It is not just managers that can have a short-term orientation—the forthcoming theoretical paper “Competition for Flow and Short-Termism in Activism,” by Mike Burkart and Amil Dasgupta, shows that activist funds too can focus on the short term. In the model, activists add value by preventing wastage by the manager. To signal their type to their own investors, they take a short-term action such as boosting leverage to make a high payout. However, in the long term, a debt overhang problem can arise, resulting in a positive NPV project being forgone in some states. A similar dilemma comes up with other actions that boost the firm in the short term at the expense of long-term performance, such as reducing R&D expenditure. Actions by activist funds therefore exacerbate the exposure of the firm to the business cycle, with interventions in good times leading to investor payouts, and subsequent economic downturns placing the firm under greater stress. This pattern has been observed recently with some private equity financed firms, and the model applies well to hedge funds as well. The paper highlights that while activist funds have a valuable role to play in corporate governance, they may introduce their own frictions into the process, by acting as short-term investors.
Spotlight by Uday Rajan
Photos courtesy of Mike Burkart and Amil Dasgupta