Fund Structure And The Long-Run Performance Of Activism
University of Connecticut
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EDHEC Business School
Boston College – Carroll School of Management
September 1, 2015
This paper demonstrates the importance of fund structure for understanding hedge fund activism. Firms targeted by activists with transparent fund structures outperform those targeted by activists with opaque fund structures by roughly 22% per year (risk adjusted). Outperformance is also measured in return-on-assets and valuation ratios. The effect is neither explained by superior target selection ability nor by takeover activity, but rather by increased operational efficiency and transparency of the target firms. However, the fund structure effect is not priced around the activism announcement date.
Fund Structure And The Long-Run Performance Of Activism – Introduction
Investor activism has been the center of debate among finance researchers and legal academics. Earlier studies (e.g., Black (1998), and Gillan and Starks (2007)) show that activist institutional investors, usually mutual funds and pension funds, do not significantly influence management on their activist agenda However, the pioneering work of Brav, Jiang, Partnoy, and Thomas (2008) shed light on the importance of the type of institutional investor for successful activism. In particular, these researchers show that hedge funds, contrary to other types of institutional investors, are able to influence corporate management due to their different organizational structure and incentives. They show that activist-targeted firms exhibit increases in performance measures and CEO turnover. Indeed, the equity market responds with an average of 7% return for targeted stocks around the announcement dates of 13D filings.
However, critics of activism argue that the positive response of the stock market to an activism announcement is only a short-term gain, while the cost of activism, such as the distraction of management from long-term goals, outweighs the short-term benefit to shareholders. This area of research has engendered growing debate in law and economics literature and in the general press; critics of activist investors indicate conflict of interest, wealth transfers, and overall poor long-run performance of target firms. Bebchuk, Brav, and Jiang (2013), however, debunk this myopic view of activism by providing supporting evidence for the positive impact of activism on long-term performance as measured by operational efficiency and valuation ratios. Also, Greenwood and Schor (2009) study takeovers as one possible avenue of value creation by activist funds. They demonstrate that the positive stock market reaction to 13D announcements reflects the market’s perception of the chances that the target firm will eventually be acquired by another firm. Also, Boyson, Ma, and Mooradian (2015) show that hedge fund activists exhibit performance persistence in successive target firms and this persistence is due to long-term improvements in target firms, rather than activist reputation effects.
In addition to the cited literature on activism, several recent papers study issues pertaining to the structure of hedge funds. Relying on SEC filings, Brown, Goetzmann, Liang, and Schwartz (2008, 2009, 2012) study fund operational risk and conclude that investors do not consider fund operational risk despite its capacity to predict fund failure. Ozik and Sadka (2013) highlight the conflicting incentives of fund managers and investors pertaining to the information asymmetry in the presence of share restrictions (see also Aragon (2007) who studies the effect of share restrictions on hedge fund returns). They show that this issue is intensified in funds with low-transparency standards, where the latter is gauged by fund domiciliation, quality of service providers, SEC registration, financial auditing, and the implementation of high-water marks.
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