Activist hedge funds have become capital market and financial media darlings. The Economist famously called them“capitalism’s unlikely heroes” in a cover story, and the FT published an article saying we “should welcome” them.

But they are utterly reviled by CEOs. And at best, their performance is ambiguous.

The most comprehensive study of activist hedge fund performance that I have read is by Yvan Allaire at the Institute for Governance of Private and Public Organizations in Montreal, which studies hedge fund campaigns against U.S. companies for an eight-year period (2005–2013).

Total shareholder return is what the activist hedge funds claim to enhance. But for the universe of U.S. activist hedge fund investments Allaire studied, the mean compound annual TSR for the activists was 12.4% while for the S&P500 it was 13.5% and for a random sample of firms of similar size in like industries, it was 13.9%. That is to say, if you decided to invest money in a random sample of activist hedge funds, you would have earned 12.4% before paying the hedge fund 2% per year plus 20% of that 12.4% upside. If instead you would have invested in a Vanguard S&P500 index fund, you would have kept all but a tiny fraction of 13.5%.

Since the returns that they produce underwhelm, why do activist hedge funds exist? Why do investors keep giving them money? It is an important question because the Allaire data shows the truly sad and unfortunate outcomes for the companies after the hedge funds ride off into the sunset, after a median holding period of only 423 unpleasant days. Over this span, employee headcount gets reduced by an average of 12%, while R&D gets cut by more than half, and returns don’t change.

The reason investors keep giving their money to these hedge funds is simple. There is gold for activist hedge funds if they can accomplish one thing. If they can get their target sold, the compound annual TSR jumps from a lackluster 12.4% to a stupendous 94.3%.  That is why they so frequently agitate for the sale of their victim.

But why is this such a lucrative avenue? It is because of the control premium. When a S&P500-sized company gets sold, the average premium over the prevailing stock price that is paid for the right to take over that company is in excess of 30%. This is ironic, of course, because studies show the majority of acquisitions don’t earn the cost of capital for the buyer. It is a case of the triumph of hope over reality – which is not unusual. It is not dissimilar to what happens in the National Football League where the trade price for a future draft pick is typically higher than the trade price for an accomplished successful player. That is because the acquiring team dreams that the player it will pick in the draft will be more awesome than that player is likely to turn out to be. But hope springs eternal!

The activist hedge funds have their eyes focused laser-like on the control premium — which for the S&P 500, which has a market capitalization of $23 trillion, is conservatively a $7 trillion pie assuming a 30% control premium. To get a piece of that scrumptious pie, all they need to do is pressure their victim to put itself up for sale and they will have “created shareholder value.” Of course, on average, they will have destroyed shareholder value for the acquiring firm, but they couldn’t care less. They are long gone by that time; off to the next victim.

And they have lots of friends to help them access the control premium pie. Investment bankers want to help them do the deal whether it is a good deal or not and that $7 trillion pie for hedge funds translates into a multibillion dollar annual slice for investment bankers. And for the M&A lawyers that need to opine on the deal. And the accounting firms that need to audit the deal. And for the proxy voting firms that collect the votes for and against the deal. And the consultants who get hired to do post-merger integration. And the financial press that gets to write stories about an exciting deal.

It is an entire ecosystem that sees the $7 trillion pie and wants a piece of it. It doesn’t matter a whit whether a hedge-fund inspired change of control is a good thing for customers, employees or the combined shareholders involved (selling plus acquiring). It is too lucrative a pie to pass up.

What will stop this lunacy? When shareholders come to their senses and realize that when an activist hedge fund has pressured a company intensively enough to put it up for sale, they are simply feeding the hedge fund beast and the vast majority of the time it will be at their own expense. When activist hedge funds’ access to the $7 trillion pie is shut off, they will have to rely on their ability to actually make their victims perform better. And their track record on that front is mediocre at best.

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