Corporate Control Activism

Doron Levit is Assistant Professor of Finance and Adrian Aycan Corum is a doctoral candidate at the Wharton School of 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 Pre-Disclosure Accumulations by Activist Investors: Evidence and Policy by Lucian Bebchuk, Alon Brav, Robert J. Jackson Jr., and Wei Jiang.

Corporate boards can resist takeovers, for example, by issuing poison pills. In some cases, they use it to negotiate a higher takeover premium and sell the firm, and in others, they protect their private benefits of control and block takeovers that would otherwise create shareholder value. In those cases, the resistance to takeovers can be overcome only if the incumbent directors are voted out in a contested election, i.e., a proxy fight. Empirically, however, bidders rarely launch a proxy fight. Most proxy fights are launched by activist hedge funds, which often demand from companies they invest in to sell all or part of their assets. In fact, the probability of a takeover is several times higher if an activist hedge fund is a shareholder of the target. This evidence suggests that activist investors play an important role in the market for corporate control. However, since bidders and activists can use similar techniques to challenge corporate boards (i.e., proxy fights), what is the relative advantage of activists in pressuring companies to sell? More generally, what are the implications of activist interventions on the M&A market? Do activists complement the effort of bidders to acquire companies, or do they compete away bidders’ rents? We study these questions in our paper Corporate Control Activism, which is available in SSRN.

We start by analyzing a simple dynamic bargaining model between the bidder and the target board. The unique feature of our model is that the identity of the target board is endogenized by an interim proxy fight stage. We argue that although both bidders and activists can launch a proxy fight (and face the same costs of doing so), only activists can effectively challenge the resistance of the incumbent directors and facilitate the takeover. Intuitively, once the bidder’s nominees are elected to the board, the bidder, who is the counter-party to the transaction, will be tempted to abuse his control of the target board, exploit its access to private information, divert resources, and low-ball the takeover premium. This is the commitment problem in takeovers. Without a commitment to act in their best interests, target shareholders are unlikely to elect the bidder’s nominees to the board. By contrast, the activist is on the sell-side and has incentives to negotiate the highest takeover premium possible. Therefore, shareholders are more likely to trust the activist and elect his nominees to the board, even without a commitment to act in their best interests. By credibly threatening to run a proxy fight, the activist can pressure the incumbent to sell the firm at a fair price. Making corporate assets available for sale is the added value of activist investors to the market for corporate control.

Generally, the severity of the bidder’s commitment problem depends on the legal and economic environment in which the bidder and the target operate (e.g., enforcement of fiduciary duties, competition for the target), as well as on actions that bidders can deliberately take in order to alleviate this problem (e.g., nominating truly independent directors, building reputation, a proxy fight combined with a tender offer). However, as we discuss in the paper in detail, these plausible “solutions” are either imperfect or costly. Since activist investors inherently suffer from a weaker commitment problem, they have relative advantage in pressuring incumbents to sell. Importantly, our argument does not require activists to be aligned with other target shareholders; activists may have their own private benefits or suffer from short-termism. Our key observation is in relative terms: Since a bidder is a counter party to the transaction and the activist is not, the conflict of interest between the bidder and target shareholders is stronger than the conflict shareholders might have with the activist. The fact that most proxy fights are launched by activists and not by bidders is consistent with shareholder activism being the market solution for the bidder’s commitment problem.

To study the implications of activist interventions on the M&A market, we augment the model with a prior stage where initially the activist builds a position, and then the bidder decides whether to perform due diligence and start takeover negotiations with the target. Our analysis highlights the complementarity between shareholder activism and takeovers: Activists profit from the possibility that companies in which they invest will become a takeover target, while bidders, who interpret the presence of an activist as a signal that the target is available for sale, are more likely start takeover negotiations when the target has an activist as a shareholder. This complementarity has several implications. First, a takeover is more likely when the target has an activist as a shareholder. Second, activist investors not only facilitate takeovers once the offer is on the table, but they can also increase the likelihood that a company becomes a takeover target even if ex-post their threat of running a proxy fight is not credible. Third, small regulatory changes, such as easing proxy access or modifying the rules that govern 13D filing, can have an amplified effect on the aggregate volume of M&A. Fourth, policies and regulations that exclusively undermine shareholder activism, such as the legalization of two-tier “anti-activism” poison pills, might adversely affect M&A even if “standard pills” that prevent takeovers are already prevalent.

Finally, it is debated whether activists invest because they believe the company is likely to become a takeover target (“selection effect”) or because they can facilitate its takeover (“treatment effect”). We show that the model’s comparative statics is sensitive to the existence of the treatment or the selection effect in equilibrium. This feature can be used to create identification strategies for empirical research. For example, if only the selection effect is in play, the volume of M&A decreases with the severity of the agency problems in target firms. However, when the treatment effect is in play, interestingly more resistance of incumbents to takeovers can result with a higher volume of M&A since there are more investment opportunities for activists. Therefore, the treatment effect can be identified by a positive relationship between the severity of agency problems in the cross section of target firms and the likelihood of a takeover.

The full paper is available for download here.

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