Over the past decade, hedge fund activists have increasingly pressured companies they invest in, demanding strategic changes and sometimes forcing managers out.
That’s not necessarily a bad thing. Activists can often goad firms into improving operations, boosting financial performance for investors over time. But behind the scenes, activism creates pitched battles as corporate managers fight to control their companies and hold onto their jobs.
Until now, there has been little information about how firms respond to hedge fund challenges and demands for change. But a new paper published by the journal Management Science sheds some light on the subject. The paper, written by Associate Professor of Accounting Yinghua Li; Inder Khurana of the University of Missouri; and Wei Wang of Temple University, shows that company managers don’t just sit idly by when their performance is attacked. Instead, they tend to withhold bad news and manipulate earnings to make the company — and themselves — look better.
“It’s human — when their reputation is on the line, when they’re publicly called incompetent or asked to resign, it’s natural for them to try to defend themselves,” Li says. But their defenses often leave investors in the dark about the firm’s true performance.
Unlike other large investors such as pension funds and mutual funds, hedge funds are not required by law to diversify their portfolios, which means they can take a much larger stake in companies they invest in, giving them more power. Some deliberately seek out companies with poor performance, hoping they can force changes to improve operations, making money for their investors. They try to convince managers to pursue a different strategy, such as repurchasing shares, increasing dividends, or selling off assets tangential to the main business line. Other times, they try to force C-suite managers out or replace board members with others who agree with their ideas.
Hedge funds can be very frank in their negative appraisal of firm managers. Here’s an excerpt from an actual letter from a hedge fund to the CEO of a company it invested in:
“…we were aware of your reputation for extravagance, poor judgment, and your overall limitations as a manager. We went in with ‘eyes wide open’ regarding the company’s declining sales, eroding margins, and over-leveraged capital structure. It was our view, however, that even a manager as flawed as yourself could implement the basic ‘blocking and tackling’ maneuvers required to restore operating margins to industry averages and thus enable the company to restructure its debt.”
Though this particular fund gave up on trying to fix the company and withdrew much of its investment, many hedge funds are able to boot out CEOs and replace them with people who will work to achieve their goals.
Managers fight back
Job security is precisely what managers worry about when hedge funds start to intervene. So, what do they do?
Li and the other researchers, who examined 510 hedge fund activism events from 2001 to 2013, found that companies subject to hedge fund interventions are much less likely to disclose bad news. That’s especially true when activists are confrontational, when they have a relatively high ownership stake, and when they have a track record of replacing CEOs and CFOs.
In addition, the researchers found that companies subject to hedge fund interventions engage in earnings management tactics to try to make their firms look good, such as lowering product prices to boost sales, overproducing inventory to reduce the cost of goods sold, and cutting discretionary expenses like advertising or research and development.
Though these maneuvers are intended to help managers survive during the intervention, the researchers found that the withholding of bad news persisted even after the exit of hedge fund activists, suggesting that hedge fund interventions can have a long-lasting impact.
One thing company managers don’t do during an intervention is issue more good news than usual. That may be because they don’t want to generate unrealistic expectations, Li says.
“Issuance of good news might generate favorable stock market reactions, but it’s a double-edged sword. Eventually, you have to report your results. If the firm said it expected to make $1.5 per share in the next quarter, but it only made $1, the market will be disappointed.” And managers who made the overly optimistic predictions will have egg on their faces.
Impact on investors
Research has shown that on average, activist hedge fund investors improve firm performance, Li says. But it can be a bumpy ride for investors, especially when firms keep bad news under their hats and artificially inflate earnings. Is there anything investors can do to learn more about what’s going on?
Yes. For one thing, they can find out if there’s an intervention. Hedge funds that plan to push for significant changes are required to file a form with the SEC stating their intention. Though some filings lack details, others are quite specific, spelling out a strategy or stating that they want to replace the CEO or certain board members.
Investors can also research a hedge fund’s track record. “Look for real improvement. If they’ve invested in five firms in the past three years and 80 percent of them improved after the intervention, you can put more trust in them,” Li says.
“At the same time, you want to watch out for potential counterproductive behaviors by managers, like withholding bad news,” she adds.
Li’s research found that firms do less withholding of bad news if they’re covered by many analysts, who presumably press them to disclose results. If investors are well-informed, managers’ attempts at manipulation won’t work.
Li hopes her paper will have similar results, helping to curtail the dog-and-pony shows managers put on when activists try to make them change their ways or force them out. “If more people read our paper…maybe they will push managers to be more forthcoming in disclosures. They could ask more incisive questions in conference calls. That would make it more difficult to hide bad news from the market,” she says.