Activists hedge funds actually good for investors
Activist hedge funds, on the whole, do good work, but the best results come from those with the deepest pockets.
A new study, looking at the performance of activists, who buy shares and then push companies to change strategy, shows continued strong results on interventions from 2008 through mid-2014.
Activists have fought many high profile battles recently with incumbent management, notably Nelson Peltz and his Trian Fund Management, which is currently seeking four board seats at DuPont.
The study found that the activist interventions generated an average abnormal extra return of 5.8 percentage points in the 21 day period around the day the holding was announced. That’s a great result, and is also in line with and tends to support findings in earlier studies which looked at activists up to 2008.
Interestingly, the most active activists hedge funds, those that were involved in the most situations, did not tend to outperform. Top activists, those whose interventions were largest in size, did outperform, turning in a 21 day outperformance of nearly 11 percentage points, more than double the respectable 5.22 percentage points of the rest of the sample.
"The market appears to anticipate the superior performance of these top hedge funds even before announcement of intervention," C.N.V Krishnan of Case Western Reserve, Frank Partnoy of the University of San Diego and Randall Thomas of Vanderbilt wrote in the study.
"Moreover, post-intervention target-firm operating performance associated with these top hedge funds is significantly superior to that of other hedge fund activists."
That’s key: not only did the top activists generate better short term performance for investors in the target companies, but they seem to be capable of twisting arms in such a way that fundamental underlying performance at the companies improves as well.
Not only did measures of return on assets improve at targets of the top, most deep-pocketed hedge funds, but research and development spending rose subsequently.
That’s interesting because it implies, that far from the complaints of target companies, who accuse activists of taking a short-term, slash and burn approach, seeking to generate short-term returns, these hedge funds are improving performance in part by increasing long-term investment.
It may well be that it is insiders themselves who are taking the short-term approach, seeking to grow earnings quarter by quarter but foolishly stinting on R&D, which may only pay off after executive stock options have expired.
The top hedge funds generating the best performance not only have more assets under management and hold more positions than the typical activist in the sample, they hold significantly more board seats in their portfolio companies.
The clear implication of this, and other studies, is that activist investors are, to be blunt, a good thing.
Not only does activism seem to produce better returns, earlier studies show meaningful three and five year effects on operating performance at target companies.
So the question is: why does activist investment work?
Maybe the central problem facing the investor is how best to manage what economists call agency problems, the conflicts of interests that naturally arise between owners of funds and those who manage the money or the companies in which it is invested.
Shareholder capitalism is an excellent system, but it produces lots of opportunity for insiders to engage in self-dealing, building empires and extracting more than their fair share of the company in compensation.
The study finds that those firms targeted by top activists tend to have a higher number of anti-takeover provisions such as staggered board elections, which are often intended to insulate management from outside, or really owner, interference.
Combine this fact with the outperformance and it is easy to conclude that anti-takeover provisions are often used to shelter management which is either self-dealing or just not up to snuff.
The top activists do better, perhaps because their reputation gives them leverage, or perhaps because of their willingness to stick with a company and take an active hand in board-level management.
Of course, sometimes there is simply a difference of opinion about strategy and, of course, sometimes management is right and activists wrong.
The data, however, implies that more often it is the other way round, and further, that there is more juice to be squeezed.
Activists hedge funds manage only about US$120 billion of the $3 trillion hedge fund universe.
Investors, of all kinds, should welcome the rise of the activists.