The Returns to Hedge Fund Activism

Hedge fund activism is a new form of investment strategy. Using a large hand-collected dataset from 2001 to 2006, we find that activist hedge funds in the United States propose strategic, operational, and financial remedies and attain success or partial success in two-thirds of the cases. The abnormal stock return upon announcement of activism is approximately 7 percent, with no reversal during the subsequent year. Target firms experience increases in payout and operating performance and higher CEO turnover after activism. We find large positive abnormal return to hedge fund activists, which is higher than the return to other equity-oriented hedge funds.We analyze the currently most extensive and thoroughly documented dataset of hedge fund activism, which extends from the beginning of 2001 through the end of 2006. We find that hedge funds increasingly engage in a new form of shareholder activism and monitoring that differs fundamentally from previous activist efforts by other institutional investors.We also find that hedge fund activism as a form of investment strategy generates large positive abnormal returns both for shareholders in the target companies and those in the activist hedge funds. When we compare the returns to self-reported activist hedge funds with the CRSP Value-Weighted Market Index and the Russell 2000 Value Index, we find that our activism index closely tracks the two market indices through mid-1998 but then departs significantly and moves upward. Moreover, since 2003, activist funds have outperformed not only both market indices but also equity-oriented hedge funds. We show that this strong performance is robust to a range of asset-pricing models—including controls for size, book value to market value, and the momentum effect as well as selection bias, incubation bias, and survivorship bias. The median self-reported activist fund in our sample has a monthly four-factor alpha of 63 bps, compared with an alpha of 39 bps for all self-reported equity-oriented hedge funds.We find that a significant portion of the targets’ abnormal returns comes from the market’s favorable reaction to the announcement of activism. This finding is consistent with the view that activism creates value. The filing of a Schedule 13D revealing an activist fund’s investment in a target company results in large positive average abnormal returns, in the 7–8 percent range, during the (Day –20, Day 20) announcement window. We also find that the positive return at announcement is not reversed over time. Activism that targets the sale of the company or changes in business strategy, such as refocusing and spinning off noncore assets, is associated with the largest positive abnormal return.We examine hedge fund strategies in detail to define the factors that contribute to the large abnormal returns. Hedge fund activists tend to target companies that resemble value companies, with low market value relative to book value, although the companies are profitable and have sound operating cash flows and return on assets. Payout at these companies before intervention is lower than that of matched companies. Target companies also have more takeover defenses and pay their CEOs considerably more than comparable companies. Relatively few target companies are large-capitalization companies. Targets exhibit significantly higher institutional ownership and trading liquidity. These characteristics facilitate the quick acquisition by activists of a significant stake.Hedge fund activists are not short term in focus, as some critics have claimed. The median holding period for completed deals is about one year. Analysis of portfolio turnover rates of the funds in our sample suggests holding periods of close to 22 months. Once activist funds invest in a targeted company, they engage in a wide variety of tactics to achieve their objectives. To illustrate some of these findings, we include two examples of hedge fund activists’ investments in portfolio companies.