Hedge fund activism is an increasingly significant part of the investment landscape.
Professor Alon Brav of Duke University's Fuqua School of Business studies this phenomenon and whether or not it benefits shareholders and others with a stake in a firm's success. His work has challenged the view of activist investors as short-term shareholders who seek to boost a firm's value for a quick sale with no interest in the long term health of the business. Brav found that on average, firms tend to benefit from shareholder activism. His latest working paper investigates the effects of activist investors on corporate innovation.
Brav discusses his findings in this Fuqua Q&A.
What's the particular importance of shareholder activism's effect on innovation?
There's an ongoing debate over whether activist shareholders increase pressure on a firm to make short-term gains at the cost of creating value in the long term. Opponents say activist investors are only interested in a short-term share price appreciation. But the evidence is overwhelming that on average, prices tend to go up when activist investors get involved with a company. And there's no evidence that prices revert to the mean, which suggests the price increase reflects an efficient market response to the anticipated long term effect of the activism. Innovation is arguably the most important creator of long-term value at a company, but also the most vulnerable when firms think short term. So looking at a firm's innovation activities after activist investors come in can give us an idea of whether activism does affect a firm's long-term focus.
How did you study these effects, and what did you find?
We studied 553 instances of hedge fund activism involving innovative target firms between 1994 and 2007. We were looking for changes in three innovation behaviors after activists became involved: the amount of money spent on research and development; the number of new patents filed by the firm; and the number of times a firm's patents were cited, which gives an idea of their quality. We compared these with carefully selected control firms which had not been targeted by activist investors.
We found that target firms get leaner, but they don't get weaker. They spend less on research and development in the five years after an activism event, but that's mostly because the scale of the firm shrinks overall. Measured per dollar of assets, we don't find evidence of a decline in spending. Meanwhile, there is no decrease in the number of patents filed or the number of citations per patent - indeed, on average, they increased. In short, firms innovated more efficiently.
Besides output, did investor activism change the way firms innovated?
We found firms innovated more in their key technology class after activists got involved, relative to control firms. Firms became more consistently focused. Instead of innovating in some peripheral division, they focused on their core capabilities and innovated in those areas. These more focused firms were more likely to sell off patents they owned outside their key areas, and we found evidence those patents were more widely cited afterward, which suggests that reallocation was the more efficient choice for those patents. So both in terms of new knowledge that's created and the repackaging of current knowledge, there seems to be evidence of firms becoming more focused. Also for individuals employed in innovation, we found those who stay after an activist event become more productive.
Can you attribute these improvements to investor activism? Might the changes have happened anyway?
Attributing this entire effect is challenging, but we can say with confidence that not all of the increases in efficiency would have happened without the activists getting involved. We tested to eliminate alternative explanations and found increases in innovation efficiency when hedge funds switched from passive to active investment in a firm. Had it not been for the activists, at least some of these changes would not have materialized.
We found board members added after an activist event tended to have more expertise in technology and innovation than board members added at other control firms. We also found CEOs hired or retained after activist involvement have longer tenure and better job security than at control firms, which can motivate better investment in innovation.
Activism has pushed a lot of boards to engage more with their major shareholders. They communicate and explain their strategies. And that's what we want-a system where management is accountable to shareholders.
The one thing that people don't appreciate is that an activist typically will take a very small block of shares. A typical stake is 6 to 7 percent, or as low as 1 to 2 percent in larger firms. The only way to have impact with 2 percent of shares is to convince a majority of the passive investors - who are interested in the long term performance of the firm - that your ideas are valid. If you can't then you go away. That tells you this is a good system.