How Does Hedge Fund Activism Reshape Corporate Innovation?
Alon Brav
Duke University – Fuqua School of Business
Wei Jiang
Columbia Business School – Finance and Economics
Song Ma
Duke University – Fuqua School of Business
Xuan Tian
Indiana University – Kelley School of Business – Department of Finance
May 16, 2016
Abstract:
This paper studies how hedge fund activism reshapes corporate innovation. Firms targeted by hedge fund activists experience an improvement in innovation efficiency during the five-year period following the intervention. Despite a tightening in R&D expenditures, target firms experience increases in innovation output, measured by both patent counts and citations, with stronger effects seen among firms with more diversified innovation portfolios. We also find that the reallocation of innovative resources and the redeployment of human capital contribute to the refocusing of the scope of innovation. Finally, additional tests refute alternative explanations attributing the improvement to mean reversion, sample attrition, management’s voluntary reforms, or activists’ stock-picking abilities.
How Does Hedge Fund Activism Reshape Corporate Innovation? – Introduction
Since the rise of shareholder rights in the 1980s, there has been an ongoing debate among academics, practitioners, and policymakers about the consequences of stock market pressure on managerial incentives to engage in innovative activities that have long-term value consequences but are not easily assessed by the market. The idea that stock market pressure leads to “managerial myopia” has been a recurring concern (Stein (1988, 1989)) and has evolved into a heated debate in recent years as activist hedge funds have come to epitomize shareholder empowerment. The concern reached a heightened level in 2015 when Laurence Fink, the chairman and CEO of BlackRock, the world’s largest institutional investor, argued that activist investors put pressure on and create incentives for corporate leaders to generate short-terms gains at the expense of long-term value creation.
Between 1994 and 2007, there were more than 2,000 engagements by hedge fund activists in which hedge funds proposed changes to payout policies, business strategies, and corporate governance, often publicly and aggressively. Recent studies, covering both the U.S. and international markets, have documented that the target firm’s stock price increases 5% to 7% when the market first learns of the activist’s intervention. Moreover, the interventions are not followed by a decline in either stock returns or operating performance during the five-year window after the arrival of the activists.2 Yet, measurement of the long-term impact of hedge fund activism has proven challenging to evaluate due to data restrictions and methodological limitations. As a result, opponents of hedge fund activism have resorted to a “myopic activists” view, claiming that activists’ agendas are biased towards the pursuit of short-term stock gains at the expense of firms’ long-term values.
Our goal is to inform the debate by analyzing how hedge fund activism reshapes corporate innovation—arguably the most important long-term investment that firms make but also the most susceptible to short-termism.4 A priori, neither the direction nor the magnitude of activists’ impact on overall innovative activities is clear. First, activists might have a negative impact on innovation because, as Holmstrom (1989) argued, innovative activities involve the exploration of untested and unknown approaches that have a high probability of failure with contingencies that are impossible to foresee. Given the lack of observability and predictability, the concern is that management might respond to pressure from current shareholders by adopting investment/innovation policies that are detrimental to long-term firm value. More powerful current shareholders could lead to greater misalignment.
Second, although managerial preferences and objectives may not be aligned with firm value maximization, the order of the relative preference is not clear a priori. Like any other investment decision, a firm should only engage in innovative activities that offer an expectation of positive net present value (NPV), and agency problems may lead to either over- or under-investment. For example, over-investment may arise if specialized investment entrenches the management (Scharfstein and Stein (2002)) or if managers derive private benefits from such activities (e.g., “grandstanding” suggested by Gompers (1996)). In such a scenario, shareholders can legitimately demand that firms spend fewer resources on innovative activities. The opposite is also plausible since agency problems may lead to under-investment: Shareholders may demand higher levels of research and development (R&D) than management wants if diversified investors have more capacity to absorb innovation risk (Aghion, Van Reenen, and Zingales (2013)).
To set the stage, we first examine innovation activities at target firms before and after hedge fund intervention, measured by both inputs (R&D expenditures) and outputs (patent quantity and quality). Consistent with previous findings that target firms reduce investment and streamline their asset base following the intervention, we find that R&D spending drops significantly in absolute amount during the five-year window subsequent to hedge fund activism. Interestingly, there does not appear to be a reduction in output from innovation—measured by patent counts and citation counts per patent—after the intervention. Consistent with the idea that target firms’ innovation efficiency improves after hedge fund intervention, most of these measures increase significantly.
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