha, ed. A Complete Dictionary of Poetical Quotations: Comprising the Most Excellent and Appropriate Passages in the Old British Poets. Philadelphia: Lippincott, 1852. Hu, Henry T. C. and Bernard Black. 

“Hedge Funds, Insiders, and the Decoupling of Economic and Voting Ownership: Empty Voting and Hidden (Morphable) Ownership.” Journal of Corporate Finance 13 (2007): 343-367. Kahan, Marcel and Edward B. Rock. 

“Hedge Funds in Corporate Governance and Corporate Control.” University of Pennsylvania Law Review 155.5 (2007, May):1021-1093. Klein, April and Emanuel Zur. 

“Entrepreneurial Shareholder Activism: Hedge Funds and Other Private Investors.” The Journal of Finance LXIV.1 (2009, February): 187-229. Reilly, David.

 “Activists Hunt Big Game, but Big Banks Remain Elusive.” The Wall Street Journal 12 October 2015: C6. Wang, Ying and Jing Zhao. 

“Hedge Funds and Corporate Innovation.” Financial Management (2008, Summer): 353-385.