Since the late 1990s, activist hedge funds have become the dominant face of shareholder activism, essentially taking over an arena that was once dominated by pension funds and mutual funds. Hedge fund activism (HFA) has attracted substantial public attention because of the large financial resources of activist investors, their ambitious agendas, and aggressive tactics that are widely covered in the media. But whether HFA is beneficial or detrimental to the shareholders of target firms remains highly controversial. Proponents marshal evidence that HFA is associated with significant medium-to long-run improvements in targets’ cost and investment efficiency and higher profitability and shareholder returns. Opponents, however, insist that HFA forces management to take myopic decisions that weaken firms in the longer run. This view has already been featured in the 2016 presidential campaign. For example, Democratic Presidential candidate Hillary Clinton recently characterized hedge fund activists as myopic, suggested that activist intervention leads to “quarterly capitalism,” and called for major reforms of the capital gains tax to “incentivize” hedge funds to hold their investment in target firms for at least six years. The debate rages in academia, media, and is going to remain juicy fodder in the political arena.
Despite this intense interest, however, the argument on the merits of HFA has curiously remained narrowly focused on its effects on the financial performance of target firms, which has hampered a resolution of the debate. In particular, comparison of targets’ post-intervention performance with their peer firms presents mixed evidence on the effects of HFA, as pointed out by a recent analysis by the Wall Street Journal (Are Activist Investors Helping or Undermining American Companies?, October 5, 2015). Furthermore, attention focuses on examples of intervention that make for good ‘sound bites,’ such as investor demands for paying large dividends, undertaking big share repurchase programs, or fights over board composition and company governance. Unfortunately, highlighting such anecdotes obscures the broad scope of HFA that often ̶ simultaneously or sequentially ̶ touches on virtually every major aspect of company management, including changes in product market strategy, negotiation tactics with suppliers and customers, and knowledge-based technical advice of production organization.
Introspection, grounded in basic economics, suggests that we broaden the scope of analysis in understanding the effects of HFA. Firms, after all, do not exist in vacuum; they have industry competitors, suppliers, and customers. In particular, if there are significant improvements in targets’ efficiency and competitive strategy, then we should observe corresponding spillover effects on their industry competitors. For example, if HFA really benefits target firms, then in a competitive industry the pain of that improvement should be tangible in the deterioration of rivals’ performance. Similarly, aggressive cost cutting and contracting efficiency measures by targets should be reflected in reduced profits of their long-term suppliers. This ‘proof should be in the pudding’ approach has intuitive appeal as a check for the true effects of HFA. In particular, while focusing on a few target firms may be inconclusive (with respects to economic effects of HFA) because of the noise in the profit declarations of individual firms, there is more reliable inference from competitor effects because typically there are a large number of rivals firms.
Our recent research (to be published in the Journal of Financial Economics), based on a comprehensive sample of activist investor interventions in U.S. firms from the mid-1990s through the end of the last decade, uncovers significant spillover effects of HFA on the industry rivals of target firms. We find that, on average, HFA has significant negative effect on rivals’ product market performance ̶ measured by their price-cost markups and market shares ̶ and on their operational efficiency, productivity, and capital investment. For example, three years after the onset of HFA, their rivals on average have 3.2% lower price-cost margins but also over 2% lower productivity compared to firms who competitors were not targets of activist investors. But if these effects are caused by HFA on targets, then they should be commensurate with improvements in targets’ economic performance; and, this is exactly what we find. Moreover, rivals with high debt or low liquidity, who are presumably constrained in their responses to target improvements, suffer more, as do rivals in more competitive industries. Conversely, rivals that had high intervention threats from activist investors, and presumably pro-actively initiated improvements in their firms, are able to effectively accommodate targets’ improvements. We spend considerable effort in separating the causative effects of target HFA from other spurious forces that may impinge on rivals’ performance.
Hedge fund activism often generates interest because of the immense wealth and flashy personality and tactics of activist investors. However, the effects of HFA have major implications since they speak to the efficiency of market monitoring of powerful executives. Executives control enormous resources and, especially in widely held firms, individual stock holders do not have the resources or information to monitor CEOs and ensure that companies pursue policies that provide the best value for their investors. By being the first to examine the industry-wide effects of HFA, we resolve some ongoing debates but also raise some potentially troubling issues. Activist investors do significantly improve the economic efficiency and competitive positions of their target firms; this is evident from the “pain” they seem to be able to inflict on the industry rivals of target firms.
However, we do not find support for the view that activist investors have industry-wide benefits, for example, through the introduction of best practices that are emulated by industry firms. Indeed, our analysis indicates that the post-HFA economic pressure on industry competitors lowers their capital investment and productivity on average, which may hasten the exit of weaker peers from the industry. And in ongoing research, we find that target firms improve profits by extracting price concessions from their suppliers. Of course, exit by economically inefficient firms is central to a dynamically efficient economy. Consistent with this, we find that the threat of activist investor intervention remains a potent incentive for firms to make pro-active improvements; such firms are generally able to compete effectively with target firms. Nevertheless, we have little knowledge today of long run economic effects of HFA on industry competition and innovation. For example, if HFA encourages “industry consolidation,” such as seen recently in the pharmaceutical industry, then there may be long run detrimental effects on R&D investment and innovation. In light of the positive industry- and economy-level externalities of R&D spending, such reductions in corporate research spending could have long run negative consequences for an economy built on continuous technological advancement. In a similar vein, there may be social costs from reduced employment if the pressured competitors and suppliers of HFA target firms are forced to lay off workers.
The analysis of the product market effects of HFA also generates some interesting hypotheses on the future of activist investor intervention. If firms become more efficient through pro-active responses to the threat of intervention, and if the number of activist investors keeps increasing, then the returns to HFA should come down over time. Furthermore, there can be a backlash to HFA from a variety of directions. Access to hedge funds is limited because the average individual investor does not have the financial wherewithal to invest in them. If HFA reduces the returns of the competitors to HFA targets (as shown by our analysis), then HFA is likely to adversely affect average investors, who are more likely to hold equity in the competitors than the target. That is, HFA is not a positive-sum game in terms of generating higher equity returns for all investors. In that case, there will be increasing pressure on mutual and pension funds (which is how most individual investors participate in stock markets) to put pressure on the management of firms they own. In this case, again, activist investors could lose their edge in return performance and could even become redundant.
The preceding post comes to us from, Hadiye Aslan, Assistant Professor of Finance at the J. Mack School of Business at Georgia State University, and Praveen Kumar, Professor of Finance at the C.T. Bauer College of Business, University of Houston. The post is based on their article, which is entitled “The Product Market Effects of Hedge Fund Activism” and available here.