How Does Hedge Fund Activism Reshape Corporate Innovation?

Wei Jiang is the Arthur F. Burns Professor of Free and Competitive Enterprise at Columbia Business School. This post is based on a discussion paper authored by Professor Jiang; Alon Brav, Professor of Finance at Duke University; Xuan Tian, Associate Professor of Finance at Indiana University; and Song Ma. 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), and The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here).

The idea that stock market pressure leads to “managerial myopia” has been a recurring concern and has evolved into a heated debate in recent years as activist hedge funds have come to epitomize shareholder empowerment. Our study, How Does Hedge Fund Activism Reshape Corporate Innovation?, aims to inform the debate by analyzing how hedge fund activism reshapes corporate innovation—arguably the most important long-term investment that firms make but also the most susceptible to short-termism.

A priori, neither the direction nor the magnitude of activists’ impact on overall innovative activities is clear. Innovative activities involve the exploration of untested and unknown approaches that have a high probability of failure with contingencies that are impossible to foresee. Given the lack of observability and predictability, the concern is that management might respond to pressure from current shareholders by adopting investment/innovation policies that are detrimental to long-term firm value. On the other hand, like any other investment decision, a firm should only engage in innovative activities that offer an expectation of positive net present value, and agency problems may lead to either over- or under-investment. Over-investment arises if specialized investment entrenches the management where shareholders can legitimately demand that innovative activities be cut. The opposite is also plausible that management tend to under-invest because they have less capacity to absorb innovation risk compared to diversified investors.

Our first set of tests examine innovation activities at target firms before and after hedge fund intervention, measured by both inputs (R&D expenditures) and outputs (patent quantity and quality). We match each target firm with a non-target firm from the same year and industry based on market capitalization, market-to-book ratio, pre-event return on assets (ROA), and the change in ROA measured between years t-3 and t-1 to capture potential deterioration in operating performance. We find that R&D spending drops significantly in absolute amount (but not relative to the total assets) during the five-year post-event window. Interestingly, there does not appear to be a reduction in output from innovation—measured by patent counts, citation counts per patent, and quality of the citations. Therefore, target firms’ innovation efficiency improves in the post intervention period.

Next, we explore three mechanisms that lead to the gains in innovation efficiency. First, the improvement in patent counts and number of citations per patent is driven by firms with a diverse portfolio of patents prior to the intervention that refocused their efforts after the arrival of activists. Moreover, the increase in innovation is concentrated in technological areas that are central to the core capabilities of the target firms. Therefore, activists seem to push firms to allocate internal innovation capacity to key areas of expertise.

Second, hedge fund intervention is followed by a more active and efficient reallocation of outputs from innovation. Specifically, target firms sell an abnormally high number of existing patents compared to their matched firms, and patents sold are those that are less related to their technological expertise. Moreover, patents sold post intervention receive a significantly higher number of citations relative to their own history and matched peers. These patterns do not appear prior to the intervention, suggesting that the higher rate of patent transactions matching peripheral patents to new and better-suited owners represent efficient reallocation of innovation outputs.

The third mechanism involves the redeployment of innovators at target firms following the intervention. The inventors retained by target firms are more productive than “stayers” at non-target peers; the inventors who leave are more productive with their new employers; and finally, the inventors newly hired post intervention are of similar productivity at the new firm. Combined, the reshuffling of human capital post intervention brings about efficiency gains because the key innovative personnel are matched or re-matched to work environments where they can be more productive.

Several additional tests address the causal link between the intervention and changes in the targets’ innovative strategies and outcomes. First, could it be that activists select companies in which management would have implemented changes to innovation anyway? We employ the subsample of openly confrontational events in which activists met managerial resistance. It turns out that hostile engagements show qualitatively similar changes. Second, could it be that activists engage in stock picking rather than add value through intervention? A legal feature in ownership disclosure offers a source of identification. Specifically, we measure the performance of firms for which hedge fund ownership (and hence stock picking) remained constant, but the fund switched from a 13G (passive ownership) to a 13D (activist) filing status. The significant improvement by target firms after the hedge funds’ decision to switch their filing relative to firms for which the hedge funds maintained a 13G filing suggests that the changes in innovation among target firms reflect an incremental effect of intervention over stock picking. Last, we estimate the incremental value of patents filed prior to the arrival of the activists but granted shortly after the intervention relative to those granted shortly beforehand. The two sets of patents are comparable because they were both filed pre-intervention due to the long delay between filing and granting of about two to three years. We document a significant increase of 31 to 45 basis points in abnormal stock return during the five-day window centered on the patent grant day, suggesting the pre-existing innovation outputs become more valuable because they are better utilized and allocated under the “new” regime.

Our study presents a more nuanced picture than a straight answer as to whether hedge fund activism encourages or impedes corporate innovation. While inputs to innovation measured by R&D expenditures decline post hedge fund intervention, 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. Thus, firms become “leaner” but not “weaker.” Moreover, the efficiency gains also emanate from the extensive margin through the redeployment of innovative assets (patents or innovators). Activists are effectively redrawing the target firm’s boundaries via the refocusing and leveraging of core competency.

The full paper is available for download here.

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