Hedge funds seem to have a permanent place at the top of the business news. Among the most recent stunners, Blackstone Group announced a $3 billion investment by the Chinese government, capping an earlier announcement that the firm would go public. And a recent survey found that top hedge fund managers make more than $1 billion a year.
Despite the industry’s high profile, the 8,800 funds’ inner workings remain shrouded. These lightly regulated investment pools for wealthy investors don’t report their holdings and say little about their investment strategies. With an estimated $1.2 trillion under management, hedge funds must impact the financial markets. The question is: How?
In one of the first studies to shed light on that question, researchers at Wharton and three other business schools find that hedge funds’ efforts to improve companies they hold big stakes in have spillover benefits for all shareholders: a quick 5% to 7% jump in stock prices. The gains, measured as an “abnormal return” on top of the broad market’s, were nearly 11% when a hedge fund pushed for the targeted company to be sold.
This makes hedge funds far more effective than other activist shareholders, such as pension funds and mutual funds, the researchers say.
According to the study, the share-price boost came during the 40-day period surrounding a hedge fund’s public announcement of a push for change. “The price gain came immediately upon the announcement,” said Wei Jiang, a finance professor at Columbia Business School who is a visiting faculty member at Wharton. The gains were therefore caused by investors’ anticipation of improved company performance to follow. “The improvements will occur anywhere from a year to two years down the road,” she added.
In fact, they did: Return on equity typically soared in the 12 months after a hedge fund announced it had targeted a company.
The research is reported in a paper titled, “Hedge Fund Activism, Corporate Governance and Firm Performance.“ Co-authors are Alon Brav of Duke University, Frank Partnoy of the University of San Diego and Randall Thomas of Vanderbilt University.
In one case cited in the study, MLF Investments, a hedge fund based in Belleair Bluffs, Fla., reported on November 19, 2003, that it had acquired 5.8% of Alloy, a direct marketing and retail company. After MLF pressured the company to consider spinning off its merchandizing business, Alloy’s share price quickly jumped 11%. Alloy put MLF’s managing partner on its board, and on May 31, 2005, announced it would do the spin off. Shares closed on that day at $8.39, more than 60% above what MLF had paid for shares acquired before the November 19, 2003, announcement.
In another case, Pirate Capital, a Norwalk, Conn., fund, reported on November 17, 2005, that it had acquired a 7.9% stake in James River Coal. The following February, Pirate sent the company a letter demanding that it retain an investment banking firm to explore strategic alternatives, such as sale of the company. James River acquiesced on March 10, sending its shares up more than 10% in a single day.
For most firms, the researchers found, gains are not just a temporary bump; they persisted 12 months after the announcement.
The study also revealed much about the types of companies hedge funds go after. “I thought hedge funds would target troubled firms, and in the end that turned out not to be the case,” said Jiang. Instead, she said, hedge funds seek healthy firms with undervalued stock, and then use their clout to press for management changes, dividend increases or other moves to benefit shareholders.
The study looked at 888 cases involving shareholder activism by 131 hedge funds from the start of 2001 through 2005. The cases were identified from news accounts of activist funds — those pushing for corporate change rather than just holding the stock as a passive investment.
The researchers used funds’ Schedule 13D filings with the Securities and Exchange Commission to identify instances in which a fund owned at least 5% of the target company’s stock, enough to get management’s attention in a push for change. The researchers then looked at each company’s stock performance in the period before and after the hedge fund announced its demands.
“We find that a large majority of activist hedge funds resemble value investors, targeting companies they believe are undervalued based on financial statement analysis,” the researchers write, adding: “Target companies have low market value relative to book value, are profitable, with sound operating cash flows and returns on assets, and tend not to be technology companies….”
Tech companies, Jiang said, are not good candidates because poor stock performance is often due to arcane matters hedge funds don’t feel equipped to tackle. The same holds true for companies in some other industries. “If you have a pharmaceutical company with a dried-up pipeline, what can a hedge fund do?” she said.
Generally, the funds did not zero in on problems specific to the targeted company, such as sales slumps. Instead, they looked at general issues in which the company behaved differently from its peers, such as the percentage of earnings paid out in dividends. “Target companies have more takeover defenses and offer higher CEO pay than companies of comparable size and book-to-market ratios,” the authors write. “Finally,” they note, “relatively few targeted companies are in the top 20% of firms by market capitalization, which is not surprising given the much higher cost of amassing a 5% stake in a firm in the top size quintile.”
Small, Rather than Big, Bites
Hedge funds typically did not seek control. The median acquisition was only 6% of the target’s shares. This distinguishes hedge funds from the corporate raiders of the 1980s, who took control of the companies they targeted, Jiang said. “Hedge funds don’t want to swallow the whole company. They want to have a voice in how to implement their agenda, but as a minority shareholder.”
Fund activism ranges from friendly to hostile, often involving more than one type of pressure. Nearly two-thirds of the announcements in the study merely state that the fund intends to communicate regularly with the company’s board to enhance shareholder value. In about a quarter of the cases, the fund makes a formal shareholder proposal for change. Proxy fights to replace board members occur in 11.5% of cases. Fund pressure is effective. In about 41% of cases, the funds get the changes demanded, while they achieve partial success in another 26%.
The biggest returns are the 10.94% share-price gain when the fund presses for sale of the company. Urging the target to change its business strategy yields a 4.37% gain, while announcement of a general intention to interact with management that carries no specific goals gets a 4.99% gain. “Surprisingly, activism targeting capital structure and governance issues exhibits near zero abnormal return,” the researchers write.
This helps explain why activist pension funds and mutual funds, which tend to focus on governance issues such as how boards conduct elections, have generally not achieved share-price gains, Jiang said. Efforts by pension funds, for example, may be driven by political or labor issues, while mutual funds may pull their punches because they hope to do business with the companies they invest in, the authors write. Also, pension and mutual fund managers are not compensated according to their success as shareholder activists, while hedge fund managers are, they add.
Hedge funds, Jiang said, “target issues that are closer to value generation.”
Although corporate governance is not among hedge funds’ chief issues, top executives often pay a price when hedge funds take a substantial stake in their firms. “CEO compensation gets cut by close to a million dollars” on average, according to Jiang.
While the study confirms the benefits of hedge fund activism during the 2001-2005 period studied, the authors warn that the easy money may already have been made. Like other forms of arbitrage, in which investors uncover under-priced securities, this one could lose value as more funds employ it.
“The number of hedge fund activist events surged during this period, and their activity [continued] to grow in 2006…,” the authors write. The average return from hedge fund activism dropped from 10.6% in 2001 to 4.8% in 2005, the researchers found, adding that “it is likely that the abnormal returns associated with it will decline, or even disappear, as more funds chase after fewer attractive targets….”
Hedge Fund Activism, Corporate Governance, and Firm Performance