Don’t Run Away from the Evidence: A Reply to Wachtell Lipton

In two recent memoranda by the law firm of Wachtell Lipton (Wachtell), The Bebchuk Syllogism (Syllogism memo) and Current Thoughts about Activism (Current Thoughts memo), the firm’s founder Martin Lipton and several other senior Wachtell lawyers strongly criticize our recent study, The Long-Term Effects of Hedge Fund Activism. Our study empirically disproves the myopic activists claim that interventions by activist hedge funds are in the long term detrimental to the involved companies and their long-term shareholders. This post responds to the main criticisms of our work in Wachtell’s memos. Below we proceed as follows:

• First, we discuss the background of how our study meets a challenge that Wachtell issued several months ago;
• Second, we highlight how Wachtell’s critiques of our study fail to raise any questions concerning the validity of our findings concerning long-term returns, which by themselves are sufficient to undermine the myopic activists claim that Wachtell has long been putting forward;
• Third, we explain that the methodological criticisms Wachtell directs at our findings concerning long-term operating performance are unwarranted;
• Fourth, we show that Wachtell’s causality claim cannot provide it with a substitute basis for its opposition to hedge fund activism;
• Finally, we explain why Wachtell’s expressed preference for favoring anecdotal evidence and reports of experience over empirical evidence should be rejected.

The Wachtell Challenge

According to opponents of hedge fund activism, activist interventions may pump up short-term stock prices and benefit the activists—who don’t stick around to eat their own cooking—but tend to harms shareholders in the long term. As is described in detail in The Myth that Insulating Boards Serves Long-Term Value (Part I) (the Myth study), this myopic activists claim has long been an influential key argument in debates over hedge fund activism and corporate governance more generally, and Wachtell and its founder Martin Lipton have been making this claim frequently and forcefully—though with little empirical evidence to support it.

Wachtell has been a highly successful advisor to boards seeking to “defend vigorously” against interventions by activist hedge funds (see Wachtell’s well-known memo Dealing With Activist Hedge Funds for a brief outline of its approach). Going beyond the provision of such expert advice, however, Wachtell has also been attempting to put forward a policy basis for the opposition to hedge fund activism and to persuade policymakers to adopt or allow measures curbing such activism.

Last November, Martin Lipton and one of us (Bebchuk) held a debate sponsored by the Conference Board on one of the policy measures that Wachtell is seeking in order to discourage activism. During this debate, Bebchuk noted that he was engaged in a co-authored empirical study of the myopic activists claim. Following the debate, in his Bite the Apple memo, Martin Lipton issued a challenge for the research project that we were carrying out. In particular, he argued that “if Professor Bebchuk is truly interested in meaningful research to determine the impact of an activist attack,” our research study should examine the following:

Our study indeed met this challenge. Analyzing the full universe of approximately 2,000 interventions by activist hedge funds during the period 1994–2007, the study tracks changes in the company’s operating performance and stock return performance during the five-year period after the “intervention month” in which the activist initiative was first publicly disclosed.

Our study disproves empirically the myopic activists claim that Wachtell has been putting forward for many years with no empirical evidence to support it. We find that the asserted long-term declines in shareholder wealth and operating performance are not supported by the data. The results of our study are summarized in a post on the Forum here and in a WSJ op-ed article here.

If Wachtell were “truly interested in meaningful research to determine the impact of an activist attack,” it could have been expected to welcome the arrival of a study that provides a systematic analysis of the very question it posed as important and to build upon it. Not so. In its two recent memos, Wachtell urges disregarding the evidence in our study as well as any future empirical work on the subject.

Importantly, Wachtell does not argue that we failed to conduct our study in the best possible way currently available or recommend that we or others conduct a different empirical analysis of the question posed in the Bite the Apple memo. Rather, faced with empirical findings that do not support its myopic activists claim, Wachtell seeks to avoid reliance on our or any subsequent empirical work on the subject and to base policymaking instead on the insights obtained from “anecdotal evidence and deep real-world experience.”

As explained below, Wachtell’s memos raise some unwarranted criticisms as well as some relevant points that we ourselves discuss in our study. None of the points raised, however, provides a basis for Wachtell’s appeals for disregarding our empirical evidence and for relying on anecdotes and reported experiences.

Stock Returns Results

To begin, we should highlights that Wachtell limits its methodological criticism concerning the validity of our findings solely to our results about operating performance. Importantly for the ongoing policy debate, Wachtell does not challenge our finding that negative long-term returns, asserted by the myopic activists claim, are not found in the data.

Stock prices increases commonly accompany disclosure filings indicating the arrival of hedge-fund activists. However, Wachtell and other opponents of activism have viewed these stock price spikes as merely reflecting inefficient market pricing in the short term. For this reason, Wachtell’s Bite the Apple memo challenged our research project to analyze returns post the 24-month period to examine the possibility that reversals of fortune and negative stock returns take place then.

Using three alternative methodologies for identifying negative abnormal stock returns used by financial economists, our study finds—and Wachtell does not question this key finding—that the asserted long-term reversal of the initial stock price is not found in the data. Contrary to Wachtell’s belief that the market fails to appreciate the long-term consequences of activism, long-term shareholders in fact do not suffer any negative abnormal returns during the five-year period following interventions. We hope that, going forward, Wachtell and other corporate advisors will revise the advice they offer boards accordingly.

Operating Performance Results

Our study finds that operating performance relative to industry peers, measured using Tobin’s Q and return on assets (ROA), improves through the end of five-year period following interventions. Wachtell raises two methodological criticisms concerning the validity of these findings.

First, Wachtell makes an unwarranted criticism based on the difference between means and medians. It argues that “averages can be skewed by extreme results” and criticizes our discussion of an initial table (Table 2) for not stressing the difference in results (displayed in that Table) obtained using means and medians. However, that initial table is altogether of little significance for our analysis: Table 2 presents summary statistics of “raw” levels—levels that are not adjusted relative to industry peers—and, as we explain in our study, the standard approach by financial economists is to control by industry. In our subsequent Table 3, which presents summary statistics using industry-adjusted levels, the results are in fact similar using both means and medians: in both cases, industry-adjusted operating performance, measured by either Tobin’s Q or ROA, is higher in each of the five years following the intervention year than during the intervention year. Furthermore, our key findings regarding operating performance are based on a regression analysis, not the summary statistics of Tables 2 and 3, and that analysis uses standard methods for avoiding excessive influence of outlier observations.

Second, Wachtell argues that Tobin’s Q and ROA are imperfect metrics for measuring operating performance. While no metric of operating performance is viewed by financial economists as perfect, we chose these two methods, as we explain in our study, because their use as operating performance metrics is standard among financial economists working on corporate governance issues. Tobin’s Q, in particular, has been used as a key metric for operating performance by numerous studies in peer-reviewed journals, including such influential and widely cited studies as Morck, Shleifer and Vishny, (1988), McConnell and Servaes (1990), Lang and Stulz (1994), Yermack (1996), Daines, (2001), and Gompers, Ishii and Metrick (2003).

In questioning the use of Tobin’s Q and ROA, Wachtell relies on an unpublished paper by Philip Dybvig and Mitch Warachka. These authors discuss potential imperfections in the use of Tobin’s Q and suggest two alternative metrics of operating performance that, to the best of our knowledge, have not yet been used by any other empirical study that has been published or made available on SSRN since the Dybvig-Warachka paper was first placed on SSRN in 2010. We can only imagine how strongly Wachtell would have criticized us if we chose to base our study on some non-standard metrics of operating performance. Indeed, Wachtell does not argue that we failed to make the best possible choices in a world with imperfect metrics for operating performance. As we will discuss below, Wachtell’s thesis is that any empirical evidence is bound to be so imperfect that it best be disregarded.

The Stock Picking Claim

Wachtell also stresses a point that we discuss in detail in our study—that the identified association between activist intervention and subsequent improvements in operating performance does not by itself demonstrate a causal link. Such association could in theory reflect activists’ ability to choose targets whose operating performance is expected to increase in any event. Under such a scenario, the improvement in long-term performance experienced by targets reflect the activist’s “stock picking” ability rather than the activist’s impact on the company’s operating performance.

Wachtell’s making this claim already represents a substantial shift in position. Accepting that activist interventions are followed by improvements in operating performance, and merely questioning whether activists should “get credit” for these improvement, is very different from the myopic activists claim that Wachtell has been making for many years—asserting long-term declines in operating performance to advocate measures that impede activist interventions. To the extent that these interventions are actually followed by improvements in operating performance, the post-intervention changes in operating performance do not provide a basis for measures to curb such interventions.

Furthermore, as we explain in our study (section III.D.2), there are reasons to believe that the identified improvements in operating performance are at least partly due to the activist interventions:

• First, the evidence suggests that the activists themselves are willing to expend significant resources because they believe that their activities contribute to the subsequent improvements in operating performance. Activism involves significant costs. If hedge fund activists believed that the improvements in performance would ensue even without their bearing such costs, they would just buy a stake and, without bearing any of the costs of activism, passively capture the benefits of the improved performance expected to take place.
• Second, our study shows that operating performance improvements follow also the subset of activist interventions that employ adversarial tactics, which are used when companies are expected to resist the activists’ suggested course of action. This finding is in tension with the view that the improvements in operating performance following activist interventions are due to corporate actions that incumbents would take even without any activist intervention.
• Third, earlier work co-authored by two of us shows that improvements in operating performance do not systematically take place after outside blockholders pursuing a passive strategy announce the purchase of a block of shares—but do occur after a subset of the blockholders switch from passive to activist stance. This finding is also consistent with the view that the association between interventions and subsequent improvement in operating performance are at least partly a product of the activists’ work and not merely a reflection of their foresight in choosing targets.

The Rejection of Empirical Evidence

In raising questions concerning our finding, the Wachtell critiques are not aiming at identifying issues that should be addressed differently in subsequent empirical work. While the Bite the Apple memo put forward questions and challenged empirical work to answer them, Wachtell, not happy with the answers that our empirical work provided to these questions, is now giving up on empirical work, arguing that “no empirical work” is capable of measuring the long-term effects of hedge fund activism. Instead, Wachtell believes that it would be better to follow the insights coming from “anecdotal evidence and depth of real-world experience.”

By real-world experience, Wachtell refers to the experience of company managers and directors, as well as their advisors. In the Bite the Apple memo, Lipton urged reliance on “the decades of my and my firm’s experience in advising corporations” as evidence of the detrimental effects of hedge fund activism. Lipton surely can be expected to oppose policymakers relying on assertions by leaders of activist hedge funds that their own real-world experience provides reliable evidence that their interventions are beneficial in the long term.

When available, economists commonly prefer objective empirical evidence over unverifiable reports of affected individuals. Sometimes, in the absence of empirical evidence, substantial reliance on such reports is unavoidable. In the present context, however, public information about stock returns and financial performance can and should be used to assess the myopic activists claim.

The use of such data provides objective evidence that is valuable for policymaking. The Bite the Apple memo was right in encouraging empirical testing of the operating performance and stock return performance post the 24-month period following activist interventions. By contrast, the recent Wachtell critiques are wrong in seeking to discourage the use of such empirical work.

We would welcome it if Wachtell (or some other resource-rich business organizations that share its views) were to contribute to the policy debate by conducting or commissioning an empirical study that would improve upon ours in some methodological or other way. In the meantime, however, Wachtell should not disregard the existing empirical evidence and should not dismiss the value of any empirical work on the subject. In our opinion, Wachtell should engage with the evidence, not try to run away from it.