In a follow-up to Monday’s posting about the impact of hedge fund activism, here are two recent studies that seem to support the OECD’s claim that activist hedge funds are good for corporate governance. Both of them reveal some of the secret sauce that can make activist hedge funds so tasty.
The first study, by Nicole Boyson and Robert Mooradian of Northeastern University concludes that – contrary to previous findings – activist hedge funds actually do accompany improved business performance. The researchers cite earlier research that finds activist investors (pensions and mutual funds, not hedge funds) are largely unable to create operational change and instead opt for governance improvements and a reduction of agency costs associated with management teams squirreling away too much cash. They say the inability to enact changes is often the result of a lack of resources dedicated to activism, political roadblocks, and inexperience actually running companies.
However, Boyson and Mooradian find that activist hedge funds seem to be able to make things work where traditional activists have not.
“Our results differ significantly from previous literature. For our sample, on average both short-term and long-term target performance improves following hedge fund activist activity. One possible reason for this difference is that hedge funds target different types of firms than other activists. Most other activists target large firms with poor stock and operational performance. While hedge fund targets also typically have poor stock performance, they are small in size and usually have good operational performance, making them potentially better candidates for improvement by activists.”
They cite several other reasons why hedge funds make good activists.
“In addition, hedge funds themselves are different from other types of activists. First, hedge funds rarely have conflicts of interest (such as politically-motivated agendas) common among pension funds and mutual funds. Second, hedge funds are willing to spend money; the average target firm holding in our sample is about $18 million. Third, although hedge funds are often considered to be short-term investors, this is not true for our sample of activist funds, as the hedge funds typically stay active in their targets for over two years. Fourth, many activist hedge funds have lockup provisions. A lockup provision requires that hedge fund investors not withdraw their money for a fixed time (usually 6 months to 1 year), thus encouraging longer term strategies.”
The authors also cite the fact that most hedge fund managers invest a substantial portion of their own capital in their funds – thus aligning their own interests more closely with those of other shareholders (this isn’t usually true of mutual funds and is essentially never true of pension fund managers).
But hedge funds’ secret weapon, says the study, might be their ability to own more than 10% of a company’s stock. Naturally, this makes management take them very seriously.
The second study, by Harvard’s Robin Greenwood and Morgan Stanley’s Michael Schor is slightly less sympathetic to activist hedge funds – but even less sympathetic to the past activist efforts of pensions and mutual funds.
Greenwood and Schor maintain that traditional activists (pensions and mutual funds) are “ineffective monitors” of corporate management and are therefore “better off selling stock of a poorly managed firm rather than advocating for change.” By contrast, they say, hedge funds are “up to the task of monitoring management”.
But they also say that hedge funds seem to succeed despite themselves:
“What accounts for these high returns [of activist hedge funds]? One hypothesis is that activists improve the firm as a going concern, either by firing management, or by forcing management to institute operational or governance changes. But this hypothesis is difficult to reconcile with evidence that hedge funds institute only limited measurable changes. Even when hedge funds are successful at implementing change, it may take several years for shareholders to recognize that these changes were good. Furthermore, a finding that hedge funds were successful monitors of management would be difficult to reconcile with the conventional wisdom that hedge funds have short investment horizons.”
So what does make activist hedge funds appear so smart? Apparently, it’s their ability to identify targets, not their operational or strategic acumen. And what makes a good target for activism? One that can be sold more easily in an M&A transaction. In fact, activist targets that remained independent (i.e. weren’t sold off) was examined, the activist hedge funds fared no better than their pension and mutual fund peers.
Activist hedge funds tended to target smaller companies with no analyst coverage and small market-to-book ratios.
But a profitable exit from an activist investment may also be a self-realized prophecy. According to the authors, the mere presence of an activist hedge fund increases the likelihood of the company being acquired.
The report concludes with this rather backhanded compliment for activist hedge funds:
“Our findings leave us with a narrower view on the role of activist investors in monitoring management. While recent popular accounts suggest that we are in an era of the imperial shareholder, our results indicate that activism tends to be most successful when there is a high probability of a takeover. Where improvements may take several quarters or even years to realize, the investment horizon of hedge funds makes them unsuitable overseers of management. Firms that would benefit from modest changes in operating policy or governance, or for which a reduction in CEO pay is to be desired, are not likely to hit the radar screen. Of course, hedge funds do occasionally succeed in changing the board, initiating or increasing dividends, repurchasing shares, or cutting executive pay– it is simply not clear that these changes increase shareholder value relative to getting the target acquired.”
Which brings us back to the OECD and ITUC reports and the central question of whether activist hedge funds have any socially redeeming qualities. While activist hedge funds may not have a track record of enacting operational or strategic change, apparently they do possess an ability to convince capital markets that a company is worth more than is generally realized. This would help explain the OECD’s paradoxical observation that the presence of short-term investors can lead to long-term business improvement.