The Effects of Hedge Fund Interventions on Strategic Firm Behavior

Inder Khurana is Professor of Accounting at University of Missouri-Coumbia Trulaske College of Business. This post is based on a recent article, forthcoming in Management Science, authored by Professor Khurana; Yinghua Li, Associate Professor of Accounting at Arizona State University W.P. Carey School of Accountancy; and Wei Wang, Assistant Professor of Accounting at Temple University Fox School of Business. 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); The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here); and Who Bleeds When the Wolves Bite? A Flesh-and-Blood Perspective on Hedge Fund Activism and Our Strange Corporate Governance System by Leo E. Strine, Jr. (discussed on the Forum here).

In the paper, The Effects of Hedge Fund Interventions on Strategic Firm Behavior, forthcoming in Management Science, we examine the impact of hedge fund interventions on target firms’ voluntary disclosure and earnings management strategies.

Hedge fund activism has emerged as an important governance mechanism that brings about significant changes in the operations and governance of target firms. With large financial resources and strong incentives to generate returns, hedge fund activists pursue a broad range of objectives and, in many cases, deploy confrontational tactics against the target firm management to achieve their objectives. Mounting evidence and anecdotes suggest hedge fund interventions can induce intense conflicts over corporates strategies, and often heated battles for corporate control, between hedge fund activists and the target firm management. Despite growing interest in hedge fund activism, there is limited evidence on how the target’s management responds to hedge fund activism that can potentially jeopardize the power and career prospects of executives. In this paper, we address this issue by investigating whether and how target firm managers use voluntary disclosure and earnings management strategies after hedge fund activists intervene.

We predict that target firm managers are more likely to withhold bad news, disclose good news, and engage in earnings management during hedge fund interventions. Bad news disclosures send an adverse signal of firm performance to the market, which gives hedge funds an upper hand in corporate control contests and puts target firm managers in a more vulnerable position. In an effort to maintain control and job security, target firm managers are more likely to refrain from releasing bad news prematurely during hedge fund interventions. By delaying the disclosure of bad news, managers buy extra time to devise and implement a turnaround strategy, which might generate subsequent good news to offset the withheld bad news. Similarly, target firm managers could be motivated to disclose more good news during hedge fund interventions, as they wish to restore investors’ confidence in the ability of the management, and make it more difficult for the activists to advance their agenda. If target firm managers believe that producing artificially positive earnings news while suppressing the supply of adverse information in the short run can increase their chance of defeating hedge fund activists, they might also attempt to inflate the firms’ reported financial performance by managing earnings. Target firm management’s desire to preserve corporate control and job security, therefore, creates an incentive to manage earnings in response to a hedge fund intervention.

To test our predictions, we construct a sample consisting of 510 hedge fund activism events from 2001 to 2013, and examine changes in the likelihood and frequency of management earnings forecasts around hedge fund interventions. To overcome hedge funds’ endogenous targeting decisions, we perform both a within-sample analysis with firm fixed effects and a difference-in-differences analysis in which a sample of non-target control firms are selected based on a propensity score matching scheme. We find that target firms are more likely to withhold bad news following hedge fund interventions, as both the likelihood and the frequency of management earnings forecasts conveying bad news significantly decrease following the intervention of hedge fund activists. We find little or no evidence that managers increase good news disclosures during hedge fund interventions. A potential explanation for the lack of a change in good news disclosures during hedge fund interventions is that good news disclosures create an optimistic expectation that is difficult to achieve. Failure to meet their own forecasts reflects poorly on managers’ ability, tarnishing managers’ reputation in the labor market and consequently provides activist hedge funds with more firepower to push their activism agenda.

We also find target firms are more likely to engage in real activities-based earnings management by temporarily boosting sales, overproducing inventory to reduce the cost of goods sold, and cutting discretionary expenses during hedge fund interventions. This effect is not present for accrual-based earnings management. The differential effects on accrual-based versus real earnings management are consistent with the notion that management uses these two earnings management tools as substitutes and that real earnings management is relatively harder to detect by outsiders. Exploring the link between bad news withholding and earnings management strategies during hedge fund interventions, we find, when firms increase bad news disclosures after hedge funds intervene, they are more likely to step up real earnings management to counteract adverse forecast news. This finding implies a substitute relation between bad news withholding and earnings management as alternative strategies that target firm managers use to resist hedge fund activists’ campaigns.

We uncover cross-sectional variation in the impact of hedge fund interventions by hedge fund attributes and firm characteristics. We find bad news withholding weakens when hedge funds intervene for a relatively long time, but strengthens when the activist pursues more confrontational agendas, has relatively higher ownership in the target firm, and has a track record of replacing target firms’ CEOs/CFOs. These results bolster our inference that bad news withholding is due to intense conflicts between hedge fund activists and target firm managers. The effect of hedge fund interventions on bad news withholding is more pronounced when the target firm has more volatile operation, as managers at these firms like have the strongest incentives to engage in opportunistic disclosure behavior when market’s ability to assess the truthfulness of disclosures is low. The main effect is mitigated when the target firm is covered by more analysts and when the target firm faces higher product market competition, which speaks to the role of external governance in constraining opportunistic disclosure strategies.

We further examine whether issuing bad news during hedge fund interventions can impose negative career consequences on target firm managers. We find that target firm managers who disclose more bad news after hedge funds intervene are more likely to be dismissed from their jobs, suggesting that bad news withholding can be an effective strategy for managers to maintain job security in the face of hedge fund attacks. Lastly, we find that bad news withholding persists even after the exit of hedge fund activists, which indicates that hedge fund interventions have a long-lasting impact on target firms’ voluntary disclosure choices.

In summary, our study points to strategic coordination between voluntary disclosure practices and real decisions by target firm managers in counteracting hedge fund activism. By resorting to bad news withholding and real earnings management as substitutive strategies, target firm managers attempt to maintain corporate control and alleviate reputational and career concerns evoked by hedge fund activism.

The complete article is available here.

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