What’s in a name? More than you think if you are a hedge fund!

By Dr. Albert Ahn

Loosely regulated investment entities, hedge funds come in many shapes. While many are happy making anonymous bets on the direction of markets and currencies, others take a more personalised approach to investment. Activist hedge funds – not to be confused with NGOs agitating for social change – buy shares in companies to pressure management to adopt the ideas promoted by the funds, from replacing board members to selling subsidiaries and pay more dividends. Managing in excess of $127.5 billion, activist hedge funds deployed $42.2 billion to press changes at 712 companies worldwide in 2019. Given this new breed of corporate raiders have the power to shape the strategic direction and financial decision-making of firms, it’s normal for incumbent management to respond to such demands. But how?

In a recent article ¹, a team of researchers applied a behavorial approach to explore how 468 firms reacted to 468 campaigns conducted by 49 activist hedge funds. Since activists do enormous work prior to launching a campaign and are under no obligation to make announcements until formally launching a campaign, the management of targeted firms is often oblivious that a tsunami of aggressive demands is about to come their way. Given this information asymmetry, market signalling theory suggests that the reputation of a hedge fund can help firms predict how a fund might behave. In principle, funds known as being generally confrontational should be expected to remain so across all campaigns. Since confrontations like proxy fights are expensive, may attract unwanted attention to a company's performance and could damage the reputation and career prospects of the firm's management, the researchers believed it would make sense for management to quickly agree with the demands of aggressive activists.

As predicted, activists with a reputation for being confrontational are indeed likely to be more successful in getting firms to agree to their demands. However, capitulating to activists is not without consequences. While activist funds are likely to make money by selling their shares once an agreement has been reached, this may affect negatively impact companies, as hedge fund activism has been associated with firms increasing their dividend payouts while lowering their research and development expenditures, cash balances and commitment to corporate social responsibility. It seems that management’s eagerness to buy peace often comes at the expense of their firm and long-term shareholders.

Meanwhile, CEOs learning that their firm is on the radar screen of an activist hedge fund would be advised to find out who’s knocking at the door. Once a bully, always a bully!

Reference:

¹ Wiersema, M., Ahn, A., & Zhang, Y. (2020). Activist hedge fund success: The role of reputation. Strategic Management Journal, 41(13), 2493-2517.