Hedge fund activism often initially bolsters the target company but new research has found that it weakens the competition, which may hurt innovation and the larger economy.
"It is survival of the fittest," said Praveen Kumar, finance professor at the University of Houston and an author of a study published in the Journal of Financial Economics. "Yes, you do want the weakest competitors weeded out. But as they exit, there is less competition and hence, less incentive to innovate for the surviving firms. Over time, consumers and economic growth may be hurt."
The long-term pain is two-fold: Average investors are more likely to hold stock in competitors of firms targeted by hedge funds. And the effort to cut costs may ultimately reduce investment in innovation at both sets of companies.
Most research involving hedge fund investment has focused on its impact on target firms. Kumar's work, conducted with Hadiye Aslan, assistant professor of finance at Georgia State University, instead looks at how rival firms are affected.
Hedge funds began to exert greater influence in the late 1990s, as people with large amounts of money to invest took advantage of a mechanism unfettered by some of the restrictions on mutual funds, pension funds and other institutional investors, who control about 80 percent of publicly traded stock.
Earlier research suggests hedge fund investors -- who generally invest enough money to gain control and exert influence on all aspects of the targeted business -- often improve the bottom line at their target companies, the authors write. "It appears to induce real effects through some combination of improvements in productive efficiency, lower agency costs, and improved business strategy," they write.
But competing firms don't fare as well, a finding that the researchers say has implications for investors in those companies, as well as for the nation's future competitiveness.
"There's no denying they make the companies more efficient," Kumar said, partly through trimming payroll, extracting discounts from suppliers and other cost-cutting measures but also by sharpening the target's business focus and investment discipline.
Competitors then generally cut their own prices and costs in order to maintain market share. Those cuts may affect investment in research and development and ultimately, the innovation required to maintain market share, he said.
While proponents of hedge fund activism argue that the entire economy ultimately benefits as the emphasis on efficiency and best management practices spreads throughout an industry, Kumar said he and Aslan found that is generally not true.
"The benefits aren't percolating to the competition on average," he said. "Their productivity and investment generally goes down." However, the authors did find that the threat of activist investor intervention remains a potent incentive for firms to make proactive investments; such firms are generally able to compete effectively with target firms.
But while the exit of weaker firms is a necessary part of a dynamically efficient economy, industry consolidation resulting from hedge fund activism may lead to less competition and ultimately, less innovation, he said.
The research involved 1,332 firms targeted by hedge funds between 1996 and 2008, focusing on those firms' competitors. None of the companies are identified in the paper. The most common targets are involved in finance, real estate, insurance, manufacturing, high tech and retail, Kumar said.
"(Hedge fund activism) has significant product market spillover effects on the industry rivals of target firms," the researchers wrote. "These effects are observed on the product market performance of rivals as measured by their price-cost markups and market shares and on their operational returns, productivity, and capital investment."
Although the research only extended through 2008, Kumar said he has no doubt that the findings remain true.
"I don't think hedge fund activism is slowing down at all," he said. "They have become more ambitious and aggressive in the last 10 years."
And that has implications for the economy as a whole, he said, noting that most investors don't have access to hedge funds, which require large amounts of capital. Most people instead invest through mutual funds, pension funds and other institutional investors.
While hedge fund investors tend to reap financial awards, the average investor is likely to be hurt.
"Most of the stock-holding public holds the competitor companies, which are vulnerable to the spillover effects of hedge fund activism," Kumar said. This may force the relatively passive managers of mutual and pension funds to become more aggressive in intervening in firms they own, reducing the advantages currently accruing to hedge funds.