The Effect of Passive Investors on Activism

Todd Gormley is Assistant Professor of Finance at the University of Pennsylvania. This post is based on an article authored by Professor Gormley; Ian Appel, Assistant Professor of Finance at Boston College; and Donald Keim, Professor of Finance at the University of Pennsylvania. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here), and The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here).

The willingness of investors to engage in activism has grown rapidly in recent years. About 400 U.S. activist campaigns are launched per year, and as noted by The Economist, the current “scale of their insurrection in America is unprecedented… one in seven [companies in the S&P 500 index] has been on the receiving end of an activist attack” over the past five years. [1] The goals of activists have also become more ambitious and the success rate of activist campaigns has improved. Activists increasingly wage proxy fights to obtain board representation, and more than 70% of these campaigns were successful in 2014. [2] The determinants of this shift in activist tactics and success rates, however, are not well understood. For example, why do activists seem more willing in recent years to engage in hostile and costly tactics, like initiating a proxy fight? And, what factors affect their likelihood of success?

One potential contributor to the rise of activism is the growing presence of large, passive investors. Passive and index mutual funds have quadrupled their ownership share of the U.S. stock market over the last 15 years and now account for more than a third of all mutual fund assets. Passive institutions (and their increasingly large ownership stakes) might facilitate activism by either decreasing costs of intervention (e.g., by lowering coordination costs during a proxy solicitation process) or increasing the expected payoff of intervention (e.g., by lending creditability to a campaign and increasing activists’ likelihood of success.) In our paper, Standing on the Shoulders of Giants: The Effect of Passive Investors on Activism, which was recently made publicly available on SSRN, we examine whether the increased presence of passive institutional investors influences the types of campaigns undertaken by activists, the tactics they employ, and their eventual outcomes.

To identify the effect of passive investors on the strategic choices of activists, we exploit variation in stock ownership by passive and index mutual funds that occurs around the cutoff point used to construct two widely-used market benchmarks, the Russell 1000 and Russell 2000 indexes. The Russell 1000 comprises the largest 1,000 U.S. stocks, in terms of market capitalization, and the Russell 2000 comprises the next largest 2,000 stocks. Because portfolio weights assigned to each stock within these indexes are value-weighted, a stock’s index assignment has a significant impact on the extent of passive ownership—we find a sharp difference in ownership by passive mutual funds (40% on average during our sample period) for stocks at the top of the Russell 2000 relative to stocks at the bottom of the Russell 1000 even though these stocks are otherwise similar in terms of their overall market capitalization. There is no corresponding difference in ownership by actively managed mutual funds between stocks at the bottom of the Russell 1000 and the top of the Russell 2000.

We find that passive mutual fund ownership is associated with significant differences in the goals and tactics of activist campaigns from 2008-2014. We find activists are more likely to pursue changes to corporate control or influence (e.g., via board representation) and to forego more incremental changes to corporate policies (e.g., increased payouts) when a larger share of the target company’s stock is held by passively managed mutual funds. Regarding the tactics of activist campaigns, we find higher passive ownership is associated with increased use of hostile, expensive tactics (e.g., proxy fights) rather than relying on shareholder proposal or exempt solicitation that are “easier, less costly and demand a lower level of commitment from dissidents” (Wilcox 2005). Combined, our results suggest that the presence of passive institutions and their concentrated ownership stakes alter the strategic choices of activists and increase their willingness to engage in more costly forms of activism.

Passive mutual fund ownership is also associated with an increase in the successes of activists. While we do not find evidence that passive ownership is associated with differences in the rate at which activists win proxy fights that come to a vote, we document a sizeable increase in the likelihood of a settlement with managers. We also find evidence that when passive ownership is higher activists are more likely to successfully influence outcomes related to corporate control such as removing takeover defenses, facilitating the sale of the targeted firm to a third party, and engaging in a hostile offer.

Overall, our findings suggest that the rise in activism and the growth of passive investors, two recent and fundamental shifts in ownership, are interconnected. In particular, our evidence indicates that that an increased presence of passive investors affects the choices of activists, an entirely separate class of institutional investors that are widely thought to play an important role in governance. Our findings also shed light on the determinants of activists’ strategic choices. While the effects of activism have been widely studied, relatively little is understood about how such investors choose their tactics and what factors contribute to their success. We contribute to this literature by showing that passive ownership has a significant impact on the tactics deployed by activists and ultimately the outcome of these campaigns.

The full paper is available for download here.


[1] See “Capitalism’s unlikely heroes: why activist investors are good for the public company,” The Economist, February 7, 2015.
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[2] For example, in an article titled, “Activist Investors Ramp Up, and Boardroom Rifts Ensue,” The Wall Street Journal reports that the number of companies targeted by an activist seeking board representation has more than doubled in the last five years. And in a separate article, “CEOs Test: Contending With Activist Investors,” The Wall Street Journal reports that activists seeking a board seat obtained at least a partial victory in 72% of such campaigns in 2014, up from a success rate of 57% in 2008.
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