Does Shareholder Activism Split the Pie or Grow the Pie?

Activist investors are often seen as the epitome of all that’s wrong with capitalism. They cut investment, fire employees, and break contracts to boost the short-term stock price—and cash out before the long-term value destruction comes to light.

The basis of this concern is sound. Investors wish to maximize shareholder value; many of them are mandated by clients, such as pension funds, with financial obligations that need to be satisfied. One way—indeed, arguably the simplest way—to do so is to extract value from other stakeholders. However, this implicitly assumes that the value that a company creates is a fixed pie, so the only way to increase shareholder value is to take from society. In a recent post, I summarized the pie-growing mentality that’s the subject of a new book, Grow the Pie: How Great Companies Deliver Both Purpose and Profit. Investors might instead increase shareholder value by growing the pie—improving productivity, innovation, and focus—thus benefiting society as well.

Which is it? We need to turn to the evidence. It’s certainly possible to find examples of pie-splitting. Renowned activist Bill Ackman—through his hedge fund Pershing Square—took a stake in retailer JC Penney, which then laid off workers and ended its famous customer discounts. This actually ended up harming long-term value for investors, including Pershing Square itself.

However, that’s a single example. It’s almost always possible to find an example of anything you’d like to show. So, before passing any regulation against activists, it’s important to study the effect of activists in general. This is what a decade of research by professors Alon Brav, Wei Jiang, and their coauthors has done. They study activist hedge funds—a particularly maligned type of activist investor, because they’re especially viewed as short-termist. Their seminal study found that, when a hedge fund makes a 13D filing (which is legally required if it acquires a stake of at least 5% and intends to influence control), firm value increases by 7%, with no long-term reversal. Separate research discovered that even after the hedge fund exits, stock prices keep rising for the next three years—contradicting common concerns that hedge funds “pump and dump”.

We still must be skeptical. Even if there are long-term benefits to shareholders, they might come from splitting the pie (e.g. through financial engineering that saves taxes) rather than growing it. Another study obtained confidential data on the productivity of a company’s individual plants, from the US Census. It found that hedge funds increase plant productivity, primarily through raising labor productivity. And this wasn’t by squeezing more out of workers—wages didn’t fall, and hours didn’t rise. Interestingly, productivity also rises in plants sold by hedge funds. Contrary to concerns of “asset stripping”, such sales reallocate plants to buyers who can make better use of them.

A fourth paper investigates investment. Hedge funds cut R&D expenditure, which appears to be the smoking gun that critics are concerned about. But innovation actually rises—more patents are generated, and patent quality increases. The company produces more with less. This highlights a broader point, beyond the question of whether activists create value. Policymakers often criticize companies for selling businesses (even if they become more productive under new ownership), and argue that a company should invest as much as possible. As Senator Elizabeth Warren argued, “the real way to boost the value of a corporation is to invest in the future”. This view underpins the criticism of share buybacks, which I’ll address in a future post. For now, it’s critical to recognize that what matters isn’t how much a company invests, but how well it invests. It takes no skill to simply spend money.

What does this academic evidence mean for practitioners? One implication is for companies. Rather than immediately viewing activists as the enemy, going on the defensive and arguing against their suggestions for reform, executives should start by entertaining the possibility that they might be right. Improved productivity and innovation are outcomes that every executive should desire, and an outsider’s perspective—challenging the groupthink of the current management team—is useful in achieving this.

A second is for investors in general, not just hedge funds. While the above studies highlight hedge funds’ effectiveness in activism, engagement by other investors has more mixed results. Hedge funds’ effectiveness is likely due to three reasons. None of these are specific to hedge funds and they can be adopted by other investors (and many of the best ones do so).

The first is portfolio concentration. Activist hedge funds have large stakes in every company they invest in, and thus skin-in-the-game. Other investors may be spread too thinly to have incentives to engage. Thus, for other actively-managed funds, every stock should be a “conviction holding”, held because it either believes in its long-term story or believes that it can turn it around—rather than holding it by default because it is part of the index.

The second is resources. An actively-managed fund should devote substantial resources to both engagement and monitoring, rather than viewing stewardship as a cost center or optional extra.

The third is incentives. Hedge funds earn 20% for any increase in performance. Some savers might balk this, just like citizens may object to high CEO pay. But the performance fee isn’t at the expense of anyone—it’s only earned if the hedge fund has grown the pie. Moreover, consistent with the long-term incentives for CEOs advocated in an earlier post, pay to hedge fund employees is typically deferred for several years. Indeed, another study finds that, when a mutual fund manager owns 1% more of his fund, risk-adjusted performance rises by 3%.

Overall, engaged ownership generally create long-term value for shareholders. This increased value arises not from taking slices of the pie from other stakeholders, but by growing the pie for the benefit of all. Now this evidence only holds in general—it certainly is not the case that every activist campaign will create value or that we should welcome unfettered activism. Some engagement will be short-term or uninformed, and some investors may attempt to micromanage the company or prioritize engagement frequency over quality. But, rather than viewing activism as blanketly bad (or blanketly good) and seeking to regulate it, we should understand the value of—and seek to promote—the right kind of engagement.