Exploiting Diversity: Activist Hedge Funds Target Companies with Diverse Boards
New research from CSP Collaborator Emilio Marti and colleagues finds that activist hedge funds are more likely to target companies with demographically diverse boards. What can socially-conscious asset owners and policymakers do to counter this?
Diverse boards have many advantages, and have been rightfully lauded as a critical step in increasing social equity and delivering impact in the “S” of ESG. Unfortunately, they also have a weakness that activist hedge funds have picked up on and begun to exploit. Existing research shows that under normal circumstances, boards with demographic diversity perform better in a number of ways: by drawing on different perspectives, demographically diverse boards tend to develop more innovative strategies, spot more promising opportunities, spend more time discussing strategic issues, and monitor management more effectively than their less diverse counterparts.
Still, bringing together different perspectives can also slow boards down and reduce group unity. In new research, Mark DesJardine (Dartmouth College), Wei Shi (University of Miami), and Emilio Marti (Erasmus University Rotterdam and Collaborator at CSP) find that activist hedge funds have started to use these “weaknesses” to their advantage in order to influence companies.
Activist hedge funds buy shares of companies to force the boards and management of companies to implement organizational changes, such as splitting up companies or changing their strategy. Through such changes, activist hedge funds hope to increase those companies’ share price. In 2022, 967 publicly traded companies were targeted by at least one activist hedge fund. These companies include global players such as HP, AT&T, Sony, SAP, and Hyundai. In Switzerland, over the last 10 years, activist hedge funds have targeted companies such as Transocean, Holcim, Nestlé, Clariant, and Credit Suisse.
Two factors — speed and board unity — are key for activist hedge funds when it comes to confronting companies, and these are both affected when boards are more diverse. First, activist hedge funds compete with companies in gaining support from other shareholders, so by slowing down boards, board demographic diversity gives activist hedge funds a head start in mobilizing other shareholders. Second, activist hedge funds benefit from alliances with some board members, so by hampering board unity, board demographic diversity increases the likelihood that activist hedge funds can win over some board members. Background interviews with senior managers at activist hedge funds, which the authors conducted, confirm that activist hedge funds are aware of these opportunities. One senior hedge fund manager laid it out simply: “if a board is made up of a bunch of diverse individuals that we think are going to find it harder to work together and will make decisions more slowly, then that’s going to tip things in our favor.”
The authors test their theory by studying hedge fund campaigns in the United States from 2009–2018. Specifically, they focus on companies with poor governance and poor performance because prior research has shown that activist hedge funds are particularly likely to target such companies. The authors find that board demographic diversity makes even more likely that a firm with governance or performance problems will be targeted by an activist hedge fund. For firms with governance problems, the likelihood of becoming a target increases from 1.7% when board demographic diversity is low (one standard deviation below the mean) to 5.0% when board demographic diversity is high (one standard deviation above the mean). For firms with performance problems, the likelihood of targeting more than triples, from 1.3% to 5.1%.
Implications and Action Opportunities
By targeting companies with demographically diverse boards, activist hedge funds could delay or even derail the mainstreaming of board demographic diversity. The new study therefore has important implications for asset owners and policy makers who see the benefits of board demographic diversity:
· Implications for Asset Owners: Many individuals and organizations are invested in activist hedge funds today through pension funds and endowments, which have been a major driver of growth for activist hedge funds since 2009. Asset owners also need to decide whether they will support activist hedge funds when it comes proxy fights with companies. The insights of the study suggest that asset owners who value board diversity may need to rethink where they invest their money and how they vote in proxy fights.
· Implications for Policymakers: If policymakers wish to encourage greater demographic diversity among boards and help society benefit from the advantages that arise from diverse boards, they should consider giving boards additional time to respond to activist hedge funds. In 2021, the Netherlands became one of the first countries to adopt such an approach when they allowed boards to initiate a “cooling off period” of up to 250 days in confrontations with activist shareholders. Such a period helps companies benefit from the advantages of demographically diverse boards without needing to fear confrontations with activist hedge funds.
By changing their relationship with activist hedge funds and supporting measures that balance the playing field, asset owners and policymakers can support board diversity and help contribute to a more just future.
Emilio Marti is an Assistant Professor at the Rotterdam School of Management at Erasmus University in the Netherlands and a Senior Collaborator at CSP.
Mark DesJardine is Associate Professor of Strategy & Management at the Tuck School of Business at Dartmouth College.
Wei Shi is Professor of Management at University of Miami’s Herbert Business School.
The paper discussed in this article, ‘The Corporate Opportunity Structure for Shareholder Activism: How Activist Hedge Funds Exploit Board Demographic Diversity’ is soon to be published in the journal Organization Science. It is available open access here.
