The lead article in Volume 23, Issue 6 of the Review of Finance is Governance Under the Gun: Spillover Effects of Hedge Fund Activism by Nickolay Gantchev, Oleg Gredil and Chotibhak Jotikasthira. This paper finds that the threat of hedge fund activism spurs non-targeted companies to improve profitability and valuations, increase payout, and reduce capital expenditure and cash holdings.
The Debate Around Hedge Fund Activism
Hedge fund activism is a controversial topic. Prominent lawyer Marty Lipton argues that the long-term future of corporate America is being undermined “by a gaggle of activist hedge funds who troll through S.E.C. filings looking for opportunities to demand a change in a company’s strategy or portfolio that will create a short-term profit without regard to the impact on the company’s long-term prospects.” US Senators Tammy Baldwin and Jeff Merkley proposed the Brokaw Act to crack down on activist hedge funds, claiming that “Activist hedge funds are leading the short-term charge in our economy. They abuse lax securities laws to gain large stakes in public companies…. We cannot allow our economy to be hijacked by a small group of investors who only seek to enrich themselves at the expense of workers, communities and taxpayers.”
Such statements have proven to be very influential. They confirm most people’s perception of activists – as greedy capitalists – and so, due to confirmation bias, they may be uncritically accepted even if they’re not backed up by evidence. Moreover, such extreme quotes give the impression that the matter is so clear cut that no evidence is needed. But before undertaking reform, diagnosis precedes treatment. Are these charges against hedge funds actually true? Accordingly, a wealth of research has studied the long-term effects of hedge fund activism on the targeted firms. Contrary to popular belief, it improves profitability, productivity, and innovation.
Yet studying the effects on targeted firms is only part of the picture. For policymakers contemplating whether to regulate hedge fund activism, they need to study its impact on the economy as a whole – the mere threat of activism may cause non-targeted firms to take action. It’s not clear which direction these effects will go in. A non-targeted company may get its act together and improve performance to avoid being targeted. Or it may take myopic actions to boost the short-term stock price, making it expensive for activists to buy a stake.
That’s where this paper steps in. Nick, Oleg and Pab aim to study how the threat of activism affects firm performance. To do this, they need a measure of activism threat. They start off by calculating investor inflows into a given activist hedge fund (say, ValueAct). When ValueAct receives more funds, it will be able to invest in more companies. The authors assume that ValueAct will allocate these new funds to industries based on its existing industry holdings. The rationale is that ValueAct will have already built up expertise in the industries it currently owns, and so will be more likely to make new investments into these same industries. For example, ValueAct turned around Adobe in 2011-2016, and then bought Seagate Technologies in late 2016, another company in the computing/software space. They repeat this for every activist hedge fund. Aggregating across all hedge funds, they obtain a measure Threat, which is the threat of activism in a given industry.
However, simply showing that industries with high Threat subsequently improve performance would be insufficient. It might indeed be that the performance improvement is due to the threat of activism. But it might also result from greater industry competition (Aslan and Kumar, 2016). For example, if ValueAct turns around Adobe, then Adobe’s greater efficiency will force other software companies to improve performance. In other words, other software companies take action to keep up with Adobe, rather than to avoid being targeted. So Nick, Oleg, and Pab develop a second measure which – crucially – is at the firm- rather than industry-level. Because it varies within an industry, it’s over and above any effect of industry competition. This measure, Threat Perception, captures how connected the directors of the firm are to targeted companies outside that firm’s industry. Following prior literature, they measure connected directors using educational links. For example, if a director of Costco did her MBA at Stanford at the same time as the director of Adobe, then her connections with the Adobe director may make her particularly aware of the activism threat and take action in response.
The authors indeed find that the combination of Threat (being in an industry held by activists who have received large capital inflows) and Threat Perception (having directors connected to directors of targeted firms outside the industry) causes firms to take action. An interquartile increase in Threat increases leverage (payout) by 0.8% (0.4%) and decreases capital expenditure (cash holdings) by 0.4% (0.6%) among non-targeted firms with high Threat Perception compared to those with low Threat Perception. In other words, while Threat causes all firms on average to take action, it has greatest effect on firms with high Threat Perception.
Now these results alone don’t show whether the spillover effects are positive or negative. One interpretation is that firms are generally underlevered (e.g. Graham (2000)), invest too much due to agency problems (e.g. Jensen (1986)) and hold too much cash (e.g. Dittmar and Mahrt Smith (2007)). The threat of activism forces firms to get their act together and make value-creating changes. But the results are also consistent with the common portrayal of activists as asset strippers who cut investment, pile on debt, and extract dividends and share buybacks.
The authors thus also study operating performance. An interquartile increase in Threat increases return on assets by 0.6% among non-targeted firms with high Threat Perception compared to those with low Threat Perception. This is consistent with threatened firms getting their act together. But this increase might be due to short-termist behaviour such as cuts in R&D or wages. However, the authors also find a differential increase in asset turnover of 0.8%. Since asset turnover is sales / assets, this increase cannot have arisen through R&D or wage cuts, but instead is consistent with greater efficiency. Indeed, they also uncover a differential increase in firm value of 2.4% over the next two years, also inconsistent with short-term manipulation.
Further cross-sectional analyses are supportive of the threat channel. For example, the threat of activism only has an effect in firms with above-median stock liquidity. This is consistent with prior research showing that liquidity helps activist hedge funds to acquire large stakes. They also focus on diversified firms and find that their non-core segments change policies in the same way as their core segments, suggesting that the effects aren’t driven by industry competition.
What does this all mean for the debate around hedge fund activism? It suggests that the positive effects may be even greater than previously documented by research that focuses on targeted firms. Surprisingly, the spillover effects aren’t just due to industry competition. This is particularly important because, even if targeted firms are in concentrated industries (so there is little competitive threat), there are potential spillovers to firms in other industries. These spillover effects must be taken seriously by any policymaker contemplating the regulation of activism.