Dedicated activist hedge funds are still a fairly new phenomena, starting in the late 90s and only picking up more than $100 billion AUM in the last few years, so there’s still plenty of debate about whether they outperform other strategies over a full business cycle, the long-term effect they have on companies, and what separates successful activists from the growing crowd. Joint research from the Alternative Investment Management Association (AIMA) and Simmons & Simmons makes a good case for activist funds to be seen as “a distinct model of shareholder engagement” that falls somewhere between traditional hedge funds and private equity, though the question of activism’s long-term performance still isn’t definitively answered.
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Investment horizon puts activism between hedge funds, PE
Even though critics often accuse activists of chasing short-term gains at a company’s long-term expense, activists actually have a fairly long holding period: 1.8 years for alternative funds holding activist positions and just under 2 years for dedicated activists, compared to just three months for trading strategies. That puts activists in between most other hedge funds and PE, which is reflected in the way they raise capital (eg longer lock-up periods). PE wants total control over a company while activists want influence, but even that line isn’t as sharp as you might think – the AIMA and Simmons & Simmons report says that there are cases of both PE activism and activists taking over target companies entirely.
“The markets for control and influence may, therefore, best be considered points on a continuum rather than wholly distinct,” says the report. “Activist funds, with their focus on such issues as the strategy, capital structure, operations and governance of portfolio companies, are generally more strategically akin to PE than many other alternative investment funds.”
Activism goes beyond identifying value
There are also strong similarities between value investing and shareholder activism, but again the distinctions are significant enough that you can’t just view it as an updated form of value. Activist targets usually have high book-to-market ratios, high return on assets, and strong cash flows compared to their peers coupled with slow earnings growth and disappointing stock performance. Activists mention that their targets are undervalued in two-thirds of US-based campaigns, even if the funds don’t consider themselves to be value investors. Still, this isn’t the Graham-style value investing that relies on Mr. Market eventually coming to his senses.
“Most value investors are analyzing companies based on their existing business and trying to project out future financial results based on management’s existing business plan,” says Jeff Smith of Starboard Value according to the report. “We analyze companies existing business plans and compare them to what, we believe, may be a better alternative business plan.”
Activists have outperformed, but not during the financial crisis
Activist hedge funds have outperformed other strategies recently, and the AIMA and Simmons & Simmons report highlights research showing that targeted companies outperform on average for a couple of years following an activist campaign, but the success of the activist funds themselves could partially be a fluke of when they became popular.
The report presents performance data going back to 1995, but there’s no real difference between activist funds and other equity hedge funds before 1999 (nor was there much activism in general), but they have pulled well ahead by the time the financial crisis rolls around.
If you look at the performance from 2011 to the present, you once again see activist hedge funds outperform other strategies by a fair margin, with a huge jump in 2012 in particular.
But from the limited data we have, activist funds are also at the extreme during down years.
“Collectively, activist hedge funds suffered worse returns in 2008 than hedge funds employing any other strategy, except for funds focused on certain emerging markets (HFR, 2014), and they underperformed the S&P 500,” says the report.
The cumulative return between 2004 and 2014 (including the financial crisis and excluding a few years of outperformance from 2002 – 2004) still puts activists ahead of other strategies, but you could make the argument that activism just amplifies what’s happening in the market, as you might expect from highly concentrated portfolios full of win-lose propositions.