The Product Market Effects Of Hedge Fund Activism

Hadiye Aslan

Georgia State University – Department of Finance

Praveen Kumar

University of Houston – Department of Finance

2015

Journal of Financial Economics (JFE), Forthcoming

Abstract:

We examine the product market spillover effects of hedge fund activism (HFA) on the industry rivals of target firms. HFA has negative real and stockholder wealth effects on the average rival firm. The effects on rivals’ product market performance is commensurate with post-activism improvements in target’s productivity, cost and capital allocation efficiency, and product differentiation. Financially constrained rivals accommodate these improvements but those facing high intervention threat respond effectively to them. The spillover effects are strengthened in less concentrated and low entry barrier industries. The results are robust to the alternative hypothesis of strategic target selection by hedge funds.

The Product Market Effects Of Hedge Fund Activism – Introduction

Since the late 1990s, activist hedge funds have become the dominant face of shareholder activism, essentially taking over an arena that was once dominated by pension funds and mutual funds. Hedge fund activism (HFA) has attracted substantial public attention because of the large financial resources – ‘huge war chests’ (De La Merced and Creswell, 2013) – of activist investors and their ambitious agendas implemented through modifications in targets’ business strategy, capital structure, and corporate governance. In contrast to the largely ineffective results of the earlier institutional investor activism (Black, 1998; Gillan and Starks, 2000; Karpoff, 2001), HFA appears to have generated significant positive financial and real effects on target firms (Brav, Jiang, Partnoy, and Thomas, 2008; Brav, Jiang, and Kim, 2013; Bebchuk, Brav, and Jiang, 2015).

The positive effects on target firms’ economic performance suggest that HFA is not just a ‘stock market sideshow’ (Morck, Shleifer, and Vishny, 1990); rather, it appears to induce real effects through some combination of improvements in productive efficiency, lower agency costs, and improved business strategy. These changes should also have product market spillover effects, however. Theoretically, the industrial organization and competitive strategy literatures predict that improvements in cost efficiency and product differentiation in target firms will impact oligopolistic industry equilibrium through a variety of channels. Indeed, we observe anecdotally that firms come under pressure to respond when some of their rival firms are targeted by activist investors.1 But despite intense interest by the media and policy makers, and recent scrutiny by academic economists, the product market spillover effects of HFA are poorly understood. In particular, what are the primary channels for the spillover effects? Are the spillover effects commensurate with the post-activism improvements in target firms? How do rival firms respond as the activism progresses? Do they cut prices to protect market shares, or are some rivals able to effect their own efficiency and product differentiation improvements? What types of rival firms are vulnerable – or protected – from the spillover effects? What is the role of industry attributes? We currently have limited understanding of these important issues.

Using a comprehensive HFA sample covering 1996-2008, with 1,332 (1,610) unique target firms (activism events), we attempt to shed light on the product market spillover effects of HFA. Guided by the theoretical industrial organization and strategy literatures, we analyze the channels for the spillovers based on factors related to the nature of the intervention, rival firms, and the type of industry. Specifically, we analyze the spillover effects on industry rivals from targets’productivity gains, operating margin reductions, capital redeployment, and product differentiation improvements proxied by increases in advertising expenditures (Chamberlin, 1933; Nelson, 1974). Moreover, we examine whether rivals are able to protect themselves from post-activism competitive pressure by improving their own productivity, cost and capital allocation efficiency, and product differentiation. We also examine the role of firm-level characteristics that make rivals more likely to accommodate target improvements and suffer adverse consequences – that is, compete on the basis of strategic substitutes (Bulow, Geanakoplos, and Klemper, 1985) – or to respond effectively and compete on the basis of strategic complements. In particular, the literature implicates rivals’ financial constraints (Benoit, 1984; Bolton and Scharfstein, 1990) and proactive reforms undertaken in re- sponse to industry shocks (Brav, Jiang, and Kim, 2013) or HFA threats (Gantchev, Gredil, and Jotikasthira, 2014; Zhu, 2014). In a related vein, we expect the spillover effects to be influenced by the competitive intensity of the industry (Raith, 2003; Giroud and Mueller, 2010, 2011) and the strength (or weakness) of its entry barriers (Porter, 1980).