Corporate Governance And Hedge Fund Activism
Shane C. Goodwin
The University of Texas at Dallas
August 2015
Abstract:
Over the past 25 years, hedge fund activism has emerged as new form of corporate governance mechanism that brings about operational, financial and governance reforms to a corporation. Many prominent business executives and legal scholars are convinced that the entire American economy will suffer unless hedge fund activism with its perceived short-termism agenda is significantly restricted. Shareholder activists and their proponents claim they function as a disciplinary mechanism to monitor management and are instrumental in mitigating the agency conflict between managers and shareholders. I find statistically meaningful empirical evidence to reject the anecdotal conventional wisdom that hedge fund activism is detrimental to the long term interests of companies and their long term shareholders. Moreover, my findings suggest that hedge funds generate substantial long term value for target firms and its long term shareholders when they function as a shareholder advocate to monitor management through active board engagement to reduce agency cost.
Corporate Governance And Hedge Fund Activism – Introduction
Agency conflict in publicly traded corporations with dispersed ownership is at the heart of corporate governance literature, which focuses on mechanisms to discipline incumbent management. One possible solution to mitigate agency cost is for shareholders to actively monitor the vrm’s management. However, while monitoring may reduce agency and improve firm value, this effort is not without cost, and the benefits from monitoring are enjoyed by all shareholders (Grossman & Hart, 1980).
Shareholders who serve as active monitors of firm management to provide a disciplinary mechanism is not a new concept. Earlier studies have shown that when institutional investors, particularly mutual funds and pension funds, follow an activist agenda, they do not achieve significant benefits for shareholders (Black, 1998; Gillan & Starks, 2007; Karpoff, 2001; Romano 2001). Nevertheless, hedge funds have increasingly engaged in shareholder activism, and monitoring that differs fundamentally from previous activist efforts by other institutional investors. Unlike mutual funds and pension funds, hedge funds are able to influence corporate boards and managements due to key differences arising from their organizational form and incentive structures.
Hedge funds employ highly incentivized managers who control large, unregulated pools of capital. Because they are not subject to regulation that governs mutual funds and pension funds, hedge funds can hold highly concentrated positions in a small number of companies and use leverage and derivatives to extend their reach. In addition, hedge fund managers do not experience conflicts of interest because they are not beholden to the management of the firms whose shares they hold. Consequently, hedge funds are better positioned to act as informed monitors than other institutional investors.
My dissertation addresses two fundamental questions with respect to hedge fund activism: (a) What are the determinants of hedge fund activist interventions and the characteristics of the Target Firms? and (b) Does hedge fund activism create long-term value for Target Firms and their long-term shareholders? My research fills the important void in the literature with respect to the shareholder activism initiated by hedge funds. My novel approach to corporate inside” ownership and short-interest positions as instrumented variables that predict a Target Firm’s vulnerability to hedge fund activism contributes to the literature on the determinants of shareholder activism.
Because shareholder activism has evolved significantly over the past 25 years, it is imperative to ensure that the extant literature properly reflects the changing financial markets. First, all meaningful academic research with respect to shareholder activism is predicated on data that use very small sample sizes, usually fewer than 200 Target Firms or activist interventions. Additionally, most datasets have limited time series and nearly all of the research is based on data prior to 2005. The most comprehensive dataset was used by Brav, Jiang, and Kim (2015) who used approximately 2,000 activist interventions from 1994-2007. Since 2007, shareholder activism has increased significantly, particularly by hedge funds. To be sure, approximately 60% of activist interventions have occurred since 2007, and approximately 75% of those events were instigated by hedge funds.
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