An unintended side effect of hedge fund activism? Loss of human capital


When hedge fund activism triggers an exodus of key employees, everyone loses.

You can think of activist hedge funds as agents of economic efficiency. Along with the rise of stakeholder capitalism, socially conscious activist investors have begun to promote more sustainable business practices (see the recent publication of Upstart Engine No. 1 victory in a proxy fight against Exxon). Over the past half century, however, interventionist hedge funds have mostly rallied behind Milton Friedman’s flag, forcing changes aimed at increasing shareholder value.

Because activist hedge funds hang on to an investment for a few years at most, they are often suspected of thinking short term. Yet their impact lasts long after they leave. Theoretically, the targeted companies should end up being leaner and meaner. The performance-enhancing effects of hedge fund activism are expected to be strong and lasting. However, recent research tells a more complex story.

In particular, the unintended loss of human capital resulting from hedge fund activism may help explain why some companies targeted by activist hedge funds do much better than others, according to my new article in Strategic Management Review (co-written by my colleague from INSEAD Guoli Chen and Wei Shi of the University of Miami). In general, companies that were the focus of hedge fund activism were much more likely to have valued employees than their untargeted peers – a difference directly related to their financial performance in subsequent years.

When uncertainty reigns

We assume that when talented and experienced employees learn that their company has been targeted by an activist hedge fund, they feel anxious and uncertain. Are their jobs secure? If they manage to keep their jobs, will their work still be bearable if they have to dance to the tune of a hedge fund? When humans feel threatened, it tends to trigger a “fight or flight” response. The power structure in most companies would prevent employees from mounting an effective counterattack. The second option – running away from the company and finding a job elsewhere – is much more accessible for the types of in-demand employees that interest us.

To test our hypothesis, we collected data from US public companies for the period 2004-2015. Not having access to information on voluntary departures of employees in targeted companies, we used a proxy verified by previous research: the cancellation of employee stock options. This power of attorney also helps us identify the loss of key employees of a company as opposed to its ranks, as it is the most valuable employees of a company who are usually rewarded with stock options.

Our analysis found that companies targeted by hedge funds experienced a 24% increase in employee stock option cancellations compared to non-target companies. Additionally, the targeted companies that had the highest cancellation rates also received less improvement in performance thanks to the shareholder-friendly changes introduced by the hedge fund. The attrition of human capital can therefore weaken the impact of hedge fund activism on company performance.

Exclude alternative explanations

When checking our results, we checked for variables such as company size, debt ratio, R&D activity and sales growth. Additionally, we looked at the potential role of layoffs, as we otherwise couldn’t be sure that stock option cancellations were the result of voluntary departures as opposed to the usual logging that accompanies activism. hedge funds. First, we excluded companies that carried out layoffs in one of our sub-sample analyzes without significant change in results. Second, given that the positive performance effect of hedge fund activism in the targeted firms is smaller if those firms experienced a higher loss of employees, it is likely that the employees who left were not. not dead wood but valuable and productive contributors to the organization.

In addition, we undertook four separate analyzes to exclude that layoffs are responsible for the effect we find. If the layoffs were to blame, businesses that were run inefficiently – that is, had a lot of deadwood to cut – should have lost more people, but in fact the opposite was the case. product. Companies with higher operational efficiency experienced more employee departures.

We also found that hedge funds known to be confrontational, and therefore more likely to advocate for layoffs, were not associated with higher attrition compared to less confrontational hedge funds. But states with lax application of non-competition agreements were associated with higher attrition – suggesting talent poaching more than firing.

Finally, the productivity of R&D employees in our sample of targeted companies – measured by the annual number of patents filed – increased in their next job, suggesting that they moved to greener pastures rather than being made redundant.

Compromised activism

Overall, our article shows that Hedge fund activism can be compromised on its own terms if talented employees decide not to stay. Most companies know that hedge fund activism can cost them dearly in the long run, but our study may serve as yet another caveat against becoming a target.

However, if a company finds itself in the crosshairs of a hedge fund, the performance implications can largely depend on the current state of its relationships with employees. Preliminary results indicate that companies that treat their employees well by offering retirement plans, incentive programs, a work environment that is tolerant of work organization, etc. are better able to retain key employees after an activist attack. Of course, certain caveats are in order. For example, the benefits and perks for employees may be prohibitive for some. Still, it’s generally a good idea for companies to do what they can to ensure good employee relations, given the relevant financial trade-offs, whether or not activist hedge funds come calling.

Philipp meyer doyle is associate professor of strategy at INSEAD.

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