Managers of public corporations sometimes need to be reminded that they work for shareholders. Without proper monitoring, managers may receive excess compensation or perks, or misuse free cash flow.
Historically, poorly performing managers have had little to fear. If a manager leads a firm to poor performance, most investors have found it easier to vote "with their feet" by selling shares, rather than making formal complaints. Large shareholders, however, have stronger incentives to monitor management.
The conventional wisdom is that because these shareholders have large positions, they keep a larger fraction of the gains that they produce by keeping watch over management. "Shareholder activism" refers to the practice of holding managers accountable for the performance of their firms. Shareholder activists have been known to ask for seats on the board, ask for the removal of a poison pill (a device that makes it difficult for a firm to be acquired), ask for a share repurchase or dividend increase, or, in extreme cases, ask for the removal of the CEO.
While a few pension funds, like CalPERS, have become famous for their activism, there is not much evidence that institutional investors as a whole have been effective activists, from the perspective of being able to institute changes that increase shareholder value. Often the reason can be traced to conflicts of interest between institutions and their corporate clients. For example, despite owning a large share of most public firms, mutual fund companies have been reluctant to engage in any form of activism (the same firms that are performing poorly may also be mutual fund clients).
The Activist Arena
Unlike mutual funds, the sole objective of hedge funds is to make money on their portfolio positions. Not surprisingly, hedge funds have entered the activist arena. The figure below shows that between 1994 and 2006, the number of public firms targeted for poor performance by hedge funds grew more than 10-fold.
More importantly, hedge funds may be up to the task of monitoring management—a number of recent academic papers have found that hedge funds generate returns of over 5 percent on announcement of their involvement, suggesting that investors believe these funds will increase the value of the firms they target.
In a new paper with Mike Schor (of Morgan Stanley), "Hedge Fund Investor Activism and Takeovers," we try to understand how hedge funds create value in their activist investments. We were skeptical of the argument that hedge funds institute significant operational changes. After all, hedge fund managers seem poorly suited to running public companies. And it seemed counterintuitive to us that a portfolio manager with a short investment horizon would be willing to devote time and energy to a task delivering long-term value. After all, there are no guarantees that the effort will pay off, or that other shareholders would recognize the increase in value by paying a higher price per share.
Our hypothesis was that rather than effecting significant operational change, hedge funds create value by putting firms "in play" as potential merger or acquisition targets. That is, the stock price rises because investors expect that these firms will soon be acquired at a sizable premium, and the involvement of the activist increases the probability that this will happen. Thus, hedge funds are better at identifying undervalued companies, locating potential acquirers for them, and removing opposition to a takeover. From the perspective of the activist, termination via merger or acquisition additionally helps solve the problem of how to exit the sizable position in the target. In a merger or acquisition, the activist exits in cash or with stock of a larger, more liquid company.
Mike and I assembled a comprehensive database of activist SEC filings between 1993 and 2006, focusing on instances where the target of the activism is a U.S. firm. In total, our database contains almost 1,000 events.
Our main result is that targets of investor activism earn high returns only for the subset of events in which the activist successfully persuades the target to merge or get acquired. This is best shown in the figure below, which plots the abnormal returns (returns net of a portfolio of "matched" stocks that were not subject to activism but were otherwise similar) around each event.
The majority of activism targets—firms that do not end up being acquired—earn average abnormal returns that are not statistically distinguishable from zero. This result applies to both announcement returns, as well as to the long-term returns following the initial activist filing. We also show in the paper that activists appear to increase the probability that firms get acquired. Put differently, we rule out the hypothesis that they simply pick stocks that are soon going to be acquired anyway.
Takeover As Motivator
Our findings leave us with a narrower view on the role of activist investors in monitoring management. While the Economist magazine recently suggested 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.
An important question that we hope can be addressed with future work is whether hedge fund activist-initiated acquisitions create value for the acquirers of these firms. One possibility is that hedge funds ensure that target shareholders receive the maximum possible price for their assets. Another possibility is that short investment horizons make them willing to accept takeover offers that do not fully recognize the overall value of the target—a merger at a low price is preferred to no merger at all.
Another question that interests us is what the role of activist investors in countries outside the United States will be. We have seen interesting examples of activism in the United Kingdom and Japan recently. We suspect that activism will become relatively more important in these countries. In Japan especially, there are relatively few mechanisms in place to ensure that managers run firms on behalf of shareholders, rather than themselves.