In this episode of The Acquirers Podcast Tobias chats with Professor Nicole Boyson. She’s the Patrick F. and Helen C. Walsh Research Professor of Finance at the D’Amore-McKim School of Business. During the interview Nicole provided some great insights into:
- How Does Past Experience Impact Hedge Fund Activism?
- Hedge Fund Contagion and Liquidity Shocks
- Hedge Funds for Retail Investors? An Examination of Hedged Mutual Funds
- Hostile Resistance to Hedge Fund Activism
- How Firms Fend Off Attacks By Activists
- The Evolvement Of Activism
- Balance Sheet and Operational Activism
- Companies Make Underlying Improvements When An Activist Shows Up
- The Link Between Activism And Corporate Governance
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
Tobias: Hi, Tobias Carlisle. This is The Acquirers Podcast. My special guest today is Professor Nicole Boyson. She’s the Patrick F. and Helen C. Walsh Research Professor of Finance, at the D’Amore-McKim School of Business. She’s got a really interesting area of research. We’re going to talk to her right after this.[intro]
Tobias: Hi Nicole, how are you?
Nicole: Hi, Tobias. It’s so nice to see you. Doing well, thanks.
Tobias: We went back and forth a little bit on your most recent paper. So, can we perhaps just describe your area of research and how this paper fits in?
The Link Between Activism And Corporate Governance
Nicole: Of course. I’ve been doing researching, I guess, roughly 20 years-ish. Grad school started in 1998. But most of my work, it’s sort of three categories. It’s hedge funds, and then within hedge funds, I started out working in hedge funds when it was a new area. So, we were just getting our hands-on data. I looked at a lot of standard stuff, like risk and return and trying to figure out if managers have skill and persistence. And then, I moved along to more focusing on activism.
Sometime in 2000– gosh, 2010-2011, probably a little bit before that, activists, there was an article in Businessweek of all places that said hedge fund activists, this is the new thing. One of my colleagues and I decided to try to dig into that, and we ended up writing a paper that was published in 2011 that looked at the link between activism and corporate governance. That was interesting because if you think about a hedge fund activist, the whole idea is, he’s coming in and he’s going to try to buy up 5% to 10% of a company’s stock and try to make changes. And it turns out that a lot of the changes are governance related. So, things like shaking up the board of directors, making it easier for shareholders to hold special meetings. Oftentimes, getting rid of management or reorganizing, and so there’s a lot of–
In corporate finance, there’s a lot of question about whether good governance actually translates into good performance for stocks. Kind of leaving that aside and just thinking of governance is important and good governance is better than bad. We tried to take a look at how activists get involved in change governance. We did find a little evidence that linked firms that improved their governance to also some improvements in other areas of the firm like ROA and stock performance and those sorts of measures.
Tobias: Activism has had this interesting evolution where I think in the 80s, a lot of it was the leveraged buyout takeover style where that was not really activism. They were literally trying to get control, and then at some stage, it evolved a little bit, and that version that started in the early 2000s was the Dan Loeb, David Einhorn kind of start where they’d buy a small holding. Where they couldn’t otherwise get control, they’d be quite vocal, and they’d use the nasty letter to try to push change through.
I think a lot of that was a response the fact that the rules for getting control was so stacked against the activists. All of that poison pills and staggered boards and so on. It’s sort of an interesting petri dish where you get to look at, does activism actually drive improvements to corporate governance? Does corporate governance actually lead to better returns in the market? You find there is some minimal evidence for that, but not much.
Companies Make Underlying Improvements When An Activist Shows Up
Nicole: A little bit, yeah. It’s hard to measure too. But, yeah, initially, our first results related to corporate governance, and activism. But then I’ve got a bunch of other projects in the space and I’ll talk about those if that’s okay. One of them, we looked at mergers. There’s a paper by Robin Greenwood and Michael Schor. Greenwood is at Harvard, super-bright guy. And he talks about activism and kind of says, “Look, activism is fine, but it really only adds value when the firm is ultimately taken over.” And he has this great chart in his paper that kind of shows that takeovers, you get like a 30% stock price pop, and that’s great, but sort of all the other firms kind of stagnate. My friend, Nick Gantchev and Anil Shivdasani, both at the time were at UNC.
We decided to sort of dig a little deeper into the merger space, and we found what Greenwood found. We found certainly that the best outcomes from activism were when the firm was taken over. But we also had some other cool results, where if an activist came in and got the firm to sort of a merger bid place. So, they got to the point where a serious offer was made, sometimes by the activists. Interesting side note, about 15% of my sample– in about 15% of the time, the activist itself would make a bid. And those are firms that you’d think of often as more traditional buyout private equity firms. Carl Icahn comes to mind. And so, they make a bid and apparently it’s credible enough because about half the time, the activist bid would actually go through and they buy the firm, they or someone else, oftentimes that would increase the demand for, “Oh, this looks interesting–” [crosstalk]
Tobias: It’s in play.
Nicole: It’s in play. That’s right, thank you. That’s the word we use. And then, the other half of the time that those bids would sort of falter. But then, there are other cases where the activist wasn’t making a bid, but some third party would and some of those would falter too. If you look at like third-party potential buyers, 90% of those ultimately went through, either to them or somebody else. If you look at potential activist buyers, about half of those went through.
But if you look at all the ones that don’t go through, so half of the 15%, and then 10% of the larger sample, what we found was that the stock returns for those were kind of in between the very good outcome of a merger, but the dismal outcome of activism without a merger. We sort of argued that firms must be– they know they’re getting this bid, they get themselves in better shape to get ready for this bid. Then, even if the bid doesn’t come through, it appears that– again, causality is really hard to determine. But it appears that the improvements they made were substantial enough to get that stock in– if it’s 30% longer-term return, say for a merger, maybe it’s 15% for these guys in the middle.
We thought that was really interesting that activists do appear to make changes, but you need a really serious event, like, “Oh my gosh, I might get taken over and lose my job to really shape up.” Where the guys who didn’t have a takeover threat, you’d see some incremental stuff but the stock price which– again, I care about ROA. But if I’m buying the stock, I care about the stock price, much harder to trace out really great long-term stock returns.
Tobias: When the activist shows up and somebody makes a bid, whether the bid goes through or not, there is some underlying improvements to the company to the [crosstalk] fundamentals–?
Nicole: Absolutely, yeah. Fundamentals. Yeah, we would take a look at things like asset sales and capital structure, leverage, all the things that we think about firms might do to improve efficiency. CEOs still sometimes got fired. That’s one huge, consistent outcome of the activ– if an activist comes in, you better be dusting off your resume because there’s like a double the chance that you’re going to lose your job if an activist isn’t there.
Nicole: Double, yeah, so it’s huge. If you just look at average CEO turnover in any given timeframe, it’s maybe 20% a year. If here’s an activist there, it’s like 40 plus. Causality, again, hard to determine, but we’re pretty comfortable that the activist had something to do with that much of the time.
Tobias: Yeah, I think it’s incredibly interesting.
Learning From 13D’s
Tobias: It’s an area that I– when I started writing my blog years and years ago, what I was initially looking for were net-nets, which are companies that basically that– you’re not paying for the business at all. And if it’s traded down that low, that’s bad news for that company. They’re basically saying it’s worth more dead than alive. But the wrinkle that– I only bought the ones where there had been a 13D filing on the company had– Ultimately, I think that that underperformed buying just the whole cohort of net-nets.
Tobias: But I felt better doing it because I felt, “Well, at least there’s some external pressure to force something to happen.” So, there’s a chance that you get a sale or you get some sort of– something happens. Management does something.
Nicole: Exactly. Yeah, and it’s interesting because we can only observe so much. So, the 13D filings, it’s just a treasure trove. For those of your viewers that 13D filing is, if any investor comes in and wants to buy up 5% or more of a company stock and has some intent on being active, they’re not just happened to cross the 5% because they’re big index fund like Vanguard in there– they’re in there.
Those guys, the passive guys can file, it’s called a 13G, much less onerous form, they file it like quarterly. But a 13D, you’ve got to file 10 days after you hit the 5% threshold. And you have to state your intent. Sometimes, the intent is really vague, like we think the stock is cheap and we just want to buy it, and that’s about half the time. But the rest of the time something really interesting, they want to push a merger or change the capital structure or improve operations or fire somebody. And as we were talking about before this, a lot of times it comes with some pretty hostile stuff. There are some activists that are famous for writing incredibly nasty letters to shareholders.
Tobias: Right, very personal.
Tobias: Oh, they’re so funny. Making fun, saying like, “You’re wasting money. And what you should do is use your pencils till their stubs and sharpen them down.” And just crazy stuff. Dan Loeb is famous for getting involved with the Olive Garden and going in and telling them to put more salt in the water. Sometimes, it gets a little crazy with their demands, but in general, that 13D filing is an indication that some institutional investor at least is taking interest and wants to shake things up.
Tobias: I think it might have been Starboard with Darden, but I think they might have been right too, they weren’t sufficiently salt in the water.
Nicole: You know what? You’re right [crosstalk] Starboard. I know we can discuss Olive Garden’s food at another day, but it was interesting that the level to which– and yeah, you’re right, it was Starboard. But the level to which different activists will get involved and how they specialize or how they don’t specialize, it’s really interesting to just go through that data and there’s a lot of it.
Tobias: I think Loeb attributes it to– there was a gentleman out here, Robert Chapman the Third who was very macho. He was always pictured with a big shark jaw behind him and all that sort of stuff.
Nicole: I’ve seen those pictures.
Tobias: He tells stories about going through the jungle and charging at– he was confronted by some monkey [crosstalk] jungle and charged– it was all part of the persona. Icahn does the same thing, “I grew up in this really rough area. I’m really tough guy.”
Nicole: Oh, yeah. Icahn, the guy’s drinking martinis on CNBC [crosstalk] all. And then, he and Bill Ackman having their very public fight and yelling at each other. If there is a common theme in my research, it turns out that I just am really interested in stories.
Tobias: It’s fun.
Nicole: It’s super fun and reading these letters, doing this kind of research is, in one sense thankless because you have to really hand collect so much data. Turns out that’s my strength, but also you get occasionally rewarded with just these hilarious stories or these letters. And the personalities of these folks are big. You’ve got to have a lot of guts to go out, hold a really concentrated portfolio for many of these guys. And people talk about activist being long term– I’m sorry short term, but that’s not borne out in the data and these guys stick around two, three, four years.
Some of them like Jeff Ubben from ValueAct, he’s now just moved on to some new things, but he’d stick around for 15 years, get on the board. So, there’s a lot of different ways that activists can go in, and I’m really interested in that cross-sectional differences across that.
How Does Past Experience Impact Hedge Fund Activism?
Tobias: Let’s talk a little bit more about your area of research. What’s your most recent paper called and what’s it about?
Nicole: My most recent paper in the activism space is about prior experience. It’s called how does past experience affect hedge fund activism? And this is the paper that I reached out to you about because we have this working hypothesis about what we think is happening. And luckily now, this paper is forthcoming at a journal. We’ve been working on it a long time, which is great.
Nicole: Yeah, thank you. Some papers take longer than others. And this one, really getting the story pinned down, it just took us a long time. But what we argue is that certain activists come to the table, if you like– Oh, they all come with a fair amount of prior experience. So, the average number of years’ experience for any of these hedge fund managers– at the start of their activism careers, it’s something like 15 to 20 years. They’ve been out doing stuff.
They’re maybe 50 years old, and they generally have backgrounds that either are in investment banking, or the other space we look at his private equity and special situations funds. And so, when we take a look at their biographies and we hand collect all this data, and just looked at what their prior work looked like, about 80% of my sample– I’m sorry. Maybe slightly less than 80% of my sample has either private equity/special situations. You think have this very intense kind of portfolio company approach or they come from investment banking, which is very different.
The way we think about it is, we think about investment bankers as having great quantitative skills, obviously strong people skills, but there’s a certain amount of skills that we would argue and we base this on some great work by Morrison and Wilhelm. Wilhelm is at UVA. And if you look at their work, they argue that investment bankers have these skills, and they call them codifiable. And these are going to be folks who have really good Excel skills and really good quant skills. They’re great at dealing with deals, mergers, and acquisitions, putting together deals and then doing that a lot of times.
Where the flipside, the special situations, private equity funds, you slide into some of the distressed and turnaround guys here too, those guys have more experience going deep. If I’m getting involved with a company, putting it in my portfolio or trying to turn it around, I’m going to get involved with that company. I’ll probably buy a bit more of the stock. I may buy across the capital structure, so maybe I own some debt too. And most likely, I’m going to try to be there for three to five years and try to really make a difference.
We put these two against each other and say, “You’re either a specialist, a private equity/special situations kind of guy.” And we argue that their skills are coming from that type of environment that’s a partnership. So, special situations funds, private equity funds organises partnerships. Investment banks, public companies. And so, the skillset that you pick up is going to be different.
So, the human capital and financial capital in the special situations, private equity guys, that’s the same thing. It’s the same people. Your partners are invested. We’re an investment bank, you might be an employee, maybe you’re managing director, but it’s just a different feel. And so, we argue that the softer skills, if you like, the skills with negotiations and with dealing with people, also really strong and important, legal and regulatory skills. If you’re working in private equity or turnaround, you better know how to read those documents carefully, understand what’s happening there, where you’re going to fit in.
We look at those two different categories, and then we compare them to the folks who don’t have any of those backgrounds. So, they might have an industry background, or maybe they’re a younger guy and don’t have much background. We find that the financial specialists, which encompass both special situations guys and the investment banking guys, tend to have better outcomes for their activism, relative to the guys with none of that experience.
And then, within that group, we find all kinds of interesting outcomes. So, the specialists tend to be in longer, their portfolios are more concentrated, they tend to be unafraid of taking really big stakes that might trigger regulatory filings. They’re more likely to do private placements. Where the other guys, the generalists, the investment banker guys, are more likely to use call options. So, there’s this sort of short-term/long-term approach. And then, when the specialists get involved, they’re more likely to get board seats, they’re more likely to have this– what appears to be a more cooperative relationship, so the target management doesn’t fight back as hard against them. So, that’s kind of interesting.
We look at those outcomes, and we find that both types have pretty good ROA long term. And we find actually that the generalists, the investment bankers, most of the bang for their buck comes from mergers and acquisitions. Both consistent with my prior work, but also with the idea that if I worked in investment bank, I probably have some expertise in M&A.
Tobias: Basically, is it fair to say the two groups break down into, one is more transactional, and one is around for a little bit longer. And the transactional ones, the investment banking guys, naturally they’re getting in there and they’re looking for a transaction like a faster sale. Whereas the longer-term guys are looking to make some improvement at the portfolio at the fundamental level and then eventually that leads to better stock price performance. Is that a fair summary of what they’re doing?
Nicole: I do think that’s fair and philosophically thinking about their approach and just the way they think about what activism means to them, I think that that’s right. They’re both playing to their strengths. I think both sets of activists are skilled and I think that a lot of that is coming from their prior experience. We were excited that it linked so nicely because you have a hypothesis, and you think, “Well, this guy’s probably going to do this.” And it turned out to be pretty consistent across the board.
One of the puzzles that we saw was that the investment bank guys, the generalists, they tended to have a much bigger initial stock price than the specialists. Again, you can think about that as short term versus long term. It kind of made sense–
Tobias: More of a pop, is that what you–
Nicole: More of a pop. Yeah. One of the only things we can say for sure about hedge fund activism is that when activists get in, the stock market is happy. You always get this 10, 12, 15 day, just nice increase in returns for that period, excess of the market, so these are like legit, excess returns. But when we broke it down, what we found was the majority of that– even that initial pop came from the expectation that those firms would eventually merge with respect to the generalists.
So, investment bankers, when they got in, were about twice as likely to say, we think you should merge, which is again, consistent. And we found that 20%, or whatever that was that chunk of it, that was where we saw most of the action in the stock price. And it turned out that those firms did frequently merge more often. It was this really nice kind of the– the guy comes in. He’s got a reputation for probably shaking things up and getting mergers done. The market knows that, they recognize that upfront. We look at 18 months out after activism, ultimately, those were the ones that were more likely to merge. So, that was kind of a cool result.
Tobias: Does one group generate a better return than the other or is it sort of the deal guys tend to be more front-end loaded and the operational guys, it takes a little bit longer, but ultimately, it’s a better return? Do you see anything like that?
Nicole: That’s how we see it. When we look at the short-term pop, that’s right, you see it more with the generalists, the IB guys, but really concentrated in the ones where they’re like, “Buddy, you’ve got to sell your firm. You need a merger.” If you look long term, long-term stock performance is notoriously difficult to attribute to anything. As an academic, if you try to put a long-term stock performance return in your paper, they’re going to tell you to take that out because you can’t prove causality–
Nicole: Anyway. Yeah. You can look at it. We find maybe a little bit of that but more comfortable for academics are the operating performance improvements. We actually do find that for both sets, slightly better for the guys who stay around longer, but we do find some operational performance improvements from the generalists and we think of that as maybe not all the way to M&A, but maybe capital structure changes or things like selling assets, selling underperforming assets.
They both replace the CEO, the specialists do it slightly more often. But, again, that makes sense, the idea that they’re going to be there longer, they’re far more likely, the specialists, to get board representation. And board representation is fascinating because these are hedge fund activists who are pretty wealthy. You might think a small investor would be like, “Cool, I’m going to get on board and make an extra hundred grand,” or whatever. For the activists, it’s not this short-term payoff. I think they really do get in there and try to make changes. So, that’s been kind of interesting to look at.
Tobias: Yeah, I think it used to be the rule that anybody who wanted to be a director shouldn’t be a director because they didn’t realize– you get paid a little bit of money, but then you’ve got this very long tail of liability–
Balance Sheet Activism and Operational Activism
Tobias: You’ve got to carry around it. When I wrote Deep Value, which came out in 2014, one of the interesting bits of research was, the paper that I looked at which just escapes me now, but it looked at two types of activism and they broke it down into basically what they called Balance Sheet Activism and Operational Activism.
So, the balance sheet activist just came in and said, “You’ve got a lazy balance sheet, you need to pay some out, you need to buy back some stock, you need to sell the company,” and all of those sort of maneuvers. And then, there were operational guys who were more like listed private equity-type investors where they were genuinely trying to make some changes. The thing that I found most interesting is, I think that the balance sheet activism is the easiest to do and it seems to be the one that generates the best returns to whereas the operational stuff is–
Nicole: Yeah. The operational stuff feels kind of thankless, but I guess if you’ve got a private equity background, it’s like that’s in your blood so you go do it and you like doing it. Maybe it’s fun. But I agree with you. The easy pickings.
We did find too. One of the really important things about activism is that it’s really hard to attribute causality and if you’re a finance professor, the gold standard is if you can find a causal relationship. So, we punt on that a little bit.
We instead look at sort of selection and we say, “Okay, given the backgrounds of these guys, how do they select stocks? What changes do they make?” You can look at really substantive things like getting on the board, or I picked these types of stocks over these types. And we found pretty consistent that the specialists, the special situations guys, didn’t seem to pick stocks that were easy to fix.
So, they weren’t necessarily distressed by any means and we kicked out the really distressed ones because we didn’t want the paper we wanted to be more about activism in relatively healthy firms. But they were more likely to pick firms that didn’t have obvious– you have too much cash or you don’t have enough leverage, or all the kinds of things that you might see from the investment banking guys.
To some extent, they are picking targets that are harder to fix, and they end up with about the same result. So, you might argue that they do have a fair amount of skill, but it’s a different process. We also can’t see when they get in. We know the activists are making more money than–
Tobias: You know when they file, but not necessarily when they buy.
Nicole: [crosstalk] That’s right. So, you can get some of that but certainly activists wouldn’t do activism if they didn’t think it was going to be profitable. And the stock price returns that we calculate are all based on public filing data. So, certainly, you might think that if you’re a talented ex-private equity guy, special situations guy, maybe you’re better at timing your entry, it’s really difficult to test that. But we did find that they just seemed much more willing to go into firms that weren’t obviously terrible– and I shouldn’t say terrible, that weren’t obviously easily fixable.
Operational Activism Is Difficult To Measure
Tobias: Well, I had two questions about the research, the operational versus balance sheet. One of them is, is it just that it’s so hard to measure what the operational guys are doing because I didn’t really appreciate that was that hard to do. It was hard to sort of tease out the excess return to what the operational guys were doing. Why is that so hard to tease out and how do you deal with it?
Nicole: Yeah, it is really hard because it’s hard to measure intangible improvements that might come through in– maybe they’ve made some operational improvements, but it somehow doesn’t come through an ROA as strongly as you think it would. You try to look at balance sheet items and income statement items and get a sense for what they’re doing. But in general, if you think about it as, there are probably some tradeoffs, maybe they improved some operations in one area, but then sales are down or revenues are down, it’s hard to sort of assess that. We ended up having to use the standard measures. That said, there are a couple papers that do a really nice job looking more at operations.
I’m forgetting the citations, but Lucian Bebchuk at Harvard has some work that looks at long-term performance. He and his colleagues– I could be mixing them up with [unintelligible [00:25:59], one of those smart B guys, they’re looking at the census data, and they can get data all the way down to the plant level. And they actually find some pretty cool– like productivity improvements, like revenues per employee, and that sort of thing.
So, they can look at plant productivity and that’s kind of an operational measure that you can’t get unless you have census access. And they do find evidence that activists– now, this isn’t splitting the way I split, but just activists in general seem to make those kinds of improvements, which again, sort of filter-through ROA, but it’s tougher at that level. So, that’s a cool result. And then, there’s another paper about innovation that shows that when activists are involved, firms are more likely to– we look at things like R&D, but that’s really noisy. They look at patents and patent filings and mostly they look at patent citations, which is the gold standard for innovation. And they do find pretty good evidence that when activists are involved, patent citations go up, so there does seem to be–
Tobias: What’s a citation? That’s somebody looking at a file and saying– that’s prior data?
Nicole: Yes, somebody else is using it. Exactly. Anyone can file it. Like you and I could go file a patent on something silly probably.
Tobias: And then it just gets ignored.
Nicole: It wouldn’t mean anything. I mean, maybe but so citation means that someone else actually is using it.
Tobias: Someone referred to it. I see. Yeah.
Nicole: Yes. So, the citations are at least a better measure that there’s some external interest in this, and possibly applying to use it or have access to it or this sort of thing. The innovation work by these guys, there’s a guy, Indiana, who does a lot of work in this space, their paper on activists and innovation is pretty compelling to me that they do seem to make operational-type improvements that don’t always show up really directly in the consolidated financial data that we get.
The Evolvement Of Activism
Tobias: The other question that I had, does this change over time? That paper that I referred to– the reason I mentioned that the publication of the book in 2014. 2014-2015, the value stops working somewhere around that kind of period of time, 2015, 2018. Prior to then, they had sort of been this golden age from 2000 around that period where just buying lower multiple stuff did really well. And that’s what a lot of these guys are doing. Since then, it’s been– I just wondered if maybe operational improvement had started working post 2015.
Nicole: I know, it’s so hard to know, because I think you’re right. One very valid criticism of activism is just they’re good stock pickers. And they go in and mean reversion, and these companies get better. There’s certainly an aspect of that. I would never deny that. And to me, stock picking is a skill. But whether the activism causes these changes is really unknown. That’s why we try to look at things we can measure. But I agree with you, the idea that operational improvements might be working is good. You could also think of activism as this evolution over time, where the first couple campaigns, the first couple hundred campaigns go back to ’94 or whatever. There’s some really lousy companies out there that need obvious fixes. So, you’ve got these–
Tobias: Low-hanging fruit.
Nicole: –great opportunities. Yes, exactly. We can get all those. And then at some point activist, one, they might get cocky and be like, “Hey, we’re going to go change like Apple or something.”
Tobias: That definitely happens.
Nicole: Carl Icahn was an Apple for a while, takes a lot of credit for what they did. Or you have just fewer opportunities. So, it’s this idea of too many dollars, chasing too few opportunities. But I do think what happens is, and why I think my work and the work that you referred to are useful to think about, is there is some separation between the types of activism that work and when they work, and what kind of skills you need. I think this idea that just anyone can file a 13D.
I mean, the original research everyone does, we just look at all of them. And that’s fine, you’ve got to look at the averages. But when you’d really think hard about what they’re doing, why they’re doing it, who they are, I think then you get a little bit more comfortable with, okay, maybe there is some cause and effect here. And maybe that guy was just luck.
Tobias: Do you have any sense of the follow through from filing a 13D? Does some people just file the 13D knowing that’s a signal to the market, and just not do anything after that?
Nicole: I think so. But usually, they get found out pretty quick. I think that initial stock price pop happens on average, but about 25% of filings actually have a negative abnormal return. I think the market knows. They know reputations of activists. I think probably back in 1994, every filing was like “Woo!” but now I think people know. I’ve never heard of that guy, and I don’t know what he’s doing, and so there’s less of a response, but I think that’s right.
We do follow most of the campaigns through. The success rate, if you want to say do they get something close to what they asked for, I want a board seat, they get a board seat, I want you to sell some assets, they sell some assets, it’s like 60% of the ones where they have a solid request. But remember about half of the campaigns in all our samples, they just say, “We think this stock is cheap,” and they reserve the right to do activist stuff, but they don’t always. So, there’s a little bit of both.
Tobias: It’s lazy, but it’s not a bad idea. If you think the stock is cheap and you file a 13D, now you get to tell everybody, “We think the stock is cheap. And look, maybe we’re going to do something.”
Nicole: Right. I do think there probably are some activists that are in there with this short-term pop, but it turns out to be not the majority and those cases obviously– it’s sort of one-off. If I pick a big activist, like Dan Loeb or Bill Ackman, they also file 13G sometimes. They absolutely sometimes will go in and just be holders of the stock. They have a concentrated portfolio. They’re going to be activist in three companies and less activist in others. And the typical activist hedge fund, Ackman not being a good example of this because he’s very concentrated, but the typical activist hedge fund about 20% to 23% of their portfolio, you just look at their long stocks are activist positions and the rest are whatever passive, active but not activist, I guess.
You can imagine, I am but one man, so how many firms can I really go be activist in at any point in time? Ackman right now– while we were doing this for my class, we looked up Ackman, he has seven holdings. That is a concentrated portfolio, I didn’t look carefully, but I’m guessing most of them are activist positions, where he has a 13D. But then, others who do activist stuff, it’s just going to be a minority of their portfolio, substantial minority, but not the majority.
Hostile Resistance to Hedge Fund Activism
Tobias: I remember in the heyday in the mid-2000s, there were a few articles that would talk about 27-year-old activists calling up pretty well-respected, established CEOs. And they might have even just been an analyst at a big firm, and they’d be telling them all the stuff they had to do. And the guy just says, “Yeah, you’re right.” And then, they hang up the phone and not do anything.
Nicole: I’m not done with you. Yeah, there’s certainly a credibility factor that matters. One of the other things I look at, in a different paper, but shows up in this one too, is the interaction between the activist and the target firm. I think that works super. Again, interesting because it’s stories, but you can see where an activist comes in, and I got this idea of reading some stuff by Matt Levine, my favorite blogger.
He was writing about poison pills being used against activists as opposed to being used against takeover sharks or whatever. Sure, activist sometimes take over firms, but the poison pill was a pretty aggressive way to say, “Hey activist, you own 5%. We’re not letting you go more than 10%.” We saw a handful of poison pills being put in, and my coauthor and I thought about, “Well, gosh, is this happening a lot. And if it does happen, what goes on in the rest of the campaign?”
We found– this is a paper called Hostile Resistance to Activism and we divided the resistance into a proxy fight or a poison pill, really hostile stuff versus oh, the company just made it a little harder for shareholders to meet, slightly more benign but still nasty, or they did nothing. We found that hedge fund activist, if the target fought back hard, and the activist didn’t counter fight back, that was like the worst of all possible outcomes. So, those just stagnated.
When we found the cases where the firm appeared to cooperate, those turned out okay. Or the cases where the firm got hostile and then the activist got hostile back, those turned out okay too. So, it was this idea of like, you go in, and it’s like a little bit of a crapshoot, like, “Is this guy going to go crazy trying to fight against me?” Or is he going to also say, like, “Hey, I agree that my governance is lousy, and we’re going to try to fix it.”
You can think about both. It’s like a personality, am I hostile or not? But also, we looked really carefully at these ideas of changes in governance and poison pills. And the poison pill thing to me, it’s a small sample, they don’t do it very often. But to me, if you are a target firm and you put up a poison pill against an activist, that is a pretty strong sign that you are not going to be a very friendly target.
How Firms Fend Off Attacks By Activists
Tobias: Then, it becomes key whether the activist fights back or not. When they don’t fight back, if you’re watching from the sidelines, you’ve got a holding in it, then probably, you want to cut bait at that point.
Nicole: You’re going to cut bait, and the activist usually cuts bait too. He kind of quietly, “too rich for my blood.” And when you think about the types of firms they target– I was reviewing a paper for journal and they were focusing a little bit on– when you come in and you target a firm, do you first consider what their governance looks like? And
I’m sure the answer is yes, but no one has studied that very carefully. That’s interesting to think about too. You want to go in and target a firm that doesn’t have a lot of takeover defenses and it’s hard to call meetings and all the different things that firms can do to entrench management. If you go after a firm that super entrenched, what happens? Do they just laugh because they have a big wall built up, and they just shake you off? So, that’s not something that’s been looked at very closely, but I do think it’s important to think about.
Tobias: There’s lots of sneaky ways of hiding it too. One of them is they all get golden parachutes, so they want them to come in. And the other one is the poison put, where they say, “We can sell our assets,” or, in a debt covenants, when you guys come in, and you get some sort of holding, all the debt come becomes due and payable. Very sneaky.
Nicole: Yes. Those stuff is so sneaky, and then the whole green mail thing, which Icahn is kind of famous for, just let me–
Tobias: Take me out.
Nicole: [crosstalk] Well, take me out at 15, and we’re good or whatever the number is.
Tobias: Not allowed to do it anymore.
Nicole: I don’t think that’s legal anymore. But it definitely was in existence for a while.
Tobias: I think that’s been a good change for the market because it has meant that the other shareholders get to participate. If you want to take me out, you’ve got to take everybody out. I think that’s a better way of doing it.
Nicole: I agree. I think shareholder democracy is on average a good thing. Not all shareholders are brilliant geniuses, but not having any say isn’t good either.
Hedge Fund Contagion and Liquidity Shocks
Tobias: In the SSRN, I was looking at your most downloaded papers. So, that’s Hedge Fund Contagion and Liquidity Shocks. Why is that paper so popular?
Nicole: Well, I have a really famous coauthor, René Stulz is my dissertation advisor. But also, I think it’s just a really cool and timely topic. When I graduated, I was working, I think, at Purdue, I might have been at Northeastern by the time. René called me and said, “Hey, I’m thinking about contagion and liquidity.” He had done a bunch of work in that space. The idea of contagion is really interesting. It’s that you think about assets that are generally not very highly correlated. So, maybe think about stocks and bonds, or maybe think about US stocks and emerging market stocks. There’s correlation but it varies over time. And it’s not usually obvious or high, because different macro factors are going to drive it. There’s a big literature on financial contagion, which effectively says, “When things go bad, assets that are not typically very correlated suddenly [crosstalk] correlated.”
Tobias: Become correlated. Yeah.
Nicole: Yes. You’ll hear people say, “Correlations go to one during the financial crisis.” That’s a little bit of a stretch, but not too far up. This was pre-crisis. It was like ’04, ’05 when we started the paper, but we were thinking a lot about, is there contagion in hedge funds? In other words, if things go bad, and we were defining bad as we didn’t have like a financial crisis. We ended up having that, and it was in our paper.
But more generally you’re in a bottom fifth percentile of return distributions or something like that. What happens? Do hedge funds that are different styles, equity market neutral, long-short equity, convertible, our fixed income, our relative value, name all the styles, do they get closer? Are they more correlated when things are bad? If that’s true, that’s particularly not good news for hedge fund investors who are typically being sold hedge funds on the premise that they are going to have lower volatility or be good diversifying tools. And so, that was our basic premise. We started writing that. We did find that correlations increased during bad times and there was some evidence of contagion.
Then, the financial crisis came which gave us more data points to look at things being really bad, and our paper ended up being focused a bit more on the recent crisis than say the prior recession. But what we found was that, not only is there this contagion across different hedge fund styles during bad times, but it seemed to be very strongly correlated with liquidity. So, the paper is called Liquidity Shocks and Hedge Fund Contagion or the other way around. We looked at liquidity shocks in the repo markets. Again, the big liquidity shocks that we saw during 2007, 2008, 2009 when markets were freezing up, and we saw, unfortunately, for hedge fund investors that contagion seemed to increase during those times.
Tobias: What’s the driver of that?
Nicole: Yeah. So, the liquidity stuff is really interesting. There’s a whole bunch of work. There’s this sort of famous paper by [unintelligible [00:40:03] and Peterson that looks at they call– I’m forgetting the name of paper, Liquidity Risk or Tail Risk or Contagion Risk. And they’re looking at this idea of liquidity spirals where you’re going to have shocks to asset liquidity and you’re going to have shocks to funding liquidity. So, you can think about asset liquidity. I hold a bunch of risky stuff on my balance sheet. And sometimes, I can sell it, like think of risky mortgage-backed securities. When times are good, everyone will buy that because housing prices are going up forever. Risky securities are risky or not risky until suddenly you freeze up.
You have this downturn in the mortgage markets, and you– just picture banks to keep it simple. Banks are holding a bunch of risky stuff. We don’t know how risky it is because it’s fairly okay. But during a normal time, banks can pledge their assets or sell their assets relatively reasonably well. During bad times, everybody starts to get nervous.
So, there’s liquidity shock on the asset side, which means that even as a big investment bank, it might be hard to sell some of these risky mortgage-backed securities. I might not even be able to pledge them as collateral. And so, then that gets into the funding liquidity. Funding liquidity says, “I’ll lend you money if you pledge me some collateral, but I don’t trust your collateral.” And so, this idea of spirals of, I have risky assets, they’re now suddenly illiquid, I need cash because I am a highly levered firm, like most banks were pre-crisis, and I need to borrow from in the short-term money markets. People don’t like my risky assets. I’m suddenly hitting a funding liquidity shock, what do I have to do?
Well, I have to sell some of those assets. Well, gosh, it’s not a great time to sell your risky assets when the risk is coming true and so, I’m going to engage in– we’ll call them fire sales if you like. I get to sell my assets. I’m not going to get what I want for them. That spirals downward.
So, this idea of funding liquidity and asset liquidity, we took that to our hedge fund data, and of course, we can’t look at all the holdings of hedge funds, but we can base– we can look at the measures of funding and asset liquidity and see how they correlate with different styles of hedge funds and the troubles that they might have had during a financial crisis. And so, you can see the fund shrink, you can see flows coming out, and you see effectively values dropping. And sadly, if everybody’s relying on the same funding source and that dries up, everybody’s going to have to sell assets at the same time, and that’s going to drive down prices, probably well beyond fundamental values.
Tobias: Yeah, it’s fascinating. Do you continue to watch it? Did you watch it through the most recent March drawdown?
Nicole: I haven’t watched it very carefully. But what’s interesting though, is that hedge funds have been just kind of terrible since 2010. They came out of the crisis, they looked okay. A lot of them failed and we had to put up gates.
But what ended up happening, again, just this is my view, looking at hedge funds. You’re in this bull market where borrowing is really easy. Hedge funds make money when there’s volatility. Hedge funds make money when there’s something to bet against. If you have a secular bull market, where funding is cheap, it’s hard to justify your value as a hedge fund when the S&P 500 is crushing you all day long, and even on a volatility side, like we’ve got this nice smooth up. So, I think contagion is still important and interesting in the hedge fund space, but I think that the underlying macro conditions are such that I wouldn’t– I think it’d be hard to be a hedge fund manager right now. It’d be boring. Now, we’re seeing a little downturn–
Tobias: More terrifying than boring.
Nicole: I know, yeah. I kind of looked at the recent downturn. I haven’t– But I do think that this idea of liquidity shocks and the spirals, everyone knew about it. And this paper by [unintelligible [00:43:43] Peterson was such a beautiful theoretical model and tons of us are out there testing it. I do think it’s still a potential issue. The Fed though has learned a lot from this as well and so the Fed stepped in and backstopped a lot of markets post crisis. I think now they’re pre-backstopping, and so I don’t think funding crisis is out of the question. But we’re not seeing anywhere near the pressure on short-term money markets that we saw in 2007, 2008.
Tobias: It was an extraordinarily rapid decline followed by an equally rapid recovery, that seems to have shot back over the previous highs. It’s as if didn’t happen.
Nicole: I know. Well, now everyone’s mad at the Fed, because they’re not buying more long-term bonds or whatever. We talked about that in my fixed income class. The Fed basically promised to keep rates at zero for three years or whatever, and the markets are still unhappy. So, it’s an interesting time to be an investor, I guess.
Hedge Funds for Retail Investors? An Examination of Hedged Mutual Funds
Tobias: Last question, last topic. I just wanted to discuss your hedge funds for retail investors and examination of hedged mutual funds. It’s a fascinating topic. What do you find? Let’s talk about first, what is a hedged mutual fund?
Nicole: Yeah, I like that paper a lot too. It was one of my very first papers that got published in a decent journal and, and my coauthors were lovely. But we were really interested in thinking about mutual funds that use hedge fund strategies. Within the mutual fund space, the 40 Act, if you like the Investment Company Act of 1940, call those mutual funds 40 Act funds, they have restrictions, but they’re not totally restricted. If I’m running a mutual fund, I can use some leverage. I can short sell. I can use some derivatives, but I’m limited as to how much, so that’s the whole point. It’s a mutual fund, I can’t go crazy. But what we found was that during that time– I think our sample ends in 2004, 2005, we were looking at a very small sample of mutual funds that were doing hedge fund strategies in the mutual fund space. And so, that was kind of cool. Our sample is tiny like 67 funds, but we had the whole universe and we thought this is novel enough. Let’s give it a shot and take a look.
We came up with some ideas about why those funds ought to either be better or worse than traditional mutual funds. And so, we ran a study that looked at– we just call them hedge mutual funds, there’s still not a great name for them, called them hedge mutual funds. We compared them to traditional mutual funds with similar style, stock to stock and so forth. And then, also hedge funds.
We had a data set of hedge funds. We found that the performance and the risk of the hedge mutual funds was better than traditional mutual funds, not as good as hedge funds. And this was the heyday for hedge funds too, remember. We argued that it makes sense. It’s restriction. I’m in the mutual fund space. I can’t do all the crazy stuff hedge funds can do, it’s incentives. Most managers in mutual funds get fixed asset fees, not a percentage of profit, not a carry, not an incentive fee. So, the incentives are different as well. And so, it was this, what can I invest in and how do I get paid?
The really cool part of that paper, and I remember being so excited when I figured it out was that about half of those hedge mutual funds were also run by a manager that had a hedge fund. It wasn’t just like Fidelity’s run in a bunch of like long-only funds and they grab a guy and go, “Go do a hedge mutual fund.” The guy’s like, “I don’t know how to short. This is not what I do.” But the hedge fund guys, for them to go into that space, makes sense. Especially if I’m a hedge fund guy that’s already within the mutual fund limits on leverage and shorting and things like that. If it’s not a huge adjustment, to take my hedge fund and stick it in the mutual fund space, why wouldn’t I do that?
We found that those were actually driving the performance. If you are a hedge fund manager with hedge fund experience and you know how to run a hedge fund, you’re going to run a hedged mutual fund pretty well, otherwise, disaster. Well, maybe not disaster. During that time, maybe not. But if you take that sample and push it forward, there’s other work looking at this space. They do find disaster, like a lot of these funds that are trying to use hedge fund strategies in the mutual fund space are just not great. They’re really expensive, their performance is not that impressive. And so, our paper really was very specific and said, “If you know how to be a hedge fund in a hedge fund space, you’ll probably figure it out in the mutual fund space. You just got to keep to some slightly tighter restrictions.” We actually talked to a couple guys. There’s this guy Dennis Bein, he’s at Analytic Investors, he may have moved by now, it was 100 years ago out there.
Tobias: In hedge fund world, that’s– everybody ages in dog years.
Nicole: I met Dennis at this conference, and we were talking about my paper and I was like, “Dude, why would you go into mutual fund space. That’s slumming,” or whatever. And he’s like, “Hey, mutual fund assets are much stickier than hedge fund assets. If we can raise, if we can increase our assets under management, sure, we don’t get carry on them, but it’s a nice steady annuity. It’s a nice stream of income. And if we can adapt our strategy to fit in that space, then why wouldn’t we do it?” It made sense to me.
There’s another guy, Leuthold, I can’t probably pronounce his name, he had some stuff. I talked to these guys and they were first of all super excited that an academic cared about their stuff, but it’s fun to talk to them. And they said, yeah, it’s asset gathering. Sure, if I was running some crazy macro fund that relied on like 100 times leverage or taking big bets, it couldn’t. It doesn’t fit in the space, but the long-short equity and equity market neutral, those work okay. So, that was a fun paper. And I think it did have some influence, I think. I remember there was some people that were running assets in that space. So, this is kind of a cool result.
Tobias: Yeah, that’s absolutely fascinating. Thanks so much for your time today, Nicole. If folks want to get in contact with you or follow along with your research or to see what you’re doing, what’s the best way of doing that?
Nicole: Probably the best way to initially find me is on Twitter. So, my handle is @nikir1. So, at N-I-K-I-R-1. My name is Nicole Boyson on Twitter, I might be the only one, so not too hard to find. I look like this. And there’s a link there to my research as well. And people can always get in touch with me at Northeastern. My email’s public on their website. So easy to find and always happy to talk about my work.
Tobias: I will put all of that in the show notes. Professor Nicole Boyson, thank you very much for your time.
Nicole: Thank you so much. It was a great pleasure.[outro]
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