The Product Market Effects of Hedge Fund Activism

Praveen Kumar is Professor of Finance at the University of Houston. This post is based on an article authored by Professor Kumar and Hadiye Aslan, Assistant Professor of Finance at Georgia State University, available here. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here), The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here), The Law and Economics of Blockholder Disclosure by Lucian Bebchuk and Robert J. Jackson Jr. (discussed on the Forum here), and Pre-Disclosure Accumulations by Activist Investors: Evidence and Policy by Lucian Bebchuk, Alon Brav, Robert J. Jackson Jr., and Wei Jiang.

Whether intervention by activist investors, such as hedge funds, is beneficial or detrimental to the shareholders of target firms remains controversial. Proponents marshal considerable empirical evidence that hedge fund activism (HFA) is associated with significant medium-to-long-run improvements in targets’ cost and investment efficiency, profitability, productivity, and shareholder returns. Opponents, however, insist that HFA forces management to take myopic decisions that weaken firms in the longer run. The debate rages in academia, media, and has already featured in the 2016 presidential campaign.

Despite this intense interest, however, the research on the effects HFA has typically focused only on its impact on the performance of target firms. But targets of HFA do not exist in vacuum; they have industry competitors, suppliers, and customers. It is by now well known that HFA has a broad scope that often—simultaneously or sequentially—touches on virtually every major aspect of company management, including changes in product market strategy, negotiation tactics with suppliers and customers, and knowledge-based technical advice of production organization. In particular, HFA that improves target’s cost efficiency and product differentiation, and generally redesigns its competitive strategy, should have a significant impact on the target’s competitors (or rival firms). This prediction follows from basic principles of strategic interaction among firms in oligopolistic interaction. Indeed, the received theory of industrial organization provides the effects of cost improvements and product differentiation on rivals’ equilibrium profits and market shares.

Specifically, rivals’ profit margins and market shares will deteriorate if they accommodate post-HFA improvements in target firms. In contrast, rivals who take pro-active decisions to counter impending or realized improvements in target firms, or because they themselves are prospective targets of intervention, may actually improve their own economic performance following HFA in their competitors. Yet the product market spillover effects of HFA are quite unexplored. Fundamental questions, such as the significance and nature of these spillover effects, their primary channels (efficiency improvement versus product differentiation, for example), and the role of the target’s industry remain unanswered. Apart from its intrinsic economic interest, examining these spillover effects can give a deeper perspective on the central issues regarding the role of HFA in effecting efficient allocation of capital and promoting productivity improvement through knowledge-based intervention.

In our paper, The Product Market Effects of Hedge Fund Activism, forthcoming in the Journal of Financial Economics, we analyze the product market effects of HFA using a comprehensive sample of activist investor interventions in U.S. firms from the mid-1990s through the end of the last decade. We uncover significant spillover effects of HFA on the industry rivals of target firms. On average, HFA has negative effect on rivals’ product market performance—as measured by their price-cost markups and market shares—and on their operational returns, productivity, and capital investment. Interestingly, the spillover effects are stronger on rivals’ price-cost margins rather than their market shares, which is consistent with the argument in the strategy and marketing literatures that the immediate response of firms to low cost competition is typically to reduce prices and protect market shares. And the relatively smaller magnitude of the market share loss of the typical rival firm is also consistent with the view that HFA tends to improve the efficiency of target firms rather than expanding their scale.

Moreover, guided by the theoretical industrial organization and strategy literatures, we analyze the channels for the spillovers based on factors related to the nature of the intervention, rival firms, and the type of industry. We find that the impact on rivals’ performance is commensurate with the post-HFA improvements in targets’ productivity, cost and capital allocation efficiency, and product differentiation. However, there is substantial heterogeneity in these spillover effects, based on rivals’ post-activism improvements, financial constraints, and threat of intervention. Rivals respond to HFA on competitors (target firms) not only by reducing prices but also by improving their own productivity, cost and capital allocation efficiency, and product differentiation. And those that are able to achieve above average improvement levels suffer lower reduction in markups and market shares. In particular, financially constrained rivals accommodate these improvements but those facing high intervention threat respond effectively to them. The effects of HFA on rivals’ product market performance are also significantly influenced by the industry competitive structure. For example, the spillover effects are strengthened in less concentrated and in low entry barrier industries.

Notably, financial markets appear to anticipate the spillover effects. On average, rival firms earn abnormally low returns following the announcement of the activist investor interest in target firms. And the heterogeneity that we observe in the post-HFA spillover effects is reflected in the announcement effects of intervention events on rivals’ stock returns. Moreover, consistent with the observed importance of the product market spillover effects of HFA, the announcement effects on rivals’ stock returns are especially pronounced when the hedge fund intervention focuses on target’s business and financial strategy.

A major challenge in empirical studies of hedge fund activism is to identify the causative effects of activist investor intervention. In particular, an important component of hedge funds’ investment skill is to identify firms that have a higher likelihood of superior competitive performance. The alternative hypothesis then is that our findings reflect differential sensitivity of target and rival firms to common industry-wide shocks, which is being strategically exploited by activist investors. We use multiple approaches to address the challenge of identifying rivals’ product market performance under the counterfactual that the target firms are not exposed to HFA, and find confirming results.

The full paper is available for download here.

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