Governance Under the Gun: Spillover Effects of Hedge Fund Activism

Nickolay Gantchev is Associate Professor at the Cox School of Business Southern Methodist UniversityOleg Gredil is Assistant Professor at the A.B. Freeman School of Business at Tulane University; and Chotibhak Jotikasthira is Associate Professor at the Cox School of Business Southern Methodist University. This post is based on their recent article, forthcoming in the Review of Finance. 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).

Hedge fund activism has become pervasive in today’s corporate landscape. In response to activist demands, targeted firms have been shown to improve governance (e.g., raising shareholder payout) and performance (e.g., boosting return on assets and asset utilization). These positive effects often come at the expense of managers and directors who see a sharp drop in their compensation and a higher likelihood of being replaced. Ample anecdotes suggest that executives of yet-to-be-targeted firms feel threatened, and often seek the help of external advisers to monitor activism in their industry and perform “periodic fire drills” to address any potential vulnerabilities before an activist emerges. In its 2018 Public Company Governance Survey, the National Association of Corporate Directors (NACD) finds that “two-thirds of [survey] respondents reported taking action to prepare for a potential activist challenge”.

Despite abundant anecdotes, it is challenging to formally establish that the threat of activism induces changes in the policies of non-targeted firms. For example, industry peers of activist targets may improve return on assets as a result of structural industry changes or increased product market competition. In our new article, forthcoming in the Review of Finance and available on SSRN, we identify the effects of activism threat on the policies of non-targets by exploiting the interaction between two sources of variation—(i) an industry-level measure of activism Threat based on the amount of new capital available to activists to target firms in an industry, and (ii) a firm-level measure of Threat perception based on connections of the firm’s directors to recent activism targets. Our assumption is that as activism intensity increases in an industry, firms whose directors perceive higher personal costs of dealing with activists are more likely to make preemptive improvements to avoid becoming the next target.

We find that an interquartile increase in our measure of activism Threat doubles the targeting frequency in an industry, and that in periods of high Threat, non-targets with high Threat perception undertake real policy changes that mirror those advocated by activists, such as increasing leverage, payout and return on assets, and decreasing capital expenditures and cash. The magnitude of these improvements is about one-third to two-thirds of those observed at activist targets, and most significant among firms that are vulnerable to activism either because of their policy shortcomings (e.g., relatively low leverage) or because of their fundamentals that facilitate activist targeting (e.g., high stock liquidity and high institutional ownership).

Our findings are robust to alternative explanations. In particular, we examine the non-core segments of non-targeted firms whose core industries experience a rise in activism activity, and find that even the non-core segments significantly improve return on assets and return on sales, and reduce capital expenditures. These segment-level results confirm that the policy improvements we demonstrate at the firm level are not driven by product market effects, or more generally by shocks to the core industry. We also show that neither industry-wide policy and M&A waves nor the size and quality of director networks can explain our findings.

The policy improvements, both anticipated by the market and realized, are reflected in the threatened peers’ valuations. Our estimates show that an interquartile increase in Threat raises firm valuation by approximately 2.4% over three years, about a third of what we observe at the targets following activist intervention. Finally, we show that the policy improvements are effective at fending off activists. As Threat increases in an industry, firms generally experience an increased probability of being targeted but such effects are significantly mitigated among the firms that proactively correct their policy shortcomings. Our estimates suggest that it takes about two standard deviations of improvements in average policies or stock valuation to fully offset the increase in targeting probability associated with heightened Threat.

Our article provides novel large-scale evidence of the disciplinary effects of activism threat, implying that the impact of shareholder activism reaches beyond the firms being directly targeted. Such positive externalities have been an important but missing ingredient in the hotly contested debate about whether hedge fund activism is good or bad for the economy. As shareholder activism has become one of the most salient forces influencing firms’ strategic and financial decisions, studying its spillover effects is critical to fully appreciating its overall societal impact.

The complete article is available for download here.

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