Activist hedge funds will soon likely have greater leverage in proxy contests, thanks to a new rule from the Securities and Exchange Commission. But will that benefit shareholders who care about long-term value? Our study suggests that it will – sometimes.
In November 2021, the SEC adopted a universal proxy rule that allows investors to choose the combination of candidates they vote for in a contested election. This differs from the existing rule, which requires them to choose between the company’s and a dissenting shareholder’s proxy cards.
The new rule lowers the barriers for nominations from traditional activists as well as from labor and climate activists and employees. It takes effect on September 1, 2022, and approximately 20 percent of Russell 3000 issuers will have to apply it at their 2022 annual general meetings in the event of a contested election.
With this likely increase in the electoral success of activists, it’s worth reconsidering the fundamental question of shareholder activism: When an activist wins a board seat, does that benefit other shareholders? What if this activist has interests that are misaligned with those of other shareholders?
Pros and Cons of Activism
Our paper speaks to the role of various activist groups, but our results are particularly relevant to activist hedge funds.
Hedge funds represent about three-quarters of the dissidents in proxy contests, and they launch about four-fifths of the contests.  In contrast to some other activists, they also build their reputations for activism to gain leverage for future campaigns. This has driven many of them to specialize, as the opportunities to engage with firms with easily fixable governance problems have been largely exhausted since the financial crisis. As a result, many activists have become industry-specific “serial activists.” 
Having activist directors is a double-edge sword. In monitoring tasks, such as verification of information about business projects, these directors challenge management – that’s beneficial. However, in other tasks, such as influencing the vote, their ability to block proposed projects may destroy value. Hedge funds have been criticized for aggressively following myopic agendas, such as cost cutting, that hurt long-term shareholder value. Put differently, when deciding on long-term investments, boards heavily influenced by activists may minimize “false positives” (approval of potential project failures) at the expense of excessively high “false negatives” (rejecting highly profitable projects, i.e., lost opportunities).
Direct and Indirect Effects
To give a fresh perspective on this problem, we study a situation in which a board approves or rejects proposals submitted by an empire-building CEO but does not actively advise the CEO, as management has access to rich industry and project information. This assumption comports with the currently popular setting in economics and finance called Bayesian persuasion. It also allows us to cleanly observe the effect of hedge fund activism. Our analysis is, however, also relevant in situations where the information is only partially under control of management.
When directors are responsible only for monitoring through approval decisions, the direct effect of the activist directors is clearly negative: Hedge fund directors block projects that the other shareholders support.
However, we identify an important indirect benefit of activists. Their presence motivates management to prepare more persuasive proposals. The quality of proposed projects improves, and the level of false positives goes down. The cost of this improvement is borne by management.
To understand how this happens, imagine that, absent activists, management proposes projects that look good overall but involve some parts that are favored by management and hurt firm value (e.g., CEO’s pet subprojects). Directors cannot identify these wasteful parts, so they approve the project, including the waste. With activists on the board, management must make the project more attractive overall to be acceptable to even the most skeptical directors. This forces management to eliminate the most wasteful parts.
In a sense, shareholder activism creates balance: Management’s empire-building bias toward false positives is offset by hedge funds’ bias toward false negatives. This makes the other shareholders better off. The optimal board therefore includes some biased directors, and their optimal proportion depends on the severity of the agency problems vis-à-vis the CEO and the distribution of project opportunities.
What If the Indirect Effect Is Limited?
Some projects are analyzed using preexisting procedures for measuring expected cash flows and value (as is the case with routine projects) but, due to their large size, they must be approved by the board. For these, the CEO doesn’t control the project information, and therefore the indirect benefit of activism is absent. In this case, only the negative direct effect remains, so hedge fund activism hurts company value.
In this context, we study what happens when the CEO randomly comes across a project that can be one of two types – routine or novel. If the project is routine, existing measurement procedures generate project information. If the project is novel, the information is provided by the CEO. Since the shareholders do not know what type of projects the CEO will come across, the optimal board reflects two conflicting objectives: It needs activist directors to assess novel projects but doesn’t need them for routine ones.
We demonstrate that a moderate level of activism is not optimal; either activists are absent, or they are present and influential. Why is so-so activism ineffective? A weak activist director can’t improve the information on novel projects and ends up only distorting decisions on routine projects. This lack of effectiveness is an interesting property of the optimal information structure provided by a rational CEO. Our paper is the first to analyze the implications of this property for optimal board composition and the role of activist hedge funds.
The new SEC rule is likely to improve the odds of electing activists to boards. For hedge funds, a greater chance of being represented on boards implies a shift from a hybrid internal-external role to a more internal role.
Will empowering activist funds come at a cost for other shareholders? In our paper, using tools from information economics and game theory, we show that directors nominated by activist groups, such as hedge funds, can benefit other shareholders, even if the activists are biased. The core of our argument is that the project information prepared by the CEO depends on the board composition. In the presence of activists, the CEO is forced to make the proposals more attractive to both the activists and other shareholders, and this improves the quality of approved projects. The channel we identify is also consistent with recent empirical finding on the benefits of hedge fund activism. 
 See Brav, Alon, et al. “Picking friends before picking (proxy) fights: How mutual fund voting shapes proxy contests.” Columbia Business School Research Paper 18-16 (2020).
 See Boyson, Nicole M., Linlin Ma, and Robert M. Mooradian. “How does past experience impact hedge fund activism?.” Journal of Financial and Quantitative Analysis 57.4 (2022): 1279-1312.
 The early literature finds little discernable positive change attributable to the activism. Recent empirical literature speaks more favorably about the hedge fund activism, both in the short and long term. It is established that the stock prices of target firms experience significant positive returns when the market first learns of the presence of the hedge fund activist. In addition, the literature documents improvements in operating performance in the longer period following hedge fund interventions, including increased productivity and increased innovation. See Brav, Alon, Wei Jiang, and Hyunseob Kim. “The real effects of hedge fund activism: Productivity, asset allocation, and labor outcomes.” The Review of Financial Studies 28.10 (2015): 2723-2769. For a recent survey, see: Brav, Alon, Wei Jiang, and Rongchen Li. “Governance by persuasion: hedge fund activism and market-based shareholder influence.” European Corporate Governance Institute–Finance Working Paper 797 (2021.
This post comes to us from professors Martin Gregor at Charles University, Prague, and Beatrice Michaeli at the University of California, Los Angeles. It is based on their recent article, “Board Bias, Information, and Investment Efficiency,” available here.