Hedge Fund Activism And Long-Term Firm Value
University of Notre Dame
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University of Amsterdam – Finance Group; Tinbergen Institute – Tinbergen Institute Amsterdam (TIA)
University of Arizona – James E. Rogers College of Law; Northwestern University – School of Law; IAST – Fondation Jean-Jacques Laffont – TSE ; University of Toulouse 1 – Industrial Economic Institute (IDEI)
Bocconi University – Department of Finance
November 19, 2015
This paper investigates the association of hedge fund activism and long-term firm value. We show that the positive long-term association documented in prior studies is likely affected by selection bias, as activist hedge funds tend to target poorly performing firms. Second, once we incorporate such selection bias using a matched sample approach, we find that firms targeted by activist hedge funds improve less in value after activist hedge fund campaigns than ex-ante similarly poorly performing control firms that are not subject to hedge fund activism. This suggests that hedge fund activism decreases, rather than increases, a firm’s long-term value, relative to non-targeted control firms that have similar characteristics as the targeted firms.
To explain our results, we explore whether the ability of activist hedge funds to substantially influence a firm’s investment policy may exacerbate a firm’s limited commitment problem toward long-term value creation and stable stakeholder relationships. Consistent with this hypothesis, we find that the reduction in value after hedge fund campaigns is more pronounced for firms where the limited commitment problem is more severe, namely firms that are more engaged in innovation and where stakeholder relationships are more important for long-term value creation.
Hedge Fund Activism And Long-Term Firm Value – Introduction
Hedge fund activism has turned into a permanent force of corporate governance. Activist campaigns targeting publicly traded firms have steadily increased in the past ten years, and especially so in recent times (Coffee and Palia, 2015). The governance changes sought by activists have ranged from modest proposals, such as separating the positions of CEO and Board Chairman, to more radical interventions, such as firing the CEO or selling major assets or the firm to an acquirer. Largely due to this increased activism, the U.S. corporate landscape has now changed, with the result that Berle and Means’ canonical account of corporate governance is no longer accurate (Gilson and Gordon, 2013). Under that account, shareholders in large public firms are portrayed as widely dispersed and, consequently, as facing collective action problems that limit their available remedies against managerial underperformance to the “Wall Street Rule” (i.e., the “exit” option to sell shares). In today’s corporate environment, however, increased institutional shareholder concentration and hedge fund activism have empowered shareholders with the ability to exercise influential “voice” over the corporate affairs.
Distinguishing corporate features, and the incentives arising thereof, explain why hedge funds-unlike more traditional institutional investors such as mutual funds and pension funds—actively rely on voice, and more generally activist campaigns, in pursuing their investment targets (Kahan and Rock, 2007; Brav et al., 2008a; Brav et al., 2008b). First, and most importantly, hedge funds largely operate outside of the security regulation and registration requirements that constrain the operations of other institutional investors, as hedge funds typically cater to a small number of sophisticated investors rather than the retail-investment market. This allows hedge funds to concentrate their investments in few targeted companies, in which they typically hold large equity stakes. Regulatory freedom also grants hedge funds greater recourse to leverage, enabling them to pursue investments that are much larger than those of mutual funds with comparable net assets. Second, hedge funds are managed by professionals who make significant personal investments in the fund, in addition to receiving highly powered incentives. Third, hedge funds are independent investors-who do not sell services to the companies they target—which makes them un-conflicted in the exercise of active governance rights. Finally, they contractually lock-up investor money for longer periods of time, which makes them less sensitive to liquidity shocks and hence better positioned to engage in active governance over potentially longer periods of time.
Yet, while everyone in the current corporate governance debate seems to agree that hedge funds activism has brought about sweeping corporate governance changes, sharp disagreement exists as to the effect of such changes on the financial performance of the targeted companies. So-called shareholder advocates see hedge funds as the natural champions of the long-dormant shareholder franchise. Under this view, hedge fund activism is described as a market-driven correction that has finally turned shareholder governance rights into an effective means of value enhancement (Brav. et al., 2008; Bebchuk, 2014; Bebchuk et al., 2015), with activist campaigns also promoting interventions by other, traditionally more passive institutional investors (Gilson and Gordon, 2013).
Economically, the shareholder advocate view of hedge fund activism rests on two main assumptions. The first is that managerial moral hazard is the main-if not the only-source of market imperfection, which implies that low corporate valuations generally reflect managerial underperformance (Bebchuk, 2005; Bebchuk, 2014). The second assumption is that boards of directors are often entrenched, which hinders their ability to serve as faithful guardians of shareholder interests (Bebchuk et al., 2002; Bebchuk and Fried, 2004). Under these assumptions, hedge fund activism ensures that market discipline is effective, enhancing shareholder monitoring, facilitating the active participation in corporate governance of other investors, and promoting greater board accountability (Bebchuk, 2007).
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