March 15, 2023 • By The UCI Paul Merage School of Business
Hedge fund activism has changed the relationship between investors and corporate leaders. The letters activists submit to corporate boards—and make public through filings with the SEC—often use harsh language to express complaints about how a company is run. A recent study finds that the influence such letters have may be tied to how confident they seem to other investors.
Margarethe Wiersema, the Dean's Professor in Strategic Management at the UCI Paul Merage School of Business, conducted a study of activist investor letters along with Matthias Brauer and Philipp Binder, both of the University of Mannheim, Germany. Their article, “Dear CEO and Board”: How Activist Investors’ Confidence in Tone Influences Campaign Success, appeared in the September issue of Organizational Science.
Their research, which is part of an ongoing series of studies focusing on hedge fund activism, reveals some surprising, and perhaps troubling, characteristics of the way activist letters give small shareholders an outsized voice in corporate governance.
Hedge fund activism is relatively new in the world of investing. As Wiersema explains, “Hedge fund activism came on the scene around the year 2000 and started to become a large phenomenon by 2010. It’s really something new. It never happened before.”
The practice appeared after the Securities and Exchange Commission (SEC) changed the rules governing shareholder engagement. The new regulations allow activists to communicate directly with other investors, without barriers. Since then, hedge fund activism has become a significant force in corporate governance, investing, and finance.
Why has it become so popular? Wiersema’s answer is simple: money. “These activists receive 20 percent of any gain in their investment,” she says. “Normally you have an institutional investor who manages your investment,” she says, “and they make between 1 and 2 percent of your total assets. But a hedge fund activists earns 20 percent of any movement in the price of the stock, so you can understand the motivation behind things.”
Wiersema began studying hedge fund activism about eight years ago when the practice’s impacts began to appear in the marketplace. “I was probably one of the first management scholars to pay attention to activist investors and begin to study them,” she says, “but from a different perspective. Rather than investigate the financial consequences, I was more interested in why and how they were able to have an influence on companies.”
What Wiersema wanted to understand was why activists, who typically only own five or six percent of the shares in the company, have the power to harass management and the board to do what they want. “That, for me, was the puzzle,” says Wiersema. “Where does their clout come from?”
To get answers, Wiersema and her fellow researchers started interviewing activist hedge fund managers and talking to CEOs and directors who had been targeted in campaigns, to get the behind-the-scenes story on what was happening and why. That led to a series of papers focused on answering the question: “What leads to a hedge fund activist’s success?”
Her most recent article, published in September of 2022, examines the factors that determine whether or not an activist campaign is successful when they target a company. “One of the things I examined in this most recent paper was the use of the letter to management and the board. This is quite often how many activist campaigns begin,” she says. “They’ll draw attention to what they perceive to be the problem by issuing a letter. When they do this, the letter has to be filed with the SEC, which is required by law. As soon as they do that, the letter becomes public.”
As Wiersema explains, these letters are not a vanity project. They’re part of the public record of what’s going on with the company. She and her team were interested in understanding if these letters play a significant role in the success of activist campaigns. “We know it’s certainly a PR tactic,” she says, “because once they file the letter it becomes public and everyone knows the activist has targeted the company.”
Specifically, Wiersema and her colleagues asked whether the substance of the letter had any bearing on the outcome of the campaign. “These letters are pretty nasty,” she says. “It’s like getting an F on your report card. When you get a letter there’s nothing pleasant about it. It’s letting the board and the CEO know all about their failures and so it’s essentially a three- or four-page complaint letter. Everyone at the executive level tarnished by what’s in these letters.”
If these letters are so negative, why does anyone take them seriously? “Normally when you’re attacking someone, you wouldn’t think you’d have much success,” she says. “We all know that if you want to get something done you sugarcoat things. You don’t tell them they’re doing a terrible job. We wanted to find out what is it about these letters that has influence.”
Wiersema and her colleagues used software to examine hundreds of letters to calculate the usage of words and phrases that display confidence. “We were able to study the tone of these letters and find the level of confidence it conveys,” says Wiersema.
“Confidence is an important factor when you’re trying to influence somebody, especially in the financial markets,” she says. “For example, there’s been a lot of research that has shown that the more confident your financial investor sounds when they’re making a recommendation, the more likely an investor will follow their advice. We also find in psychology research that confidence has a long history of influence. The more confident you are when you present yourself, the more faith people will have in what you say. In juries, for example, we know that people are more convinced by eyewitness testimony if the person appears confident and less persuaded if the person appears uncertain.”
By creating a measure of confidence based on the use of certain words, Wiersema and her team analyzed hundreds of activist letters. “We found that the confidence in the letters does indeed lead to higher rates of success. In other words, investors are reading these letters. They are evaluating whether what is being said in these letters is true or not based on whether they believe what the activist is saying. That’s what confidence gets at. Do they trust what is being said and do they believe their concerns are valid? Do they feel confident about the recommendations being made by the activist in the letter to improve profitability?”
When they first considered studying the efficacy of activist letters, Wiersema says she was skeptical. At first glance the letters didn’t seem very different from each other. “My co-author first had the idea of looking at the letters,” she says. “I’ve seen dozens of them, and I didn’t really believe that the nuances of the letter itself would lead to different outcomes. I thought the letter is important, but that it was largely a PR tactic. I didn’t really expect to see any differences in the impact the letters might have.”
As they began to look more closely, Wiersema started to change her mind. “Many activists have multiple campaigns. People like Carl Icahn and Nelson Peltz have issued many letters. That raised the question of whether some activists were using a formula to create letters, or are they tailored to the company they’re writing about.”
They found a surprising variety. “The confidence that they display varies not only by investor but by the company that they are targeting,” Wiersema says. “That means they’re not using a stock format.”
The confidence levels reflected in the letters may be higher thanks to activists relying on their expertise in the target company rather than using a cookie-cutter approach. “Confidence is a surrogate for competence,” Wiersema says. “We can’t assess anyone’s competence in the letter because we don’t really know. But confidence is something we can measure by their use of certain words and phrases. That confidence is then inferred to relate to competence.”
Confidence is Underused
Wiersema was surprised to find that even the most successful activists don’t seem to know how impactful their letters really are. “If they knew that confidence was tied to success, then I think they would do this every single time,” she says. “So, the fact that they don’t suggests that they aren’t aware of what is actually working.”
“This gets back to the initial question about why someone with only six percent of the shares is capable of influencing management,” she says. It’s not so much that their letters influence the leadership of the company. Instead, the letters are effective if they can gain the support of other investors, which creates pressure on CEOs and directors to respond.
Winds of Change
Wiersema is intrigued by how much activist letters have changed the game both for investors and for corporate leaders. “In the past, institutional managers have always sided with management,” she says. “Historically, investors have tended to support whatever management proposes. These activists have come along and upended all of that. The biggest implication is that these letters actually matter. No one has pointed this out before. Even the activists themselves don’t seem to realize the importance of these letters.”
Wiersema thinks the study has broader, potentially frightening implications. “It’s disturbing to me that the way a third party writes about management and the board can influence actions at the top level,” she says.
“We’ve just recently seen this in action when Nelson Peltz went after Disney to gain a seat on the board,” she says. “It went as far as the first quarterly earnings call where Robert Iger had returned as CEO and immediately conceded to Nelson. Not by giving him a board seat, but by announcing that they were going to make changes to increase profitability and reduce operating losses at the streaming unit by doing layoffs, which was what Nelson had wanted to see. What activists say, and the confidence in how they say it, has a strong influence.”
Wiersema has also noted how activism has impacted the recent wave of layoffs in the technology industry over the last few months. “The tech sector has been one of the most targeted by activists recently. That’s why so many technology companies have announced layoffs,” she says.
Whether or not these changes are good or bad depends largely on your perspective, but Wiersema sees the rise of investment activism as a guardrail of sorts. “I feel like these activists have become a disciplining force for management, especially when it comes to justifying their investments,” she says. “For example, they really went after Mark Zuckerberg with his Meta project to say that the kind of money he was investing in Meta wasn’t smart based on the limitations of the technology right now.”
It seems hedge fund activism is here to stay. But will the impact be positive or negative? Wiersema isn’t sure. “I can’t be the judge of that,” she says. “I do get a little concerned sometimes because a lot of the best ideas take a little more time to develop. By shifting the focus to profitability and market share in the short term, we may be sacrificing innovation in the longer term.”