Hedge Fund Activism, Friendly or Hostile?

With an estimated $1.2 trillion under management, hedge funds are having an impact on the financial markets. In one of the first studies to shed light on how this is happening, researchers at Wharton and three other business schools find that hedge funds' efforts to improve companies they hold big stakes in have spillover benefits for all shareholders: a quick 5% to 7% jump in stock prices.

The gains, measured as an "abnormal return" on top of the broad market's, were nearly 11% when a hedge fund pushed for the targeted company to be sold. This makes hedge funds far more effective than other activist shareholders, such as pension funds and mutual funds, the researchers say.

According to the study, the share-price boost came during the 40-day period surrounding a hedge fund's public announcement of a push for change. "The price gain came immediately upon the announcement," said Wei Jiang, a finance professor at Columbia Business School who is a visiting faculty member at Wharton. The gains were therefore caused by investors' anticipation of improved company performance to follow. "The improvements will occur anywhere from a year to two years down the road," she added.

Return on equity typically soared in the 12 months after a hedge fund announced it had targeted a company. The research is reported in a paper titled, "Hedge Fund Activism, Corporate Governance and Firm Performance." Co-authors are Alon Brav of Duke University, Frank Partnoy of the University of San Diego and Randall Thomas of Vanderbilt University.

Using a large hand-collected dataset of hedge fund activism in the U.S. over the period 2001 through 2005, the study found that most tactics are non-confrontational, and attain success or partial success in two-thirds of the cases. However, hedge funds seldom seek control of target companies. The market reacts favorably to hedge fund activism, as the abnormal return upon announcement of potential activism is in the range of 5-7 percent, with no apparent reversal in the subsequent year.

The study also revealed much about the types of companies hedge funds go after. "I thought hedge funds would target troubled firms, and in the end that turned out not to be the case," said Jiang. Instead, she said, hedge funds seek healthy firms with undervalued stock, and then use their clout to press for management changes, dividend increases or other moves to benefit shareholders.

The study looked at 888 cases involving shareholder activism by 131 hedge funds from the start of 2001 through 2005. The cases were identified from news accounts of activist funds, those pushing for corporate change rather than just holding the stock as a passive investment.

Fund activism ranges from friendly to hostile, often involving more than one type of pressure. Nearly two-thirds of the announcements in the study merely state that the fund intends to communicate regularly with the company's board to enhance shareholder value. In about a quarter of the cases, the fund makes a formal shareholder proposal for change. Proxy fights to replace board members occur in 11.5% of cases. Fund pressure is effective. In about 41% of cases, the funds get the changes demanded, while they achieve partial success in another 26%.