Validation Capital

Edward B. Rock is the Martin Lipton Professor of Law at New York University School of Law; Alon Brav is Peterjohn-Richards Professor of Finance at Duke University Fuqua School of Business; and Dorothy S. Lund is Assistant Professor of Law at the University of Southern California Gould School of Law. This post is based on their recent paper. 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); Dancing with Activists by Lucian Bebchuk, Alon Brav, Wei Jiang, and Thomas Keusch (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).

Although it is well understood that activist shareholders challenge management, they can also serve as a shield. In our new paper, we describe “validation capital,” which occurs when a bloc holder’s—and generally an activist hedge fund’s—presence protects management from shareholder interference and allows management’s pre-existing strategy to proceed uninterrupted. In other words, sometimes an activist shareholder can serve as a “shark repellant” or a modern-day “white squire.”

And as is true of much shareholder intervention in governance, the provision of validation capital can represent a positive or negative for firm performance and shareholder value, depending on the circumstances. In the “happy story,” validation capital addresses information asymmetries between management and outside investors that may cause outsiders to misjudge management’s quality and vision for future successful performance. When a sophisticated bloc holder with a large investment and the ability to threaten management’s control chooses to vouch for management’s strategy after vetting it, this can send a credible signal to the market that protects management from disruption. More specifically, the validation capital signal affects other investors in two ways: first, it builds support for management among the general shareholder population; second, because of this support, activists will be less likely to prevail in a challenge to management’s strategy, and, as a result, less likely to attempt to do so. This protection ultimately benefits all of the shareholders, including the bloc holder, whose shares will increase in value.

In some cases, an investor will validate management solely as a result of their decision to buy or hold (think Warren Buffett); in other cases, providers of validation capital play a more active role in shielding management. Indeed, providers of validation capital may secure inside information by serving on the board, and they sometimes serve as an “anchor” or “reference” investor by advertising their alignment with management, either in public statements or in conversations with other shareholders.

Although validation capital can be beneficial, like any relational investing, it can have a “dark side.” In the “sad story,” one worries that a bloc holder will help to entrench under-performing management from outside interference that would benefit the company and its shareholders in exchange for a direct or indirect side payment. In this scenario, the bloc holder acts as a hired “bodyguard” who receives a side payment in exchange for the promise to ward off other investors that seek to threaten management’s control. In light of the bloc holder’s expectation that their protection will depress the company’s stock price, a side payment is necessary to induce its participation. Such a side payment could take various forms including preferential investment terms upon entry; a premium upon exit; extra compensation for directors; and even inflated reimbursement for proxy expenses. Providing “bodyguard” services may be rational when the side payment is large enough to offset the bloc holder’s expected losses as a result of the decline in the company’s share price.

Given the proliferation of bloc holders and their increasingly active role in governance, it is important to understand the potential implications of validation capital for firm performance and value, and the relative likelihood of the virtuous and corrupt variants. Our paper begins to tackle this question. In so doing, we first survey the legal and market mechanisms that constrain corrupt relational investing. Side payments to bloc holders by public company management will generally be disclosed under federal securities law. In extreme circumstances, the payment of a side payment could trigger heightened judicial review by Delaware courts.

Ultimately however, these legal requirements may only somewhat deter side payments; instead, we believe that market mechanisms, facilitated by disclosure, provide the key constraint. In particular, corrupt relational investing can only be rational in very limited circumstances. A management team that seeks protection must be assured that the bloc holder’s support will be effective against other investors, and must also be assured that the bloc holder will be willing to hold on to the block for potentially a long period of time and not defect. Likewise, a hedge fund that plans to provide “bodyguard” services must worry about returns as well as the risk that reputational harm will compromise future interventions. This may lead the investor to require a prohibitively large payment as compensation for this risk. We argue that these forces do much to inhibit management teams from offering side payments, and constrain activist shareholders from accepting them.

Our empirical study offers evidence in support of our prediction that corrupt validation capital will be rare or non-existent. We studied a cross section of public companies targeted by hedge fund activists in 2015 and generated little evidence of substantial side payments of the size necessary to induce the corrupt form of validation capital. That was so despite the fact that our analysis demonstrated that many opportunities for side payments exist: management can offer expense reimbursement, differential pay for the activist director(s), a promise to repurchase shares, consulting fees, a private placement of shares, notes or warrants, and/or warrant amendments. Our study indicates that management teams and activists enter into such arrangements in, at most, a third of all activist events, but a closer look at these events indicates that they are not likely candidates for corruption. In other words, it appears that market and legal mechanisms operate to constrain the corrupt form of validation capital, at least with regard to U.S. public companies and activist hedge funds.

The complete paper is available for download here.

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