Empirical Finance Research Blog has a review of a new paper, Hedge Fund Activism, Corporate Governance, and Firm Performance, which finds that the “market reacts favorably to hedge fund activism, as the abnormal return upon announcement of potential activism is in the range of seven percent, with no return reversal during the subsequent year.” Further, the paper “provides important new evidence on the mechanisms and effects of informed shareholder monitoring.”
The authors seek to address the questions posed by “critics and regulators” about the benefits of hedge fund activism to shareholders and the claim that hedge fund activists “destroy value by distracting managers from long-term projects.” Specifically, the paper seeks to answer the following questions:
- Which firms do activists target and how do those targets respond?
- How does the market react to the announcement of activism?
- Do activists succeed in implementing their objectives?
- Are activists short-term in focus?
We’ve set out below brief answers to the questions posed in the paper:
Which firms do activists target and how do those targets respond?
Hedge fund activists tend to target companies that are typically “value” firms, with low market value relative to book value, although they are profitable with sound operating cash flows and return on assets. Payout at these companies before intervention is lower than that of a matched sample. Target companies also have more takeover defenses and pay their CEOs more than comparable companies. Relatively few targeted companies are large-cap firms, which is not surprising given the relatively high cost of amassing a meaningful stake in such a target. Targets exhibit significantly higher institutional ownership and trading liquidity. These characteristics make it easier for activists to acquire a significant stake quickly.
How does the market react to the announcement of activism?
We find that the market reacts favorably to activism, consistent with the view that it creates value. The filing of a Schedule 13D revealing an activist fund’s investment in a target firm results in large positive average abnormal returns, in the range of 7 to 8 percent, during the (-20,+20) announcement window. The increase in both price and abnormal trading volume of target shares begins one to ten days prior to filing. We find that the positive returns at announcement are not reversed over time, as there is no evidence of a negative abnormal drift during the one-year period subsequent to the announcement. We also document that the positive abnormal returns are only marginally lower for hedge funds that disclosed substantial ownership positions (through quarterly Form 13F filings) before they file a Schedule 13D, which is consistent with the view that the abnormal returns are due to new information about activism, not merely that about stock picking. Moreover, target prices decline upon the exit of a hedge fund only after it has been unsuccessful, which indicates that the information reflected in the positive announcement returns conveys the market’s expectation for the success of activism.
Activism that targets the sale of the company or changes in business strategy, such as refocusing and spinning-off non-core assets, is associated with the largest positive abnormal partial effects of 8.54 percent and 5.95 percent, respectively (the latter figure is lower than the overall sample average because most events target multiple issues). This evidence suggests that hedge funds are able to create value when they see large allocative inefficiencies. In contrast, we find that the market response to capital-structure related activism – including debt restructuring, recapitalization, dividends, and share repurchases – is positive, yet insignificant. We find a similar lack of statistically meaningful reaction for governance-related activism-including attempts to rescind take-over defenses, to oust CEOs, to enhance board independence, and to curtail CEO compensation. Hedge funds with a track record of successful activism generate higher returns, as do hedge funds that initiate activism with hostile tactics.
Do activists succeed in implementing their objectives?
The positive market reaction is also consistent with ex-post evidence of overall improved performance at target firms. On average, from the year before announcement to the year after, total payout increases by 0.3-0.5 percentage points (as a percentage of the market value of equity, relative to an all-sample mean of 2.2 percentage points), and book value leverage increases by 1.3-1.4 percentage points (relative to an all-sample mean of 33.5 percentage points). Both changes are consistent with a reduction of agency problems associated with free cash flow and subject managers to increased market discipline.
We also find improvement in return on assets and operating profit margins, but this takes longer to happen. The post-event year sees little change compared to the year prior to intervention. However, EBITDA/Assets (EBITDA/Sales) at target firms increase by 0.9-1.5 (4.7-5.8) percentage points by two years after intervention. Analyst expectations also suggest improved prospects at target firms after hedge fund intervention. During the months before Schedule 13D filings, analysts downgrade (future) targets more than they upgrade them whereas after intervention is announced analysts maintain neutral ratings. Given that successful activism often leads to attrition through sale of the target company, ex post performance analysis based on surviving firms may underestimate the positive effect of activism.
Are activists short-term in focus?
Hedge fund activists are not short-term in focus, as some critics have claimed. The median holding period for completed deals is about one year, calculated as running from the date a hedge fund files a Schedule 13D to the date when the fund no longer holds a significant stake in a target company. The calculation substantially understates the actual median holding period, because it necessarily excludes events where no exit information is available by March 2007. Analysis of portfolio turnover rates of the funds in our sample suggests holding periods of closer to twenty months.
Empirical Finance Research has some tips for implementing the “hedge fund activist alpha strategy” based on their experience watching real-world activists work their magic:
1. Focus on small companies
2. Watch for activists who are entering companies at the same time mutual funds are dumping (watch for 13-G’s filed concurrently with 13Ds). This way you can buy at cheap prices while the mutual funds are putting pressure on the stock. Eventually, the selling pressure is gone AND you have an activist there to make sure the ship is sailing straight ahead.
3. Call the company in question and assess how ‘open’ they are. Sometimes even the best activist campaign can’t beat an overly entrenched and crooked management.
4. Call the activist and get a feel for what they want to do with the company. In my experience, activist investors are usually class-act capitalists and may give you hints as to the direction they want to take a company.
5. Do your own due diligence and determine where the ‘hidden’ value is located. If you have an assessment of exactly what the activist is after, you may be able to determine how successful they will be in their attempts to unlock this value. Here is a quick example. If you determine the activist wants to unlock value when there is a discrepancy between the value of an asset on the books and the value of an asset in the real-world (i.e. a real estate holding), but you determine that selling the asset would be a nightmare (maybe you live down the street from the property) and/or involves abusive tax treatment that not many people understand, you may shy away from following the activist.