The market likes hedge fund activism — a lot. On the date a hedge fund announces plans to take an activist shareholder stance in a firm, the stock of targeted firms jumps 6 to 7 percent above the day’s average stock price gain. This enthusiasm suggests investors have high expectations of hedge fund intervention.
But critics claim those expectations are unwarranted. Targeted firms, they say, may pay more dividends in the short run but also take on more debt in lieu of shaking up underperforming firms or adding long-term value through real productivity gains. The critics argue that hedge funds make only quick cosmetic fixes and perform superficial financial engineering designed to produce only short-term gains.
Are hedge fund activist gains purely cosmetic, or do their interventions result in substantive long-term changes? Professor Wei Jiang, working with Alon Brav of Duke University and Hyunseob Kim of Cornell University, shows that improved performance in the wake of hedge fund intervention is a real phenomenon.
The researchers first looked at firm productivity, using the US Census’ annual surveys of US factories that employ two or more people. The surveys record capital stock, labor hours, materials input, and output at each factory, which the researchers used to estimate productivity for both individual factories and averages. The surveys offer an assessment of productivity independent from stock market activity and any alleged attempt to make productivity gains appears through financial engineering.
Next, the researchers looked at approximately 650 instances between 1997 and 2004 in which hedge funds exerted an activist role over manufacturing firms, allowing the researchers to compare market performance with productivity surveys. They found that after a hedge fund takes an activist stance, productivity increases by 10 percent, on average.
How might this be happening? “One way to increase productivity is to sell off underperforming assets and concentrate on core competencies, ” Jiang says. “We find that hedge funds not only improve the productivity of assets in place but that they push away underperforming assets — and, importantly, the assets’ new owners increase productivity, too.”
Just spinning off underperforming assets, while typically a good move, isn’t enough to warrant the kind of market reaction described above. The researchers find that the new hedge funds owners are able to operate firms’ remaining assets much more productively.
“Once we identified this channel we immediately asked, in what kinds of markets would this be best? ” Jiang says. “Remember that while hedge funds are often not necessarily experts in a specific business — they plausibly don’t have more inside knowledge than a CEO or senior executive at a firm, though they might have a more objective opinion about its condition — they do tend to manage portfolios that specialize in particular industries. So they could have a better understanding of the interplay between different players in that industry. ”
Microsoft’s Attempt to Acquire Yahoo!: A Case in Letters presents an example of how an activist hedge fund can have a real effect on a firm. I analyze how a hostile takeover can be difficult if the CEO of the target firm is unwilling to yield, even when the deal is favorable and has strong support from the majority of outside shareholders. In this case, Yahoo! rejected a lucrative deal from Microsoft, an offer that came with a heavy premium. After Microsoft’s hostile takeover failed, two hedge fund activists, Carl Icahn and Third Point, came in and succeeded in ousting Yahoo’s CEO. We are still waiting to see how the new CEO is performing, but overall I think people agree Yahoo! has had a favorable turnaround.
— Wei Jiang
The researchers find that hedge funds prompt the largest gains in performance in industries that are not highly concentrated rather than an industry with only a handful of players (such as soft drinks).
One noteworthy test the researchers conducted as part of this study examined when hedge funds shift their ownership stance from passive to active. When a fund (or any investor) accumulates 5 percent or more of ownership in a company and also intends to influence control of the firm, it must file a Schedule 13D form with the SEC. If the fund, despite its 5 percent holding, intends to remain a passive investor it can file a shorter form, the form 13G. The researchers find close to 300 cases between 1994 and 2007 where a hedge fund switched from a 13G to a 13D — that is, where funds didn’t change ownership stakes but did shift from a passive to active stance. The real effect — the 10 percent increase in productivity — occurs only after the fund shifts its stance.
“Our research provides strong evidence that hedge funds are not simply picking firms that will improve in the future regardless of their actions, ” Jiang says, “but that they are targeting companies whose performance they think the can improve through shareholder activism. ”
Wei Jiang is professor of finance and economics, chair of the finance subdivision and a senior scholar at the Jerome A. Chazen Institute for International Business at Columbia Business School.
Read the Research
"The Real Effects of Hedge Fund Activism: Productivity, Asset Allocation, and Industry Concentration"