Are activist investors bad for businesses?

What do companies as diverse as Microsoft, General Motors, DuPont and PepsiCo have in common? They’ve all been targeted by hedge fund activists – investors who don’t just buy shares, but also seek to have a direct impact on a company’s decision-making. In 2003, activist hedge funds managed less than $12 billion in assets; that rose to over $110 billion last year, and some now put the figure at close to $200 billion. As their size has increased, so too has their influence: “No recent development has influenced firms’ strategic and financial decision-making as profoundly as the surge in shareholder activism,” noted a JPMorgan report.

Figure 1: Total activist hedge fund assets under management ($bn)

Chart source: JPMorgan; Data source: HFR industry reports
Note: Numbers only account for single-strategy activist managers; multi-strategy funds and investment managers engaging in activism as a sub-strategy are excluded

It’s an investment strategy that has come under fire, particularly for its short-term focus – apparently at the expense of long-term growth. Speaking at the World Economic Forum’s International Business Council this summer, Martin Lipton, a lawyer specializing in corporate policy and strategy, warned that while activism brings short-term gains, “it has become a very significant drag on the economy”, deterring firms from investing in innovation, R&D and employee training.

Figure 2: Holding period for activist campaigns

Chart source: JPMorgan; Data source: SharkRepellent
Note: Average holding period for long-only institutional investors was around three years

Others are less critical. When activists invest, stocks in the target companies tend to shoot up – by on average 48%, according to Bloomberg. Critics argue these gains are short-lived. But a paper from researchers at Harvard, Duke and Columbia, which studied operational and stock performances in the five years following activist interventions, found no evidence to support this claim. In fact, they found quite the opposite: “Such interventions are followed by long-term improvements, rather than declines, in performance.”

New research from scholars at Duke, Columbia and Cornell confirm these findings: the average firm targeted by activists becomes more productive after the investment: “The evidence regarding both stock returns and firm operating performance speak favourably on the effect of hedge fund activism.”

But until this latest paper, little research has been done on how activist investors affect other stakeholders, such as employees. Given the importance of employee satisfaction – in a 2013 survey, executives ranked it the third most significant factor behind their company’s success, ahead of productivity and innovation – the findings of the research should add another dimension to the debate.

Figure 3: Which factors are most likely to bring success?

Source: Harvard Business Review
Note: Importance top box scores (8-10) for all respondents

The findings are worrying. Despite increases in productivity and share prices, employees see very little of those gains: “Workers do not fully capture the value of productivity improvements but instead relinquish most of the surplus to equity investors after hedge fund intervention.” In fact, employees at firms targeted by activist investors experience what the researchers refer to as a “de facto but implicit wage reduction”. As Figure 4 shows, it’s in line with a more general trend in the US: while productivity has been increasing, incomes have been trailing behind.

Figure 4: Trends in productivity, GDP per capita, private employment and median family income in the US

Chart source: Harvard Business Review; Data source: Federal Reserve Bank of St Louis; Erik Brynjolfsson and Andrew McAfee, The Great Decoupling

With policy-makers scratching their heads over low productivity rates, anything that provides a much-needed boost should be applauded. But if activists really want to be good for the businesses they’re investing in, they need to figure out how to turn companies around in a way that brings value to all stakeholders.

Author: Stéphanie Thomson is an Editor at the World Economic Forum

Image: People are reflected on a graph showing the U.S. dollar and Japanese yen rate in Tokyo July 3, 2013. REUTERS/Issei Kato