Developed markets like the US are seeing the rise of Activist Hedge Funds. Who are they? And What do they want?

Hedge Fund Activism

On 3rd June 2021, Engine No 1 made it to headlines when it secured three seats on ExxonMobil’s board with just a $50m stake in a $250bn oil giant. Engine No 1 is an Activist Hedge Fund that took this board seat with a mandate to prepare ExxonMobil for a future free of fossil fuel. This is not the first time ExxonMobil is a target firm for Hedge Fund Activism. Around the same time when Engine No 1 was trying to secure board seats, DE Shaw, another shareholder in ExxonMobil, pushed Oil giant to make changes in management, cut costs, etc. In response to which Exxon did all the required changes to satisfy De Shaw, which ended its activist stance in March.
“Activist Hedge Fund” is a relatively new term for me, and this news made me curious about it. Numerous questions popped into my mind, and this article sums up the findings from my crusade for answers.

What is Activist Investor/Hedge Fund?

Traditionally investors will find undervalued businesses, i.e., the share price is less than what it’s worth. Then investors will wait passively for the share price to rise. The investor has hundreds of companies to investigate and many different reasons for stock price rise and fall. Thus, it may take more time to reach the target price than expected. Some investors get impatient and take an active part in the decision-making of their target firm to act as a catalyst to boost the share price.

In technical terms, an activist investor is an individual or group that buys a significant stake in a public company to influence company operations by obtaining seats on its board of directors. Most hedge funds invest using unconventional strategies, but others take a more active role in actualizing the value of their investments — these are known as activist hedge funds. Activist hedge funds engage the company’s board and management in the discussion and wage proxy battles, liquidate assets, and even force sales of companies.

Law in the US states that after acquiring a significant stake, the investor has to file Schedule 13D, which states the clear intention of activism; investors who do not intend to become activists may file a Schedule 13G instead. There is no such law in India that recognizes Activist Hedge Funds, but recently Chairperson of SEBI, the Indian stock market regulator, urged institutional investors such as mutual funds to be more activist in their dealings with companies they have invested in to protect the interests of minority shareholders.

“Institutional investors can and should act as a counterforce to any unwanted decision being pushed in the board, which may not be in the interest of all stakeholders,” Ajay Tyagi, chairperson of the Securities and Exchange Board of India, in an online summit on corporate governance.

What are hedge funds gaining by doing activism?

Activist Hedge funds are primarily looking for good returns for their investments, but they are not restricted to a narrow way of looking at business in which the bottom line is of huge importance. Instead, activist Hedge Funds’ demands are more holistic. Apart from their involvement in financial and growth-related decisions, their demands would also focus on improving companies’ environmental, social, and governance (ESG) records.

For instance, On January 6, 2017, JANA Partners, a New York-based activist hedge fund, and the California State Teachers’ Retirement System (CalSTRS) sent a letter to Apple’s board of directors. The letter stated, “We believe there is a clear need for Apple to offer parents more choices and tools to help them ensure that young consumers are using your products in an optimal manner.” The letter also cites a substantial body of expert research, which has found that — Overuse of iPhones by children and teenagers has been linked to lack of attention in the classroom, difficulty in empathizing with others, depression, sleep deprivation, and a higher risk of suicide.

Activism is possible only when hedge funds can monitor executives’ actions, implying additional costs for the hedge funds. Studies have also shown that target firms create considerably more value than the controlled sample of peer firms. This excess value earned due to activist hedge funds’ intervention is much more than the monitoring cost involved, incentivizing hedge funds.

What are the implications of Activist Hedge Fund on target firms?

Common strategies followed by any company are spending on R&D and introducing a new product that fills that demand gap, improves sales by extensive marketing campaigns, and reduces cost by improving the efficiency of the process, using the most optimized material, etc. However, when hedge funds come with a demand that seems more ESG focused than hardcore business-focused, many allegations are made. These allegations include the view that Activist Hedge Funds are myopic investors, that are not concerned about long-term value creation but are milking recent trends. Furthermore, opposers claim that this myopic vision hampers the innovation capability of the target firm as they create a blockade in the current strategy of the board.

All these allegations, or we can say hypotheses, are being tested by many research scholars and have found results in favor of Activist hedge funds. For example, Tang, T. in a research article studied from sample consists of 231 activist hedge funds, 976 targeted firms, and 1169 hedge fund-target pairs from 2001 to 2007. Tang, T. found that activist hedge funds do not cut target firms’ R&D but significantly increase their innovation output after interventions. Such an increase is more significant among target firms whose hedge funds have explicit objectives and aggressive tactics. Moreover, hedge fund activists improve innovation outputs for target firms in both highly competitive and less competitive industries, suggesting that activist hedge funds enhance innovation by reducing managerial career concerns and slack through effective monitoring.

What can be its implication on developing countries like India?

The number of Activist hedge funds is rising in developed markets like the US. Big asset owners like CalSTRS have recognized the benefits of ESG focused development in companies will result in long-term returns. Dedicated Activist hedge funds are also increasing asset size steadily, thus indicating the profitability of being activist.
Developing countries like India may not be getting many Activist hedge funds very soon, but all the ESG development in foreign firms will not take long to become an industry norm. Indian companies then have to make a call whether to implement these ESG changes or not. If these changes are not suitable in the Indian context, it will create another set of challenges for Indian firms to run business and lawmakers to create a level playing field.