Hedge Fund Activism: Proof of Why Speech, and not Silence, is Gold in Business!

Last week, Darden Restaurants Inc. underwent a complete makeover of its board, where the current board, in its entirety, was asked to step down after an election. Yahoo Inc. is considering a merger with AOL after its shares began to tumble as an aftereffect of the Alibaba IPO. And last month, eBay decided to spin off its PayPal division into a separate public company in 2015.

These companies may appear to have nothing in common except perhaps the fact that they are undergoing dramatic shifts in their operation and/or management. However, the truth is that these companies, and many others, have one thing in common; they are all targeted by hedge fund activists.

Hedge fund activist Starboard Value was responsible for the removal of the entire board of Darden, as well as pushing Yahoo towards a merger with AOL. Billionaire hedge fund activist investor Carl Icahn was responsible for pushing eBay to spin off PayPal.

Activism has, in recent times, become an extremely popular investment strategy among hedge funds, so much so that the number of activist hedge fund launches jumped from 12 in 2012 to 28 in 2013, according to a report by Preqin. 

Number of Activist Hedge Fund Launches by Year 

Source: Preqin Special Report: Hedge Fund Activist Report

So what is hedge fund activism? Professors April Klein and Emanuel Zur, in their working paper, ‘Hedge Fund Activism’ define hedge fund activism as “a strategy in which a hedge fund purchases a 5% or greater stake in a publicly-traded firm with the stated intent of influencing the firm’s policies.” The policies include buybacks, spin-offs, acquisitions, and/or the sale of the firm itself.

How do we know whether a firm has purchased a 5% or greater stake? The answer lies in the Schedule 13-D filing, which has to be filed by the hedge fund with the Securities and Exchange Commission (SEC) when it purchases a stake of 5% or more in a firm. The SC 13-D filing reveals the identity of the buyer, the target firm, the stake in the company and the “purpose” for the purchase.

Now that we have got the boring definitions out of the way, it is time to focus on the performance of hedge fund activists. Hedge fund activists, have in recent times, been outperforming the traditional hedge funds. A recent news article in Wall Street Journal indicated that the returns of activist hedge funds gained 6.5% in the first half of 2014, almost twice the returns of traditional hedge funds. A similar pattern was seen in 2013 too where activist hedge funds generated average returns of 11.82% when the broader hedge fund industry generated only 7.88%.

Performance Comparison of Traditional and Activist Hedge Funds

Source: Wall Street Journal

So how do hedge funds become such successful activists? Studies have shown that the unique organisational structure of hedge funds makes them effective activists. Activist hedge funds hold few positions, although large in value, focusing on as few as 10 to 30 companies at one time, and thus, they are able to engage with the management and successfully implement changes in firm policies. According to Christopher Clifford, Assistant Professor at the University of Kentucky, it is the hedge fund’s freedom to lock-up investor capital and the power to use leverage and options, to increase effective ownership stakes, which make them reliable and effective activists.

Whatever may be the reasons and whatever the future may hold, one thing is clear: hedge fund activists have clearly proved that in business, speech, and not silence, is gold!