Activist funds, which buy stakes in companies in order to force changes in their operations, are one of the hottest trends in finance. Over the past year, the money flowing into them has surged so much that their assets under management are up more than 50 percent, while those of hedge funds as a whole have risen less than 15 percent.
What is driving the growth of activism? The most immediate reason is that the funds are performing well, as a report from Citigroup Inc.’s Financial Strategy and Solutions Group, of which I am chairman, shows. Since the beginning of 2009, activist hedge funds, on average, have earned an annual return after fees of almost 20 percent, compared with 13 percent for the stock market as a whole and 8 percent for all hedge funds. (That’s right: After fees are taken into account, hedge funds have underperformed the market.) The managers of the most successful funds are becoming legends by combining outsize returns with colorful personalities.
These funds are also growing in number, and they’re aiming for larger and larger companies. This year, for example, Carl Icahn bought a large share of Apple Inc. stock, ValueAct Holdings LP has targeted Microsoft Corp., and Trian Fund Management LP has pursued DuPont Co. Although most activist campaigns still occur in the U.S., foreign activity is rising rapidly, too.
Even strong stock market performance is no longer protection against an activist effort. This year, more than half of targets had outperformed their peers before the activist campaigns began. Activists clearly believe that, with changes, successful companies can perform even better in the future.
Activists are increasingly turning their attention to conglomerates with multiple lines of business and low investment. And many companies are targeted multiple times; 60 percent of the companies activists went after this year had been the subject of previous campaigns.
What impact do the activist funds have on the companies they invest in? It would be impossible for activists to earn such high returns if their campaigns did not increase the value of the shares they buy. And that is indeed what happens: On average, from a month prior to the campaign through two years after it starts, targeted companies receive returns about 20 percent to 30 percent higher than those of their untargeted peers.
This average, however, masks substantial variation in the targeted companies, research by the Financial Strategy and Solutions Group shows. Indeed, more than half of them experience returns that lag the market. Activists often invest in several companies simultaneously, and big returns from one more than offset weak returns from the others and bring the average well above the market.
All of this makes you wonder: What lasting differences do activist hedge funds make in the way targeted companies operate and in the lives of the people working there?
Alon Brav of Duke University, Wei Jiang of Columbia University and Hyunseob Kim of Cornell University have explored these questions for manufacturing companies in the U.S. On average, the researchers find, activism causes a temporary decline in productivity, presumably as the company reorganizes, but within three years, productivity rises significantly.
That scenario is consistent with the financial returns, and research shows an important mechanism for the improvement: Activists often push for the sale of less productive plants and, under new owners, those plants become noticeably more productive.
What about the effect on workers? Brav and his co-authors find it is decidedly negative. While the workers’ productivity rises -- on average, 7 percent -- their hourly wages remain the same.
Furthermore, the number of workers and the hours per worker both fall, for a total decline of more than 10 percent in labor hours. Brav and his co-authors conjecture that the workers may have previously enjoyed wages above their market value, and that the activist intervention removes this wage premium. Note also that they examined only averages; given the variation in financial returns, one might expect the effects on business performance and workers to also vary significantly.
As activists become ever more prominent, and the easier targets are exhausted, their average excess financial returns may diminish. And even (or especially) where activism helps to produce better value, workers do not seem to share in the benefits.
(Peter Orszag is vice chairman of corporate and investment banking and chairman of the financial strategy and solutions group at Citigroup Inc. and a former director of the Office of Management and Budget in the Obama administration.)
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