The case against hedge fund activism
BY Martha Porado | April 9, 2019
While shareholder activism is a hot topic among institutional investors, where hedge funds are concerned, it doesn’t seem to have much impact on investee company profitability, according to a paper by J.B. Heaton, an independent financial economics researcher.
Hedge fund activism is a great story, one that investors can wrap their heads around, says Heaton. “It’s like a house. You could find a house that looks kind of shabby and, if I fix it up, I could turn a profit. Hedge fund activism is basically a fixer upper story.”
The one successfully profitable way hedge fund managers engage with companies is when they encourage them to sell themselves to another company, which has a tendency to boost the price of the company being bought in the short term, Heaton says. Unfortunately, other than that, hedge fund managers don’t actively engage in ways that boost profits within a company, he adds.
“They don’t really do much at these firms,” says Heaton. “Obviously, any time you put a firm up for sale, you get a good bump. Let’s say, 15 to 30 per cent if you can get a company or a big chunk of a company up for sale. And the truth is, other than that, they do nothing.”
As for why hedge fund managers don’t effectively add value in other ways, hedge fund managers aren’t particularly well-disposed to coming up with ideas on how to improve how companies, he says. “It’s really not surprising. What insights do you think a bunch of guys in a room in midtown have on how this shipper should change its business? They just don’t come up with anything interesting.”
Governance is one popular issue with active shareholders, but where real price action for an equity is concerned, there are usually other factors that can drown out any positivity of a governance adjustment, he says. “It’s just not necessarily as important as how your product does.” Apple Inc., for example, could make all the changes to corporate governance it wants, but if the next iPhone doesn’t perform well, it won’t matter to the stock price, says Heaton.
Hedge fund managers also have a tendency to find opportunities in battered businesses a little too late, once the firms are already too far gone to be saved, says Heaton. “When you see a firm that’s really troubled, a lot of times, it’s more or less unsalvageable, at least from the equity point of view.”
Companies that are basically insolvent, where their assets aren’t worth as much as their debt, can still have decent equity valuations for a period because there’s always a chance things will turn around, says Heaton. A manager could look at a company like this and have ideas for what it might do to improve, he adds. But if a manager shows up when there is already a 50 per cent chance of the firm filing for bankruptcy, it’s simply too late, he says.
Hedge fund managers also suffer from a sort of “winner’s curse,” the paper said. This is an economic phenomenon that appears during competitions, it said. For example, when bidding on an auction, bidders are hoping to come in undervalue for an item, but bidders’ estimates can vary. The highest bidder, or winner, in this scenario is the most likely to have overpaid based on the value of the item. Within hedge fund activism, this can happen when many parties are competing to find companies with something wrong with them that they could help fix.
“Hedge fund activists. . .are likely to be too pessimistic since the competition for activist targets likely results in the most pessimistic –and therefore most incorrect –activist being the one to appear at a given firm,” the paper said. “If this is the mechanism matching hedge fund activists to firms, it is unlikely to match the most valuable ‘outside’ view with the corporation that could benefit from it.”