Activist Battle Turns Academic

September 20, 2013   Stephen Taub

New York lawyers and a group of academics square off over whether activist investors should be loathed or loved.

It’s no secret that activist hedge funds have been pretty busy of late. The perennial question, of course, is whether their campaigns boost shareholder value.

As you would expect, it all depends upon who is judging. In recent weeks two passionate partisans on both sides of the issue have been waging a war of analysis: Harvard Law School professor Lucian A. Bebchuk and the takeover defense crowd at New York law firm Wachtell, Lipton, Rosen & Katz, led by Martin Lipton, widely credited as the inventor of the poison pill back in the 1980s.

Bebchuk threw the first punch in early August when he wrote an op-ed in the Wall Street Journal touting his latest empirical study, "The Long-Term Effects of Hedge Fund Activism," co-authored with Alon Brav, professor of finance at Duke University’s Fuqua School of Business, and Wei Jiang, professor of finance at Columbia University Graduate School of Business.

Their study disputes the assertion that hedge fund activism is detrimental to the long-term interests of companies and shareholders. The professors analyzed about 2,000 hedge fund interventions from 1994 through 2007 and tracked companies for five years following an activist’s arrival.

Their conclusions: In the five years following the month of the initial involvement, the target company’s operating performance compared with its peers improves consistently. "On average, the companies targeted by activists close two-thirds of their gap with peers in terms of return-on-assets and two-fifths of this gap in terms of 'Tobin’s Q,’ a standard measure of how effectively companies turn book value into shareholder wealth," Bebchuk wrote in the Wall Street Journal. The study’s authors also debunked the notion that the stock-price spike when hedge funds initially take a stake in a company is reversed over the long haul, asserting that shareholders did not suffer in the subsequent five-year period.

The article — and the study it was based upon — did not sit well with the folks at Wachtell, Lipton. On August 26 the law firm fired off a client memo disputing the study’s methodology and its conclusions. For starters, the firm questioned the validity of using Tobin’s Q for a variety of reasons. And the firm criticized Bebchuk and his co-authors for highlighting the average Q ratio, rather than the median, which it claimed would be more appropriate.

"Indeed, the article . . . does not reference . . . that the median Q ratio for each of the first four years following the attack year is lower than the median Q ratio in the year of the activist attack," the law firm wrote, adding that only in the fifth year does the median Q ratio exceed the Q ratio in the "attack" year.

The firm also criticized the article for failing to disclose the average holding period of the activists in the study, asserting, "it is undoubtedly less than five years." Wachtell says activists should not be credited for improvements that finally show up in the fifth year after the "attack."

The law firm also questioned whether Tobin’s Q is even a valid measure of company performance. It pointed to a 2012 paper by Washington University Olin School of Business professor Philip H. Dybvig that found that Tobin’s Q is inflated by underinvestment. So it is not fair to point to a high Q as evidence of better company performance, the law firm argued.

"Companies that forego [sic] profitable investment opportunities — including as a result of pressure from activists to return capital to investors or defer investments in R&D and CapEx — can actually have higher Q ratios while reducing shareholder value that would have been generated by those investments," Wachtell stated in its memo. It also raised several reasons one should not use book value as a proxy for replacement value.

Wachtell also criticized Professor Bebchuk for relying heavily on a company’s return on assets, since that metric suffers from the same shortcomings as Tobin’s Q. In addition, the law firm argued that Professor Bebchuk did not address what it deems to be the crux of the debate: whether activists can impair long-term value creation.

"These defects, among others, are sufficient in and of themselves to raise serious doubts about the conclusions that Professor Bebchuk draws from his empiricism," Wachtell stated.

Ultimately, Wachtell repeated the decades-long claim that the short-term interests of activists such as hedge funds destroy companies’ ability to invest for the long-term.

Of course, Bebchuk and his co-authors took issue with Wachtell, Lipton’s memo, so they dashed off a memo of their own earlier this week in rebuttal. In it, they emphasized that Wachtell did not argue that the professors failed to conduct their study in the best possible way currently available or recommend that they or others conduct a different empirical analysis.

"Rather, faced with empirical findings that do not support its myopic activists claim, Wachtell seeks to avoid reliance on our or any subsequent empirical work on the subject and to base policymaking instead on the insights obtained from 'anecdotal evidence and deep real-world experience,’ " they add.

Addressing Wachtell’s specific criticisms, the professors argued that debating whether to use mean or median is not the big issue. Rather, they said, another part of their study shows the results are similar using both means and medians — that industry-adjusted operating performance, measured by either Tobin’s Q or ROA, is higher in each of the five years following the intervention year than during the intervention year. The professors also emphasized that they used Tobin’s Q and ROA because their use as operating performance metrics is standard among financial economists working on corporate governance issues. Bebchuk and his co-authors said there are reasons to believe there is some connection between improvements in operating performance of the target companies and activist interventions.

"We would welcome it if Wachtell (or some other resource-rich business organizations that share its views) were to contribute to the policy debate by conducting or commissioning an empirical study that would improve upon ours in some methodological or other way," the professors added. "In the meantime, however, Wachtell should not disregard the existing empirical evidence and should not dismiss the value of any empirical work on the subject. In our opinion, Wachtell should engage with the evidence, not try to run away from it."

You can bet this is not the last salvo in this debate.

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