Public Short Selling by Activist Hedge Funds

Ian Appel, Assistant Professor of Finance at Boston College Carroll School of Management; Jordan Bulka is a PhD Student at Boston College Carroll School of Management; and Vyacheslav Fos is Associate Professor of Finance at Boston College Carroll School of Management. This post is based on a recent paper authored by Professor Appel, Mr. Bulka, and Professor Fos. 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 Dancing with Activists by Lucian Bebchuk, Alon Brav, Wei Jiang, and Thomas Keusch (discussed on the Forum here).

The last two decades have seen a dramatic increase in the prominence and influence of activist hedge funds. Academic research on activists largely focuses on their long positions and whether they are associated with improved firm outcomes (e.g., Brav, Jiang, Partnoy, and Thomas, 2008; Bebchuk, Brav, and Jiang, 2015). However, recent years have seen a new phenomenon: high-profile public short selling campaigns by activist hedge funds. David Einhorn’s short of Allied Capital provides an illustrative example. In May of 2002, Einhorn announced his short position in Allied at an investment conference, arguing the firm engaged in questionable accounting practices. Allied’s stock dropped over 10% the following day, and by the next month its short interest had increased six-fold. The SEC eventually launched an investigation into Allied that “zero[ed] in on many of the criticisms made by short-sellers.”

In our paper, Public Short Selling by Activist Hedge Funds, we undertake a comprehensive analysis of voluntary disclosure of short positions that specifically focuses on activist hedge funds. We ask three main questions related to this phenomena. First, how common is disclosure of short positions by activists and what are the characteristics of activists that undertake them? Second, what are the effects of such campaigns on firm value and the behavior of other stakeholders? Finally, why do activist hedge funds engage in this behavior?

To address these questions, we manually construct a database containing information on public short selling campaigns by activist hedge funds. We identify 280 campaigns by 49 activist hedge funds from 1996–2015. Campaigns are generally disclosed through the media, investment conferences, or letters to investors and feature a wide array of allegations, including general overvaluation, concerns regarding the business model/product, and fraud. We document several key results.

First, the prevalence of public short campaigns has increased significantly in the past decade. Prior to 2008, the average number of public short selling campaigns was fewer than 10 per year. However, from 2008 onwards, the average number of campaigns approximately tripled, peaking with 59 in 2015. Activists who undertake short campaigns differ from those that do not along a number of dimensions. For example, activists that disclose short positions tend to have more experience with long activism campaigns and are more likely to employ hostile tactics. We also find that targets of public short campaigns differ from targets of activism campaigns on important dimensions: short targets tend to be growth firms with strong past performance while long targets tend to be value firms with weak past performance (Brav, Jiang, Partnoy, and Thomas, 2008).

Second, the announcement of campaigns is associated with negative abnormal returns for targets. Cumulative abnormal returns (CARs) are approximately -4% in a 20-day window around public disclosure. This negative abnormal performance is not short-lived; CARs decrease to less than -12% 100 days after the announcement of a short campaign. We obtain similar results for the sample of campaigns announced at investment conferences, suggesting that confounding events (e.g., announcement of negative news) do not drive the findings. The negative price reactions are consistent with previous papers that examine disclosure of short positions in other contexts (e.g., Ljungqvist and Qian, 2016; Zhao, 2016).

Third, we show that public disclosure of short positions is associated with changes in the actions of other stakeholders. We find that aggregate short interest increases by 10% following such disclosures. Campaigns are also associated with a sizable increase in media coverage as well as coverage with a negative tone. Finally, disclosures of short positions are followed by an increase in litigation. This result is driven by shareholder lawsuits, fraud/accounting lawsuits, and IP lawsuits, all of which can impose significant costs on firms. These findings are robust to limiting the sample of campaigns to those announced at investment conferences, where concerns related to the endogenous timing of disclosure are mitigated. Overall, our findings suggest short campaigns are associated with subsequent changes in behavior by other market participants that potentially decrease firm value.

Finally, we examine why activist hedge funds voluntarily disclose short positions. We provide a theoretical framework in which activist investors can voluntarily disclose short positions, but such disclosure entails a cost. For example, disclosure of short positions can invite scrutiny from regulators for potential market manipulation. However, activists have particularly strong incentives to acquire information because they have access to technology that increases the value of their long positions. As a result, activists are more likely to acquire information that is sufficiently negative to overcome the costs associated with public disclosure.

Overall, while public disclosure of short positions has historically been costly, our findings indicate that the benefits of disclosure outweigh its costs for some activists.

This suggests that costs and benefits of disclosure potentially vary across investor types. Thus, understanding the disclosure incentives of different types of institutions may play an important role in informing the policy debate regarding disclosure rules for short sales.

The complete paper is available here.

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