by Cydney Posner
It is widely recognized that one of the primary causes of the current stock buyback phenomenon has been pressure from hedge fund activists. But, as suggested in this NYT DealBook column, the activist playbook is certainly not limited to buybacks and dividends: “[a]s activist hedge funds take aim at companies left and right from their spreadsheet-laden war rooms in Manhattan’s glass towers, their expertise is financial engineering, not running companies. And so the activists love to argue for sales, split-ups, stock buybacks and other financial machinations. The idea is that a quick financial event is more likely to generate immediate returns than the harder and longer-term work of building value.”
Trend spotters have observed that one of the first victims of these “financial machinations” appears to be R&D spending. As reported in this post by Professor John Coffee, that observation finds support in a recent study. Looking at campaigns launched by activist hedge funds, the “study finds that even those targets that escape a takeover still are forced to curtail their R&D expenditures by more than half over the next four years.” Coffee speculates that companies actually “acquired as a result of an activist campaign probably experienced an even greater decline.” In contrast, the study showed that R&D expenditures for a matched control group rose modestly over the same period. “Presumably,” Coffee observes, “it is self-evident that if an economy cuts back drastically on its investment in ‘R&D,’ it will experience less innovation and technological advances in the future…. That should be a cause for concern.”
This trend that may soon play out in an upcoming proxy contest involving DuPont, one of the country’s oldest companies, as discussed in this DealBook column. In an activist attack against DuPont, Nelson Peltz, leader of the activist hedge fund Trian Fund, “has openly declared that his goal is to shut down DuPont’s central research labs and split the company into three parts — moves that would directly dilute scientific progress that DuPont has worked to develop.” According to the column,
“DuPont has used its central research labs to support all its businesses, providing the breakthroughs that have spurred their growth. In 2014 alone, $9 billion of DuPont revenue, or 32 percent, came from internal innovations. Without the steady stream of scientific breakthroughs coming from its central research labs, where will DuPont’s future revenue come from? The Peltz proposal is troubling because it mirrors a disturbing trend in which financiers are gutting American research labs that develop tomorrow’s innovations. In reality, they want to increase short-term earnings, see an uplift in the stock price and close out their positions. They are speculators, not investors. When a hotel chain increases its short-run profit by neglecting to make necessary repairs, customers eventually stop coming to stay in dilapidated rooms. Similarly, for science-driven companies like DuPont, research and development is at the heart of their growth. Today’s investments lead to tomorrow’s breakthroughs and profits. Cutting R.&D. investments that create innovative new products will leave these companies lagging global competition in years to come.”
Even more surprising is that this attack is aimed at a company that, by most hedge fund standards, has been very successful. In the six years that CEO Ellen Kullman has been in office, DuPont has already taken steps to narrow its focus by spinning off some businesses with a view toward concentrating on three high-tech businesses. During that period, the company has “provided a total return to shareholders of 266 percent with more than $13 billion in dividends and stock buybacks to its shareholders. Ms. Kullman’s results far exceed the Standard & Poor’s 500 index and Mr. Peltz’s own Trian Fund.” What is going on? Why target a successful company?
In his interesting post, Professor Coffee distinguishes between the type of defensive activism (opposing management initiatives) that originally characterized hedge fund conduct from the type of offensive conduct (i.e., where the hedge fund purchases shares “specifically to challenge management”) that has characterized hedge fund activism for past decade or so. Coffee attributes this development to the inability of hedge funds to consistently outperform the market using regular techniques, such as stock-picking, driving many of them to adopt approaches that, in effect, seek to engineer stock price increases:
“Relatively quickly, a consistent pattern emerged to characterize this new activism: on the filing of a Schedule 13D by an activist investor, the stock price of the target shows an immediate abnormal return of around 6 to 7%. Whether this short-run price improvement later dissipates has long been debated, but now there is newer data. The latest study, just released in March, shows that long-run returns to shareholders depend on the outcome of the activists’ engagement with the target. If the activists fail to achieve their desired outcome, the long-term return is modestly negative. If, however, the activists succeed, everything depends on what outcome they were seeking. The market largely ignores changes in corporate governance and “liquidity events” (such as special dividends or stock buybacks), but jumps with alacrity in response to takeovers and restructurings. This suggests that the real source of the gains to pro-active hedge funds is not superior corporate strategy, but increases in the expected takeover premium for the target. Apparently, the market perceives most corporate governance issues as important only as a signal of an impending takeover battle. Still, if nothing more materializes, the target’s stock price will stabilize or decline. Even if activists present themselves as superior business strategists or marketing gurus, their success comes largely from jump-starting a takeover or a bust-up. [footnotes omitted]”
Although the idea of “bust-ups” and other takeovers is not new, according to Coffee, some of the tactics are, particularly the development of “conscious parallelism” among a “wolf pack,” defined as “a loose association of hedge funds (and possibly some other activists) that carefully avoids acting as ‘group’ so that their collective ownership need not be disclosed on Schedule 13D when they collectively cross the 5% threshold.” As discussed in this post, members of the pack often use the 10-day window prior to disclosure to tip their plans, profiting from the use of material nonpublic information. As Coffee points out, their “profits are nearly riskless.” Coffee indicates that the market reaction to a 13D filing that announces formation of a wolf pack substantially exceeds that for 13D filings by other activists — a 14% abnormal gain as opposed to 6% — and attributes this reaction to a market perception of a higher likelihood of a takeover premium or a “bust-up” sale. He also cites two recent studies that show there is a more than 75% probability of success for wolf pack campaigns. Moreover, because they are not technically “groups,” wolf packs seem to be able to evade the types of “shareholder protection” measures, such as poison pills, that used to provide protection against these types of attacks.
What to do about this issue? Coffee believes that legislation and regulation appear unlikely, at least for now: “But the real question for the immediate future is whether mainstream institutional investors (such as pension funds) will ever resist the hedge funds’ siren song. The DuPont campaign is significant precisely for that reason.” It may well be that mainstream institutions are beginning to do exactly that. CalPERS and ISS have lined up on the opposite side of the table from hedge fund activists in some contests last year. And recently, the CEO of BlackRock sent a letter, as reported in this DealBook column, to 500 of the largest U.S. companies, advising them that they may have gone too far in trying to curry favor of investors by returning so much capital though dividends and stock buybacks to goose short-term stock prices: “these maneuvers, often done under pressure from activist investors, are harming the long-term creation of value and may be doing companies and their investors a disservice, despite the increases in stock prices that have often been the result. ‘The effects of the short-termist phenomenon are troubling both to those seeking to save for long-term goals such as retirement and for our broader economy,’ [the CEO] writes in the letter. He says that such moves were being done at the expense of investing in ‘innovation, skilled work forces or essential capital expenditures necessary to sustain long-term growth.’”
Taking the other side is Greg Satell in an article published in the March 31, 2015, Harvard Business Review, “Stock Buybacks Aren’t Hurting Innovation.” The article argues that businesses in the U.S. “already are spending heavily on research and development – data from the National Science Foundation (NSF) shows an uptick in US business investment in R&D.” Moreover, recently (up to 2012) investment in R&D has even been “outpacing longer term trends.” The author also questions “the assumption that investor preference for quick returns limits managers’ ability to invest in the future. In fact, private capital investment, an even larger ticket item than R&D, has also been increasing and is at historically high levels of GDP.” Even funds that are long-term holders, the author argues, believe that companies should not just sit on their cash; rather, they “believe that returning excess capital to investors is healthy, not just for share prices, but for the economy….So it appears that the current surge in share buybacks may be a reasonable course of action: faced with a superabundance of capital, firms are both increasing investments and returning the excess to shareholders so that it can be invested elsewhere.”