Caught in the Cross-Fire: Creditor Reaction To The Threat Of Hedge Fund Activism
University of Notre Dame
Warren Buffett’s 2018 Activist Investment
University of Notre Dame – Department of Finance
University of Oklahoma
January 15, 2016
We show that the threat of hedge fund activism (HFA) negatively impacts bondholders. When an industry is subject to abnormally high HFA activity, non-target firms with high intervention likelihood (based on firm characteristics) experience significant increases in bond yield and default probability as well as deterioration in ratings compared to other non-target firms in the industry with low intervention likelihood. These effects are more pronounced in firms that experience greater improvements to equity performance post-threat, poorly governed firms, and when there are more hostile interventions. In loan initiations, high intervention likelihood firms face larger spreads and more restrictive covenants. Our findings suggest that managerial response to the threat of HFA involves exploitation of bondholders, to which potential creditors react negatively. Our paper brings additional insight into the controversial role of HFA as an external governance mechanism.
Caught in the Cross-Fire: Creditor Reaction To The Threat Of Hedge Fund Activism – Introduction
Recent decades have seen the rapid growth of hedge fund activism (HFA), a new phenomenon in corporate governance, where activist hedge funds build stakes in target firms in order to press management for various changes. Precisely how HFA affects corporate governance and firm value is subject to increasing scrutiny. The literature for the most part documents a positive effect in terms of equity returns and firm performance, not only for actual targets, as first documented in Brav et al. (2008), but also for non-target firms that do not undergo intervention but face such threat. Intuitively, managers have great incentive to avoid intervention, as evidence of resultant managerial pay cuts and job loss abounds.
In this paper, we investigate an important but overlooked effect of HFA. While managers under threat of hedge fund intervention generate more value for shareholders in effort to reduce that threat, bondholders may be hurt in the process. Klein and Zur (2011) document a transfer of wealth from bondholders to shareholders for actual HFA targets by showing that these firms experience significant drops in bond rating and price following hedge fund intervention. We want to know whether managers also have tendencies to exploit bondholders when faced with the threat of intervention, and what circumstances exacerbate those tendencies.
In short, we find the threat of HFA leads to loss of bondholder wealth and negative credit market reactions. More specifically, threatened firms receive 0.45% higher bond yield, 1.25% greater default probability, and a 0.4 notch higher (worse) bond rating and overall firm rating than other firms. Relative to respective standard deviations, these changes are economically significant. We also find threatened firms significantly increase leverage, repurchase shares, and decrease cash holdings, which increase equity return but not surprisingly worry their creditors. In terms of new loan initiations, threatened firms receive higher loan spread and more covenants, in particular dividend restrictions. Altogether, the evidence confirms our hypothesis that managers, when facing HFA threat, in effort to boost equity value and reduce such threat, transfer wealth from bondholders.
We explore factors that might increase managers tendency to exploit bondholders in warding off activist hedge funds. In sum, we find greater transfer of wealth from bondholders to shareholders in poorly governed firms, in years of heightened intervention activity, and in years with more hostile interventions2. We also find that bondholders of firms that manage to increase equity value more experience greater loss of wealth. These results suggest that the extent to which the manager-bondholder agency problem is permitted affects the degree to which a manager would sacrifice bondholders interest when under the threat of hedge fund activism.
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