Hedge fund activism has generated a large amount of public debate. On one side, the hedge fund activists and their academic cheerleaders argue that hedge fund activism is good for shareholders and society at large. On the other side, potential target companies, their law firms, politicians, and commentators (including academics and judges) blame it for undermining companies and long-term investment. Yet a decade’s worth of research shows that neither side is right.
Up to the mid-2000s, there was little persuasive evidence that shareholder activism generates any economically meaningful improvements in share prices or the operating performance of corporations. Commentators pinned the failure of shareholder activism on the poor incentives of the shareholder activists of the time, notably public pension funds.
Hedge fund activism was supposed to be different. Hedge fund managers have powerful financial incentives, collecting a healthy management fee on the assets they manage and earning 10 to 20 percent or more of their funds’ profits.
Early academic work on hedge fund activism by financial economists and corporate legal scholars proposed that these powerful economic incentives would lead hedge fund activists to focus on changes that would benefit shareholder value, unburdened by the political agendas of past shareholder activists like labor unions or public pension funds. Early research did show that the announcement of a hedge fund activist’s targeting of a firm, on average, generated stock price increases of around 8 percent.
It turned out, though, that most of that average return was driven by activism campaigns where the activist pressured the company to sell itself or take similar action. Aside from encouraging such sales, however, research shows that hedge fund activists seem to have little impact on their targets.
Activism has been equally unimpressive for investors in hedge funds, which seem to suffer from a “physician, heal thyself” problem of the first order. For example, Elliott Management, the best-known activist firm, barely eked out a positive return in 2018, though in fairness Elliott’s returns — especially given its $30 billion-plus size — are far better in most years than those of most of its competitors. Still, Elliott has not returned more than 16 percent in any year since 2009, far below the best years of the S&P 500.
In a new paper forthcoming in Virginia Law and Business Review, I explore three possible reasons why hedge fund activism has disappointed expectations of shareholder advocates and investors alike.
First, hedge fund activists have no comparative advantage in generating ideas for meaningful change at target firms beyond the sale of the firm. Of course, selling the firm — especially for more than it is worth — is good for target shareholders. But other price catalysts and improvements that hedge fund activists advocate — including changes in corporate governance mechanisms — tend to generate no meaningful returns for target shareholders.
That hedge fund activists lack comparative advantage is unsurprising, since they are almost never expert in the businesses of the firms they target, and the consultants and former executives they sometimes rely on for expertise likely have less insight into the business than executives actively competing in the field.
One can only smile at a recent quote from, Jeff Smith, an activist who has taken on the role of chairman of the board of directors at Papa John’s International Inc. He stated: “This has been a fun due diligence process for me and my office. We’ve been bringing in Papa John’s pizza and rivals’ pizza and doing taste tests in our office several times a week[.]”[1] While I suspect this comment is tongue-in-cheek, one wonders what possible comparative advantage the hedge fund activist has in leading a nationwide pizza chain.
Second, hedge fund activists underperform because of a kind of winner’s curse, where they are too pessimistic about the prospects of the firms they target, in turn overestimating the degree to which activism can improve the target. Many activists, in other words, are simply wrong about the firms they target because the hedge fund activist that is most negative on a particular firm – and therefore most likely to be wrong in the sense of the winner’s curse – is the activist most likely to show up at the target firm’s doorstep.
Third, hedge fund activists often target declining firms, the equity in which is often unsalvageable by the time the activist has taken notice. Such efforts are often a sort of preliminary vulture-capitalism, where the activist seeks to expropriate other corporate stakeholders before bankruptcy. But these distressed corporations are frequently beyond repair without a bankruptcy reorganization, so the activists are often unsuccessful.
In the end — and in the spirit of Thomas Edison’s famous comment about his failures on his way to inventing the light bulb — we have probably learned little more from a decade of research on hedge fund activism than additional reasons for why it does not work.
ENDNOTE
[1] Julie Jargon, Starboard CEO Jeffrey Smith Becomes Chairman of Papa John’s, The Wall Street Journal, Feb. 4, 2019.
This post comes to us from J.B. Heaton, the president of legal and financial consultancy J.B. Heaton P.C. It is based on his recent article, “The Unfulfilled Promise of Hedge Fund Activism,” available here.