The Paradox of Hedge Fund Activism

Activist investors can focus too hard on short-term performance, to the detriment of long-term value.

Hedge fund activism is detrimental to the long-term performance of firms, new research has found.

Firms targeted by activist hedge funds do tend to improve over the long run—but only because those firms are usually performing poorly to begin with, according to a study by finance professors Martin Cremers (University of Notre Dame), Erasmo Giambona (University of Amsterdam), and Simone Sepe (University of Arizona), along with PhD student Ye Wang (Bocconi University).

When compared with similarly underperforming firms—as opposed to the industry as a whole—companies subject to hedge fund activism showed less long-term improvement than peers not targeted by activists.

One reason why targeted firms performed worse, according to the study, is because activist hedge funds are “naturally more empowered than other shareholders to challenge the board of directors to change corporate policies or even corporate strategy, promoting the adoption of decisions to fire the existing management, increase leverage, reduce cash, or sell the firm to a prospective acquirer.” Even the mere threat of these interventions prompts a “detrimental” focus on short-term performance by the incumbents, who fear losing their jobs, and undermines the ability of corporate managers to pursue value-increasing long-term investments.

Additionally, market mechanisms other than activist hedge funds—such as key employees, top executive management, directors, long-term shareholders, large customers, and suppliers—were found to generally be “more successful than the typical activist hedge fund campaign in turning these relatively poorly performing firms around.”

On average, the value of firms targeted by activist hedge funds was 5.5% lower than that of non-targeted peers at the end of the first fiscal year of an activist campaign, and nearly 10% lower after three years.

“Adversarial” activists—hedge funds employing hostile tactics—were even more harmful, particularly when targeting companies engaged in innovation, which rely more on long-term investments. The value of innovative firms targeted by hostile activists was found to be 50% lower that than of non-targeted firms after the first three years.

While the researchers acknowledged the benefits of activist investing for corporate governance, they found that the costs “seem to outweigh potential benefits.”

The full report, “Hedge Fund Activism and Long-Term Firm Value,” can be downloaded by SSRN.

Related: Inside Activist Hedge Funds & When (and Where) Activist Investing Goes Wrong