Carl Icahn, competitor.

Photographer: Victor J. Blue/Bloomberg

Activists Are Tough on Companies They Don't Own

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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There is a lot of fairly boring back-and-forth debate over hedge fund activism, in which proponents of activism argue that it's good because it improves corporate performance, and opponents of activism argue that it's bad because it provides only short-term boosts but is destructive in the long run. There are studies both ways, each side picks the evidence it likes, and it remains an eternally suspended question that in any case tells you nothing about whether any particular activist proposal is good or bad.

So it is pleasing that two finance professors, Hadiye Aslan and Praveen Kumar, found a new way of measuring activism. Instead of looking at firms that are targeted by activists, they looked at the competitors of those firms, and found that activism is bad for them:

We examine the product market spillover effects of hedge fund activism (HFA) on the industry rivals of target firms. HFA has negative real and stockholder wealth effects on the average rival firm. The effects on rivals' product market performance is commensurate with post-activism improvements in target’s productivity, cost and capital allocation efficiency, and product differentiation.

If activism is bad for the target's competitors, that must mean, transitively, that it is good for the target firm. Or, I mean, not. If you started out thinking that activism improves performance, then the finding that activism takes market share away from competitors will confirm your beliefs. If you started out thinking that activism is short-term-oriented and leads to under-investment, then the finding that this happens in part through cost-cutting might also look like confirmation. And the debate will continue where it left off. 

But I particularly like this paper for the light that it sheds on another debate, the one about whether index funds should be illegal. This debate gets rather less media attention, probably because it doesn't really exist, which is a shame because it is much funnier than the is-activism-bad debate. 

Recall that the anti-index-fund theory goes like this:

  1. Big, broadly diversified, passive-ish institutional investors -- including but not limited to broad stock index funds -- tend to own the stocks of many companies in the same industry.
  2. Those investors would prefer for those companies not to compete against one another too viciously, which would lower margins and be bad for all the competitors.
  3. A mechanism exists.
  4. Companies with lots of diversified institutional investors actually don't compete vigorously, and they earn supracompetitive profits.
  5. That is an illegal antitrust conspiracy.

I think everyone can agree on claim 1, but after that it gets pretty weird. Weird, but not necessarily wrong. It all more or less makes sense. It's just weird. Diversification is so central to modern investing that no one really wants to believe that it is economically harmful, never mind illegal. And so no one really does.

One reason to ignore the theory is that, as plausible as it sounds, it has some pretty thin empirical support. A lot of it is based on one study of concentrated share ownership in the airline industry, and since airlines are stereotypically always going bankrupt, it is hard for anyone to take seriously the idea that they earn supracompetitive profits even if it's true.

But Aslan and Kumar's results would seem to provide broader empirical support for the theory. For relevant purposes, activist investors are the opposite of diversified institutional investors. They are undiversified: They build big stakes in a few individual companies, rather than spreading their bets around broadly. And they are active: They demand that managers do things, rather than just leave them alone to manage their companies however they want. One thing that they demand seems to be that managers compete harder. And so managers dealing with activists do compete harder. And their competitors suffer for it.

That's fine for the activists: They own shares in this company, not in the competitors, and if this company wins a zero- or negative-sum game then the activists are happy. Other, normal, diversified shareholders, who also own the competitors, have less reason to want their companies to play negative-sum games. So you might expect passive diversified shareholders to vote against activist campaigns, and particularly against operational proposals focused on competition. And there is some suggestive evidence for that.

So maybe diversified institutional investing really is anti-competitive. Or, at least, its opposite -- concentrated activist investing -- seems to be pro-competitive. Should you care? I mean, in the long run, in theory, competition is good and monopolies are bad. And the law does disfavor anti-competitive conspiracies. On the other hand, diversification is also really good for investors, and it would be rather a shame to get rid of it. And fierce competition has its own obvious downsides. Competing by cost-cutting often means competing by job-cutting, and who knows, maybe those supracompetitive profits are being reinvested in human immortality or whatever.

Or maybe diversified passive investors and concentrated activist investors are two balancing elements of one ecosystem, and if diversified passive investors didn't exist you wouldn't need activists, and vice versa. 

Last week we talked about this Roosevelt Institute paper calling on regulators to limit stock buybacks, "affirm board power" and "clarify the fact that shareholders are not owners or residual claimants" of public companies. Today Senator Tammy Baldwin, a Wisconsin Democrat and perhaps the leading congressional critic of stock buybacks, criticized buybacks in a keynote speech at an event hosted by Americans for Financial Reform called "Hedge Funds & Private Equity: Transferring Wealth Up."  It seems reasonable to say that stock buybacks, and the activist hedge funds that demand them, are not much loved by the American left.

This leads to some awkwardness. If you want to prevent stock buybacks, what you are doing is demanding that big corporations accumulate more capital, and more power over the economy. If you want to limit (activist) shareholder rights, what you want is for corporate managers to have more power. It is perfectly reasonable to want big companies to accumulate more capital and corporate managers to have more power! It is just not intuitively that much of a progressive platform, at least as progressivism used to be understood. There was a time when corporate capital and managerial power were the enemy. Now financial capitalism is the enemy, and corporate capital and managers are potential allies in the fight to restrain financial capitalism.

Where does that leave antitrust, and competition? Antitrust law has historically been a progressive tool to prevent the concentration of corporate power; stereotypically Democrats like antitrust enforcement more than Republicans do. In a world where progressives are more tolerant of concentrated corporate power, and where activist financial capitalism turns out to promote competition, I wonder if that will change.

  1. Relevant findings include that "the typical rival suffers reductions in price-cost markups and market shares," and that:

    In terms of operating performance, HFA on average pressures profitability, cash flows, and productivity of rival firms, but not their capital investment, presumably because competitors may be forced to increase investment in response to improvements in target firms.

    There is also a small negative stock-price cumulative abnormal return for rival firms over the 10-day period surrounding an activist announcement. But the rivals' stock-price return depends on what the activist is proposing:

    Among the specific proposals, demands for changes in firm governance, such as changing the composition of the board and trimming executive compensation, have insignificant announcement effects, consistent with the literature that finds insignificant stock return effects of governance proposals for target returns (Gillan and Starks, 2000). In contrast, demands for changes in business strategy and capital structure of target firms have statistically significant and economically sizeable negative effects on rivals' stock returns. The size and significance of the negative announcement effects on rivals when HFA focuses on changes in the business strategy of target firms is of substantial interest from the viewpoint of industrial organization and strategy literatures. Our findings indicate that financial markets expect HFA to raise target performance through improvements in production efficiency, product differentiation, and business strategy rather than through tacit collusion with rivals (Green and Porter, 1984).

  2. In that the people who think index funds should be illegal:

    • Are mostly academic types, with not much visible support from, say, corporate managers or regulators or politicians or lobbying groups or anyone else who might make that actually happen, and
    • More or less deny that they think index funds should be illegal.

    I know, though. I know.

    Meanwhile, the people who argue that index funds should not be illegal are basically just me. And I kind of agree with the other side! It is quite a debate. It takes place mostly in footnotes.

  3. According to an e-mailed statement from her office, the AFR event "was sponsored by AFL-CIO, Americans for Financial Reform, American Federation of Teachers, and The Center for Economic and Policy Research." And yesterday she sent another letter to the Securities and Exchange Commission criticizing stock buybacks.

  4. What would Marx say?

  5. The Roosevelt Institute authors -- Mike Konczal, J.W. Mason and Amanda Page-Hoongrajok -- are quite sensitive to the weirdness here:

    Some may hesitate to give managers more power and protection, but there are two reasons to consider this approach. First, this action should be carried out in tandem with the other policy proposals in the agenda. The most effective way to address short-termism is holistically, seeking to end short-termist trends but also empower good management. Second, the business judgment rule is powerful but not invincible. If management fails to demonstrate to a judge that it utilized all available information in its decision-making, it will be overruled in shareholders’ favor.

  6. Some of this draws very loosely on Jürgen Kocka's forthcoming "Capitalism: A Short History."

  7. But:

    For better or worse, the Administration’s enforcement record does not bear out this impression. With only a few exceptions, current enforcement looks much like enforcement under the Bush Administration. Antitrust enforcement in the modern era is a technical and technocratic enterprise. Although there will be tweaks at the margin from administration to administration, the core of antitrust enforcement has been practiced in a relatively nonideological and nonpartisan way over the last several decades.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
Zara Kessler at zkessler@bloomberg.net