CEOs under attack from hedge fund activists likely to cut corners

New research from the University of Missouri finds firms targeted by investment activists are likely to boost earnings temporarily, withhold information

January 16th, 2018

COLUMBIA, Mo. — Hedge fund activists have garnered headlines for putting pressure on CEOs of publicly traded companies such as Pepsi, Samsung and General Motors. These activists often have change agendas and use their ownership position to influence a firm’s strategic direction. However, few studies have looked at how firm managers typically respond to such interventions. A new analysis from the University of Missouri reveals that CEOs under fire often follow a similar game plan that includes withholding information and seeking short-term earnings gains.

“These executives are fighting for their careers, their reputations and their companies,” said Inder Khurana, professor and Geraldine Trulaske Chair of Accountancy in the Trulaske College of Business. “It appears that they are willing to cut some corners and be less than forthcoming to try to gain as much leverage as possible during these hostile situations.”

Khurana and his co-authors reviewed publicly released earnings guidance and communications from 510 cases of hedge fund interventions. Those reports were benchmarked against similar companies not facing hostile interventions.

“In addition to withholding information, we found these executives are more likely to attempt to manipulate the bottom line by temporarily boosting sales and overproducing inventory to reduce the cost of goods sold,” he said. “Finally, they are more likely to cut discretionary expenses in areas such as marketing, research and development.”

As part of the study, Khurana also looked at whether hedge fund interventions impose negative career consequences for executives. The researchers found that transparency did not help an imperiled CEO.

“We found that firm managers who disclose more bad news after hedge funds intervene are more likely to be dismissed from their jobs,” he said. “In other words, it appears that withholding bad news can be an effective strategy for managers to maintain job security in the face of hedge fund attacks.”

Interestingly, Khurana did not find an increase in good news disclosures by business leaders under attack, which he theorizes is a strategy to keep expectations for future earnings measured.

“When an activist pursues a confrontational agenda, these CEOs tend to keep their cards close to their chests,” he said.

“The Effects of Hedge Fund Interventions on Strategic Firm Behavior” is written by Khurana, Yinghua Li of Arizona State University and Wei Wang of Temple University. It has been accepted by Management Science and will be printed in a forthcoming issue. A summary of the paper was recently published by the Harvard Law School Forum on Corporate Governance and Financial Regulation.