Activist Hedge Funds: War for the Hearts & Minds of Accountants

By Christopher Faille

There may be a war underway for the hearts and minds of corporate accountants. According to a recent paper by Curtis Hall and Mark A. Trombley, both of the University of Arizona, Eller College of Management, hedge funds with one particular strategy, the shareholder activists, provide “at least some incremental monitoring of accounting and reporting” within the firms they target. Further, though they don’t take a firm position on this, the authors hint that stock analysts are pulling those same firms in the other direction.

The Hall and Trombley paper, “Accounting Responses to Hedge-Fund Activism,” studies discretionary accruals, that is, artificial income-increasing or income-decreasing accrual decisions, designed to manage earnings. If an accrual decision increases this quarter’s earnings for the sake of meeting a previously established target, it will necessarily do so at the expense of future quarters. Likewise, if an accrual decision sacrifices some share of this quarter’s earnings, it does so in order to give an artificial boost to quarters yet to come.

Either way, the practice threatens the significance and reliability of financial statements. It would be a cheering development to learn that activist hedge funds, in the pursuit of their own alpha, end up discouraging such bookkeeping trickery. Hall and Trombley’s work supports precisely that inference. For what they document is that once hedge funds acquire large block positions, the “activism targets generally reduce discretionary accruals.”


Hedge funds might be considered a subset of “institutional investors,” and other institutions too, in principle, can follow an activist strategy. But Hall and Trombley find that activism by other types of institutional investors doesn’t have the same monitoring effect.  Mutual and pension funds have to work within diversification rules and policies that “prevent many such shareholders from accumulating economically significant ownership positions,” and the managers have limited personal interest in expending the energy necessary to have this sort of impact.

The authors studied a database of 484 corporations chosen as a subset of the firms covered by Standard & Poor’s Compustat, their source for the accrual accounting data. The firms that made their list of 484 had all been the object of a 13D filing by a hedge fund between 1995 and 2007.

As that table indicates, the mean firm within this data base is followed by more than five analysts. The median firm is followed by three. When Hall and Trombley divided their sample into two subsets – high and low analyst coverage subsets – they found, somewhat to their surprise, that the results of the breakdown were “consistent with the idea that analysts create additional pressure for earnings management (e.g. by issuing earnings forecasts that serve as earnings management targets.)” It seems plausible that companies with high analyst coverage, and thus a lot of such pressure, would have more discretionary accrual accounting underway before the activists show up, creating larger room for a decrease in such discretionary decisions in the wake of activism than can be seen amongst companies that had had little or no analyst coverage.  The raw numbers support that plausible hypothesis.

Yet, as noted, the authors come to no definitive judgment on that point. Some of their statistical testing makes the significance of the amount of analyst coverage seem to disappear.


But how exactly, do hedge funds lessen discretionary accrual decisions? As the authors say, specific accounting changes are seldom an explicit objective of activists. Though those who have just bought a large block of stock might demand board membership, improvements in firm performance, openness to a merger or acquisition, seldom do the 13D filings specifically reference deferred accruals.  The authors suggest an indirect effect: the activists may change the system of corporate governance (which is often an explicit goal) and this in turn may “reduce the ability of executives to manage earnings via discretionary accruals.”

Indeed, ten years ago, a study by Sonda Marrakchi Chtourou and associates indicated that “effective boards and audit committees constrain earnings management activities,” and that this “gray area between legitimacy and outright fraud” tends to shrink as boards become larger and the role of outsiders on the board increases.

Much more recently (indeed, last year) C. S. Agnes Cheng et al., in a paper on “Hedge Fund Intervention and Accounting Conservatism,” though they used a different statistical approach, likewise found that firms targeted by activist hedge funds exhibit an increase in conservatism that becomes more pronounced as the hedge funds increase their financial stake and the hostility of their tactics.

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