ESG investors be warned, look for these [counterintuitive] signs in your portfolio
By Hansen Mou, PhD
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Executive Summary
According to S&P Global Market Intelligence reports, today’s long-term hold ESG-conscious investors face weak financial showings of hedge fund activist campaigns (whereby hedge funds purchase minority shares of a target company to pursue changes to company leadership and objectives) with far lower success rates, yet the ESG environment has undoubtedly grown with more funds having an ESG focus.
Research published in the Strategic Management Journal suggests hedge fund activist campaigns from 2000-2016 resulted in any short-term financial gains being entirely erased in 5 years, along with a 25% decrease in company ESG had no campaign happened.
Long-hold ESG-conscious investors should thus avoid holding likely targets for hedge fund activists until they can reconcile their own social responsibility metrics with more recent data.
Implications: assessing the changing face of activist hedge funds
With activist hedge funds controlling more than $146 billion dollars worldwide according to the authors and present in a quarter of all S&P 500 companies according to a Reuters article by Herbst-Bayliss, ESG-focused investors should be on the lookout for activist hedge funds encroaching on their own investments. According to S&P Global, every industry except for materials, real estate, and utilities have faced increasing challenges from activist campaigns (“Investor Activism Campaigns FY 2022 Overview”, S&P Global Market Intelligence). Of these, the communications services sector saw the highest increase from 2018 to 2022 at 163%, while the financials, health care, and industrials sectors led in overall number of campaigns. These sectors presented greater opportunities for growth based on their underperforming S&P 500 Sector Indices compared to the overall S&P 500 Index.
An analysis from Goldman Sachs in April 2023 found that an equal-weighted holdings of activist targets would outperform the Russell 3000 by 3% over a 1-year period. However, these gains typically lack the foundational changes that promote sustained long-term growth (“Shareholder activism: What investors seek, which companies are targeted, and how stocks perform”, Goldman Sachs, April 2023). The same article found that targeted companies saw expected sale growth decline to match their sectors after only 9 months. Furthermore, while targeted companies saw on average 6% increase in share price, the median difference was a 13% decrease after 2 years relative to their sector.
A more recent report analyzing activism campaigns from 2018-2023 painted a starker picture: all activist investing campaigns except for the leading activist hedge funds underperformed the market within a single year (“Do Activists Beat the Market?”, Harvard Law School Forum on Corporate Governance). This trend suggests that the short-lived success of activism campaigns have shortened further, demonstrating that while these sorts of results can still satisfy the short-term investment horizons of activist hedge funds, long-term investors should be vigilant to avoid being caught in the crossfire.
But despite increased activity, activist campaigns in recent years have seen diminishing success, falling from 37% in 2018 to 18% in 2022 (“Investor Activism Campaigns FY 2022 Overview”, S&P Global Market Intelligence). In addition, S&P Global reported that since 2018, environmental and social-related activism has been the primary driver of the rising number of activist head fund campaigns, with the share increasing by 20 percentage points to 37% of activist campaigns (“Investor Activism Campaigns FY 2022 Overview”, S&P Global Market Intelligence). The influence of “old-school activists” has waned while some of the world’s largest asset managers like BlackRock Inc. and Norges Bank Investment Management have fueled ESG focused investment (“ESG Activist Investors to Get Even More Active in 2022”, Intelligize.com, January 2022).
Research: short-term activist hedge funds cost ESG in the long-term
The activity of activist hedge funds, which purchase minority shares to gain influence in companies with the objective of driving change in company leadership and objectives, has had little academic consensus on their impact. A 2020 paper published in the Strategic Management Journal examined 1,324 activist hedge fund campaigns from 2000 to 2016 and comparing their performance to companies spared from hedge fund activism. Campaigns were identified using a combination of Schedule 13D filings as well as data from Activist Insight. The results indicated an overall decline in long-term financial performance (tracked by Tobin’s Q) and corporate social performance (CSP, tracked by KLD Research & Analytics Index) when activist hedge funds get involved.
Regarding financial performance, the study found that hedge fund activism led to an average increase in market value of 7.66% and a slight increase in profitability by 1.5% in the first year for target companies, but these gains gave way to reversals after the 4th year. Meanwhile, operating cash flow was found to decrease from the outset by as much as 15% in the first year. These short-term performance gains typically result from changes in strategic investments through significant cost-cutting efforts. The study noted that this typically resulted in increased cash flow for the company’s operations while cutting investment activities, resulting in cash surpluses in the 1st year that give way to cash deficits after year 2.
The study also found that CSP for achieving ESG objectives stagnated after activist ownership, resulting in a 24.79% decrease after 5 years compared to projected CSP without activist ownership. Comparing these results to the increasing CSP of non-targeted companies, the study concluded that activist ownership typically put CSP initiatives on hold, resulting in stagnating social performance.
Recommendations: extra caution and due diligence for ESG-minded investors
The possibility always lurks that activist funds will secretly accumulate more than 5% share of ownership before making the required disclosure, and the SEC does not prevent private cooperation between activists and institutional investors. Thus, long-term ESG-focused investors should take steps to identify potential targets of activist campaigns in their holdings and recalibrate for potentially worse CSR returns.
Day One: To stay informed, ESG-focused investors should read the original article and apply the analyses on their own modern and relevant data, particularly using their own ESG metrics (the study’s use of KLD Research & Analytics Index is just one of many available). The definition of ESG quality lacks consensus and there are untold ways to calculate it (“ESG Ratings: A Compass without Direction”, Harvard Law School Forum on Corporate Governance, August 2022) and not all metrics may be impacted in the same way as the one used in the original paper.
After: In applying an analysis with modern data, investors should take into account that the original paper took all activist hedge funds as equal without distinguishing between those that were actually ESG-focused in strategy (which in 2000-2016 data maybe made sense, but does not today). The SEC under the Biden administration set new rules at the end of 2021 limiting companies’ ability to sidestep ESG proposals on corporate proxy statements (“Shareholder Proposals: Staff Legal Bulletin No. 14L (CF)”, SEC, November 2021). Thus what kinds of companies ESG activist funds are likely to target (vs non-ESG activist funds), and the different ESG-metric results, will continue to change in the near term.
Finally: Investors can profile, and avoid, key characteristics of potential targets in their holdings. Goldman Sachs reported that 89% of companies with one and 70% with multiple of the following performance characteristics are often associated with activist targeting: slow sales growth, low EV/sales valuation, weak net margins, and trailing 2-year underperformance for excess returns (“Shareholder activism: What investors seek, which companies are targeted, and how stocks perform” Goldman Sachs, April 2023). Furthermore, Diligent Institute studied the 3,098 company directors who engaged with activist investors in 2021 to find that only 19% had technology expertise, 11% had a compliance background, and 1.4% with sustainability acumen. Relevant industry experience was also noted to be lacking for these company directors, especially in the energy and utility sectors with only 11% and 14% having industry experience, respectively (“Activist Investors: Setting the Pace on ESG”, Diligent Institute, October 2021).
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Hansen Mou was awarded a PhD in Chemical Engineering from the Columbia University and is a member of the Columbia Graduate Consulting Club. The research applications proposed in this article are solely the views of the author and do not necessarily reflect the views of the original academic journal article authors nor any individual member of our Editorial Board. All content on this article is for informational purposes of a general nature only, and does not address any circumstances of any particular individual or entity. Do not construe any such information as investment or financial advice.