The recent wave of activist hedge fund launches has piqued interest in both investor and academic circles. But what do hedge fund activists actually bring to the table? And do they increase or destroy value? These questions were addressed last week at a Corporate Ethics and Investment Seminar hosted by the Society of Quantitative Analysts in New York.
Activist hedge funds are investment vehicles that pool resources to take large stakes in mismanaged companies and subsequently influence the boards of directors of their target companies to increase shareholder value. Unlike private equity firms and the corporate raiders of the 80's, activist hedge funds may explore shorter-term positions and use active long and short trading in the company stock, public debt and derivative securities to generate short-term alpha.
So, is hedge fund activism good for everyone? The consensus among academics at the seminar was a resounding “no.”
According to the speakers, activist hedge funds are good news for other shareholders of their target firms and a bad news for executives of the same firms. Alon Brav, a professor at Duke University, found that announcements of activist hedge funds taking significant equity stakes in companies generate positive returns for other shareholders (an average gain of 5% to 7% over 20 days following the day of the announcement). At the same time, the target firms' CEOs suffer: the CEO's pay appears to decline and their turnover increases following the emergence of an activist hedge fund manager taking an equity stake the firm.
So, what strategies can activist hedge fund managers use to obtain more alpha?
Two professors, M. Daniel Beneish and D. Craig Nichols of Indiana and Cornell Universities, respectively, proposed an innovative, short-term value-generating strategy for activist hedge fund managers based on the “entrenchment” hypothesis: CEOs, for example, often tend to “entrench” or build powerful kingdoms that, in the worst case, divert cash from the company into kingdom-preserving activities. Entrenched executives tend to be more likely than their non-entrenched peers to window-dress publicly announced figures through "financial management" of the reporting items, such as accounts receivable, accruals and leverage. Retroactive discovery of such "financial management" has been shown to decrease share price anywhere from 10% to 20% of value.
Beneish and Nichols propose estimating the probability of earnings manipulation based on historical data, and then shorting the companies with high probabilities, while going long those companies with the low probabilities of earnings manipulation. When announcements of earnings manipulation in high-probability companies come out, managers then close positions to capture positive alpha in the post-announcement return difference.
Of course, traditional techniques to steer the direction of fund holdings still generate money. According to Brad Barber, a professor at UCLA, CalPERS has been using the following activist investment measures since 1984 with great success: Repeal of poison pills; Declassification of the board; Ensuring independence of the majority of directors; Elimination of dual class shares; Enforcement of independence of the nominating and compensation committees, among other measures designed to ensure the integrity of management.
Michael Jensen, a professor at Harvard University, argued that activist hedge funds do help to ensure integrity in business.
"Integrity matters not because it is virtuous, but because it creates workability, which in turn increases the opportunity for performance,” Jensen said. “Integrity is thus a necessary, but not a sufficient condition for value maximization."
Long live activism? Only time will tell.