Activist hedge funds reduce companies’ social and environmental sustainability and their long-term value.
No company is safe from hedge fund activism. In 2019, activist hedge funds targeted 839 companies in 19 countries. Activist hedge funds control more than $146 billion in assets, part of the more than $3 trillion hedge fund market.
A hedge fund is a specific type of investment partnership. Many hedge funds are “passive,” investing in businesses and waiting for returns. “Activist” funds, by contrast, invest in order to influence a company’s management and strategy. They aim to change governance structures, operational priorities, and management decisions in order to dramatically improve short-term financial performance and provide value to shareholders.
But while activist hedge funds may provide short-term gains for shareholders, they take a heavy toll on companies. If an activist hedge fund targets your company, here’s what you can expect over the next five years:
Market value will increase 7.7 per cent one year after an activist hedge fund campaign, but decrease 4.9 per cent after four years and 9.7 per cent after five years.
Profitability will increase 1.1 per cent one year afterward and 1.5 per cent two years later, but then decrease in the following years.
Operating cash flow will fall 15.8 per cent in the second year and 27.1 percent in the fifth year.
Corporate social and environmental performance will fall 18.6 per cent after two years and 24.8 per cent after five years.
Workforce numbers, operating expenses, R&D spending, and capital expenditures will all decrease.
This account of activist hedge funds’ impacts comes from new research by Mark DesJardine (Penn State) and Rodolphe Durand (HEC Paris). They studied 1,324 firms that were targeted by activist hedge funds between 2000-2016. Targeting occurs when an activist hedge fund acquires shares in a company with the explicit intention to influence the control or management of a company. The researchers also interviewed numerous activist hedge fund principals and founders and the leaders of two multinational firms recently targeted.
The researchers measured sustainability, also called corporate social responsibility (CSR), by using MSCI KLD data. MSCI KLD assesses companies’ performance related to community, diversity, employee relations, environment, and human rights. Activist hedge fund investment affected all these aspects of sustainability except community (e.g., philanthropic giving); diversity and the environment were most affected.
Why Activist Hedge Funds Hurt Sustainability
Activist hedge funds want to improve companies’ market value: to raise the stock price so that the they can sell shares at a profit. “I have never seen a case [of hedge fund activism] where shareholder returns is not number one,” the founding manager of a prominent US hedge fund told the researchers.
Most activist hedge funds focus on quick profits, typically selling their stakes between one and two years after purchasing them. During that time, they commonly increase stock price by demanding that firms cut costs or divest assets. Activist hedge funds also use proceeds from these sales to redistribute cash to shareholders through share buybacks and dividends.
As short-term shareholder benefits take precedence, the interests of longer-term shareholders and other stakeholders fall in priority. Several fund managers told the researchers that corporate social and environmental efforts appear as an extra cost that can be cut to immediately improve returns; they are unnecessary “fat.” Corporate social and environmental efforts often aim to create long-term value, beyond the average hedge fund’s horizon.
Ironically, even company efforts to fight off activist hedge funds can lead to drastic changes. Because activist hedge funds usually control a relatively small percentage of the company’s stock, the hedge funds will often try to win over other shareholders by arguing that a company is mismanaged. In response, targeted companies may try to boost their own stock price, in ways that echo an activist hedge fund’s proposed strategy. After his company was targeted, one CEO told his top 500 managers to “not work on anything in the next 9 months unless it has a direct effect on short-term profitability.”
The pressure of a hedge fund attack can have grim consequences throughout a company. A senior executive of a targeted company explained: “You get this pressure during a battle like this.… The pressure goes down the lines to your operational people, saying, ‘Keep moving, work harder, we got to make money.’ And from this, I think, there can come this rash of health issues and deaths all the way down the line. Your company has to perform better, but to do that you have to put people at risk.”
Ironically, strong social and environmental performance can make companies vulnerable to activist hedge funds, DesJardine and Durand found in other research, with Emilio Marti (Erasmus University). Companies who spend more on CSR than their peers are more likely to be targeted. Activist hedge funds lack reliable information on potential targets, and may interpret spending on social and environmental initiatives as a signal that the company is wasteful.
How to Protect Sustainability and Long-Term Value
Activist hedge funds have targeted many leading companies, from 3M to Unilever. But you are not powerless to resist them. Here are four actions to take.
1. Communicate with your company’s shareholders and stakeholders. Tell them about the consequences of hedge fund activism for the financial and social sustainability of targeted companies. Highlight how the short-term priorities of activist hedge funds likely threaten priorities of long-term shareholders and other stakeholders.
2. Lobby policymakers. Currently, activist hedge funds escape many regulations that govern other institutional investors. Policymakers could (1) require activist hedge funds to disclose ownership positions before they accumulate a 5% position in a company (the current threshold for regulatory disclosure), and (2) regulate the coordination of groups of activist hedge funds, also known as “wolf packs.” Earlier awareness of activist hedge funds’ intentions would allow companies to prepare for an attack, instead of being blindsided.
3. Seek long-term shareholders. Socially-minded and long-term shareholders can moderate an activist hedge fund’s focus on short-term profits. To attract these shareholders, clearly communicate how long-term strategies, especially those focused on CSR, will create future value. Highlight this long-term value creation story at road shows and investor meetings.
4. As an investor, reconsider your investment portfolio. Pension funds and endowments have been primary investors in activist hedge funds in recent years. Many individuals, through retirement plans or other investments, are personally invested in activist hedge funds — which may contradict their social priorities. Alternatives exist in sustainable finance and impact investing.
For advising on shareholder activism and/or models based on these data, contact Mark DesJardine at email@example.com.
 A company’s probability of being targeted by an activist hedge fund increases from roughly 3 per cent to 4 per cent per cent when its corporate social responsibility (as measured by KLD) increases by one standard deviation above the average level of CSR. When a firm’s CSR increases by two standard deviations above the average, its probability of being targeted nearly doubles, rising to 5.1 per cent.