Institutional investors, such as hedge funds, are increasingly active in terms of their attempt to influence the direction of the firms they invest in.  While in a recent article, I highlighted how this interest can successfully influence the strategy of a firm, recent research from INSEAD highlights how this can have consequences.

While my original article illustrated the ability of investors to prompt firms to take a more positive stance on areas such as climate change or diversity, the INSEAD paper highlights how they can also force a more short-term approach in order to secure financial returns.

Lasting impact

While their focus may be somewhat short-term, however, their impact tends to be more long-lasting, with this often because of the loss of human capital that results from hedge fund interference.  The researchers found that firms that were the target of hedge fund activism were more likely to lose key employees, and this in turn made them more likely to suffer poorer financial performance in subsequent years.

The authors argue that this loss of talent is largely because of the uncertainty caused by the hedge funds activity.  For instance, they may worry about the interference into their work from the activists, especially as the power structure in many organizations may limit their ability to fight back.

What’s more, for the most talented employees, there will often be plenty of alternative opportunities available to them and so moving on will be that bit easier than for less talented peers.

Talent loss

The hypothesis was tested using data collected on American companies between 2004 and 2015.  The researchers used the cancellation of employee stock options as a proxy for voluntary departures.  This approach also allows the researchers to focus in on key employees, as it’s usually the most valuable people that get awarded stock options.

The data revealed that those firms targeted by activist hedge funds saw a 24% rise in the departure of key employees.  What’s more, these firms also suffered commercially, with fewer performance boosts achieved by any of the changes demanded by the investors.

Interestingly, firms targeted by more militant hedge funds didn’t appear to have higher rates of attrition than those targeted by less militant investors.  What did appear to make a difference, however, was the availability, or lack thereof, of non-compete clauses that prevent employees from moving to rival firms.

This was especially important, as the data found that the productivity of employees working in R&D actually rose in their new role, suggesting that they were actually going on to better things rather than being let go for poor performance.

As such, if activist investors actually want to make a lasting impression on their firm, and indeed to secure good financial returns as well as drive meaningful change in how the company operates, then they should devote extra effort and energy to ensure that key employees stay around.

For firms themselves, the key takeaway is that if you can offer employees plenty of reasons to stick around, whether that’s supporting labor organization in the workplace, offering profit-sharing schemes, providing good retirement plans, and, of course, generally being an excellent place to work, then that can help to buffer any negative fallout from being targeted by activist hedge funds.