Activist Hedge Funds’ Transparency Problem

Academics warn of subtle but potentially damaging effects of activist investment.

Activist investment funds can inadvertently hinder transparency at the firms they target as company boards go on the defensive, academic research has shown.

Jing Chen of the University at Buffalo, New York, and Michael Jung of New York University, found companies reduced the amount of guidance reported to analysts and investors in the first quarter following initial interest from known activist investors.

“Firms cognizant of being targeted by an activist hedge fund or a ‘wolf pack’ of funds are advised by numerous law firms and investment banks to regularly monitor changes in activist hedge fund holdings and to prepare for potential confrontational campaigns by continuously reviewing external communications policies,” the authors wrote.

“Corporate governance issues can be affected by activist hedge funds without a public hostile or non-hostile campaign against management.”In their paper, “Activist Hedge Funds and Firm Disclosure”, Chen and Jung studied the behaviour of 2,689 firms before and after investments were made by activist investors.

They found that companies were “less likely to provide any type of guidance” immediately following an activist fund’s investment, and many companies stopped providing guidance to analysts and investors altogether.

“These results hold even for firms that met or exceeded analyst expectations for the quarter and have a history of consistently providing guidance in previous quarters,” the authors said. “Since guidance has been shown to be beneficial to capital market participants in many ways, reduced guidance has meaningful market implications.”

The research also noted reductions in transparency even when the activist investor involved did not make public their intentions or engage in hostile behaviour. Chen and Jung said this suggested that “any other potential consequences are likely to be more subtle than previously examined.” In addition, they argued that “other corporate governance issues can be affected by activist hedge funds without a public hostile or non-hostile campaign against management.”

Activist hedge funds—which typically hold concentrated portfolios and attempt to bring about meaningful change in the companies they own—have more than $120 billion in total assets, according to research published in February by the Alternative Investment Management Association. This marked a 269% increase since 2009, aided by a 19.4% annualized average return during the period.

Prominent investors such as Carl Icahn, Bill Ackman’s Pershing Square Capital, Dan Loeb’s Third Point, and Elliott Advisors have led high-profile campaigns to bring changes to listed companies in recent years.

At the end of September, Elliott Advisors’ long-running interest in UK-listed investment company Alliance Trust brought about the removal of chief executive Katherine Garrett-Cox from the company’s board of directors.

Last year, Carl Icahn pressured eBay to spin off its online payment subsidiary PayPal. His efforts were unsuccessful at the time, but earlier this year the two groups separated. Third Point’s Loeb successfully brought about changes of management at both Sotheby’s and Dow Chemical in November 2014.

Read Chen and Jung’s paper, “Activist Hedge Funds and Firm Disclosure”, in full.

Related: Activism Skyrockets, But Investors Are Selling Fast & DTE Energy’s Kevin Kenneally: Activist Investors and De-Risking