ACTIVIST INVESTING  |  STREETWISE

Activist Funds Excel at Collecting Fees, Not Fixing Companies

By Jack Hough     Updated Feb. 4, 2023 10:56 am ET / Original Feb. 3, 2023 1:14 pm ET

I’m thinking of launching an activist hedge fund that buys big stakes in underperforming companies and demands their board seats. Not the positions—the actual seats. “Everyone stands until the share price doubles,” I’d tell directors in a vigorously leaked letter. “Sincerely, Bottom Up Investment.” I’d charge the standard 2% a year plus 20% of profits, and promise never to offer advice.

The statistical evidence suggests that Bottom Up could perform as well as the greats, who, it turns out, aren’t that good. Activists in general don’t seem to add much value to the companies they target beyond an initial pop in the stock price. They also tend to earn uninspiring returns for their own investors, after taking hefty fees.

What’s an activist? A corporate raider without the commitment. If you’ve ever been to a Peewee basketball game and heard parents coaching from the stands, picture one of them walking to the bench, sitting down, grabbing the clipboard, and telling Silas to stop chucking from the outside, Jasper to hit the boards, and Henry to go turn his shorts right-side-out. The actual coach would probably welcome that help as much as CEOs appreciate raiders and activists, the two main types of high-finance buttinskys.

A raider buys, say, 10% of shares outstanding and then makes a tender offer to shareholders, usually at a premium price, to secure voting control. With control, the raider can replace the board and hire, fire, sell, merge, borrow, and change strategies at will. An activist, on the other hand, typically buys 5% to 10% of shares and then tries for board seats or operational changes without buying control. Step 1: Ask nicely. Step 2: Put out a slide deck calling management bumblers or self-servers, only with charts. Step 3: Try to convince other shareholders to vote the board or managers out, called a proxy fight.

In popular perception, raiders are short-termist villains, like Gordon Gekko in Wall Street, while activists are defenders of shareholders against corporate squander and greed. Zohar Goshen, who teaches corporate governance and securities regulation at Columbia Law School, challenges this view. “Activists are no better than raiders; if anything, they are likely worse,” he wrote in a paper published in November in the Yale Law Journal.

It comes down to what Goshen calls “mistargeting.” Raiders often pay 30% to 50% of a company’s preraid stock market value just in their offered price premium to win control. So they had better pick targets carefully. But activist campaigns, not counting the initial outlay for shares, are relatively cheap. One study put the average cost of one ending in a proxy fight at $11 million. That makes it tempting to target companies willy-nilly, raising the chances of misjudging.

Sometimes activists mistake patient companies for poorly run ones. Carl Icahn pushed (ticker: NFLX) to sell itself in 2012 and failed. The stock is up more than 3,500% since then. They can also identify struggling companies and make things worse. Bill Ackman picked a turnaround CEO for J.C. Penney who ended discounting, sending revenue off a cliff. Some make money on companies that ignore their advice, like Dan Loeb, who couldn’t get Sony Group (SONY) to break up, and rode shares higher. And some demand that Olive Garden salt their pasta water. I’m not sure what that is an example of, but an activist fund called Starboard Value did it in 2014.

Put aside for the moment matters of incentives, mistargeting, and optimal tortellini salinity. Do activists make money? There are two ways to answer that question: not really and no. The first pertains to long-term excess returns for target companies. They “insignificantly differ from zero,” according to a 2019 University of Washington study that weighted companies by market value, like index investors do.

The second answer has to do with returns for investors in activist funds. There’s a Bloomberg Activist Hedge Fund index that returned 132% over the nine years through the end of 2022, versus 145% for the SPDR S&P 500 exchange-traded fund (SPY). The Insightia Activist Index, owned by Diligent, which sells corporate governance analytics, has a longer run of data, and looks worse for activists. Last year, activists outperformed. Some of them trumpet past successes. But, as with active mutual fund managers, that isn’t necessarily a good predictor. Many companies need fixing. Activists just don’t seem better at it than the rest of us coaching from the stands.

So why do we pay so much attention to Trian’s current proxy fight with Walt Disney (DIS) or the four-way activist Hacky Sack game that is (CRM)? “We love these stories because humans love to watch conflict,” says J.B. Heaton, an investment lawyer and researcher who wrote a chapter on activism for The Oxford Handbook of Hedge Funds (2021). “But when you really push and look...their results are not good.” One exception, he says, is when activists can convince companies to sell off something big—because buyers tend to overpay. But he calls their governance and strategic initiatives “worthless.”

Why, then, are some activist investors so rich? “What really matters in the money-management industry is having a good story,” says Heaton. “If you have a good story, you can raise money. And if you can raise money...you make money off the fees.”

If I can’t get Bottom Up off the ground, I have another hedge fund idea. Investors are betting on a return to low rates, and Wall Street is suddenly brimming with hot garbage. GameStop (GME) is up 22% year to date; theater chain AMC Entertainment (AMC), 49%; Coinbase Global (COIN), 130%; Carvana (CVNA), 200%; Bitcoin, 42%; the ARK Innovation ETF (ARKK), 42%.

All I have to do is find ill-advised assets that haven’t run yet, load up, and wait—classic garbitrage. But my first idea, Bed Bath & Beyond (BBBY), just popped 30% this past week. And my second, Dogecoin, is already up 33% for the year. Looks like the blue chips of bad ideas are already spoken for. I’m currently screening for nonfungible holographic flatulence tokens, but if nothing turns up, I might have to dip down in quality.

Write to Jack Hough at jack.hough@barrons.com.