(Reuters) - It looks as if hedge fund activists engineer not just a short-term pop in target firms’ stock prices but also long-term improvements in innovation.
While studies have shown that news of an activist position in a stock leads to a 5 to 7 percent pop, some have argued that hedge funds are simply creating a short-term share price gain at the expense of long-term competitiveness and productivity.
That’s partly gainsaid by data showing no decline in share or operating performance in the five years after an initial intervention by an activist investor. It’s also true that activist campaigns often, if not always, lead to cutbacks in the size of firms and of their research and development efforts.
A new working paper finds benefits to innovation at firms which get picked on by hedge fund activists, benefits which may extend to other firms not directly involved.
“The output from innovation, patent quality and quantity, tend to improve. These improvements are concentrated in areas that are central to the firms’ business and technological expertise,” Alon Brav and Song Ma of Duke University, Wei Jiang of Columbia University and Xuan Tian of Indiana University write in the working paper.
“Thus, our evidence suggests that firms become ‘leaner’ but not ‘weaker’ subsequent to hedge fund interventions. Moreover, the efficiency gains also emanate from the extensive margin through the redeployment of innovative assets (patents or innovators).” (here
The study looked at innovation at firms taken on by activists, both before and after the interventions. Not only the inputs, the money spent on research and development, but also the output, the number of patents registered and how often they were cited by others, all tended to improve. Spending on R&D drops significantly in the five years after an activist event but most of the measures of quality and quantity of output improve “significantly,” implying that firms which activists are targeting get better and more focused at allocating assets to their core competencies.
This undermines the argument that activists are swashbuckling raiders who leave smoking and disabled ruins in their wake, but does it imply that this is actually the doing of the hedge funds involved?
It looks as if better husbanding of resources is central to the improvements. The patents taken out by the firms increase in number and are cited more often, and much of the improvement is found in areas of technology which are central to the firms’ core capabilities. In other words, it looks as if firms were prospecting in new areas, and not always successfully, before the arrival of an activist investor.
This is also shown in the fact that following an activist campaign, firms sell an unusual number of existing patents. Not only that but these patents they sell then go on to get cited more when they belong to their new owners. This implies not just that the capital gained by selling the patents may be better deployed by the firms doing the selling, but that the firms doing the buying are able to make better use of the intellectual property, perhaps because it is in an area in which they are themselves more vital and competitive. So not only do activists improve innovation at the firms they target, they may be setting off a virtuous circle of better allocation and better innovation at other firms with which they do business.
This improvement extends beyond a company’s patent bank to its human resources. The study was able to track the productivity of inventors who stay at firms, those who leave and those who are hired after a hedge fund campaign.
“The inventors retained by target firms are more productive than ‘stayers’ at non-target peers; the inventors who leave following hedge fund intervention are more productive with their new employers; and finally, the inventors newly hired post-intervention are of similar productivity at the new firm,” according to the paper.
Again, improvements in outcome all round, not just at the target firm.
Finally, the paper looked at whether any of this might be the result of sample bias: the idea that hedge funds do a good job of stock picking firms which are ripe to register these kind of improvements on their own. Two factors suggest that activists should get some of the credit. First, when they file a 13D form with the SEC, denoting an activist position, target firm performance improves, as does the value the stock market places on new patents.
None of this is to say that activists don’t have their own agendas and can sometimes harm the long-term productivity of firms.
On the evidence, though, it looks like they should be welcomed.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at firstname.lastname@example.org and find more columns at blogs.reuters.com/james-saft)
Editing by James Dalgleish