Activist Hedge Funds: Evidence From The Recent Financial Crisis
Zazy Khan
University of Verona
May 27, 2016
Abstract:
This study extends the empirical evidence of hedge fund activism impact on target firm performance. We investigate whether activism strategies as well as their effects have changed following the recent financial crisis of 2007-2008. The analysis is based on the U.S. data covering 112 hedge funds, 551 target firms, from 2000 to 2013. We find that returns to activism accrue to approximately 5% during the (-20, 5) event window. Activism-related categories that generate significant and positive abnormal returns include capital structure, business strategy, and general undervaluation. Since the financial crisis, business-related activism generates the highest returns, followed by activism in financially depressed firms. We also find significant cross-sectional abnormal returns, both before and during the crisis, for hedge funds who do not pre-specify an objective. One year post-activism performance suggests that target firms experience substantial improvement in value, profit margin, and investment.
Activist Hedge Funds: Evidence From The Recent Financial Crisis – Introduction
Despite the tremendous growth in the US hedge fund industry following the global financial crisis, merely a few studies have empirically attempted to gauge the effects of the crisis on fund{targeted firms.1 The financial crisis, on setting around mid-2007, undeniably challenges the traditional approach to activism due to additional regulatory bindings and a much competitive environment to the viability of fund activism. In addition, the crisis allows testing if there are any material changes in funds’ targeting patterns and ways to influencing the firm’s internal governance. This study examines the impact of the recent crisis by investigating whether activist funds have changed the targeting behavior and the firms’ performance in the short-run and the long-term.
In their seminal study, Berle and Means (1932) posit that dispersed shareholders with a negligible ownership stake in sizeable US corporations assert less likely any significant influence by their monitoring. Modern corporate finance literature introduces distinct mechanisms to keep an adequate due diligence on the firm’s management. The emphasis of such arrangements is to align the manager’s interest with those of shareholders to alleviate the associated agency issues { however, empirical evidence suggests that so far these measures have appeared less successful in mitigating the agency problems (Baker et al., 1988). Of these monitoring means, the inclusion of blockholder is proposed on behalf of diffused shareholders (Jensen, 1986); however, the evolved outcomes have been economically insignificant (Wahal, 1996; Karpoff et al., 1996; Black, 1998; Carleton et al., 1998; Romano, 2001). The limited role of such monitoring has been subjected to free riding (Shleifer and Vishny, 1986; Black, 1998; Kahan and Rock, 2007; Partnoy and Thomas, 2007), high cost (Black, 1998; Kahan and Rock, 2007), limited investment (Black, 1998; Karpoff, 2001; Parrino et al., 2003), weak financial incentives (Rock, 1990), regulatory constraints (Romano, 2001), conflict of interest (Davis and Kim, 2005), among others.
The activist hedge fund has successfully drawn considerable attention from both academics and industry through its effective monitoring and delivering substantial performance. The very organizational framework, including fewer regulations (Ackermann et al., 1999), relaxed taxations (Jaeger, 2003), sophisticated investment strategies, for example leverage, short selling, derivatives, and concentrated portfolios (Partnoy and Thomas, 2007), (Jaeger, 2003, p. 133), and performance{based incentives (Ackermann et al., 1999) allows it to outperform other non-hedge funds. Contrary to limitations associated with non-hedge funds, a growing body of fund-related literature argues for its distinctive characteristics and presents it as a leading candidate in a monitoring role (Bratton, 2006; Briggs, 2007; Kahan and Rock, 2007; Partnoy and Thomas, 2007; Armour et al., 2009). Despite the crisis period, hedge fund related activism has persistently been generating positively significant abnormal returns for its investors (Becht et al., 2014).
The impact of hedge fund activism on target firms’ performance has rigorously been discussed and studied in recent decades (Klein and Zur, 2006; Brav et al., 2008; Greenwood and Schor, 2009; Boyson and Mooradian, 2011; Bebchuk et al., 2014). The empirical findings of largely documented studies are consistent with the notion that fund-related activism generates positively significant abnormal returns around the announcement of Schedule 13D Disclosures. However, the evidence on long-term firm’s performance is mixed and partly subjects to sample frame and composition.
A general consensus exists among the researchers that the stock market favorably reacts to the announcement of a fund’s involvement in a target firm, and as a result, generates positively significant abnormal returns (Klein and Zur, 2006; Brav et al., 2008; Boyson and Mooradian, 2011). In pre-crisis sample studies, Klein and Zur (2006) report 10.3% abnormal returns over a relatively longer ({30, +30) event window including the date of notification. In another study, Greenwood and Schor (2009) utilizing long-horizon data (1993{2006), document 3.5% abnormal returns in 15 days event{window. To add more evidence, Brav et al. (2008) show seven percentage points abnormal returns in excess of matching firms based on size/book-to-market/industry in ({20, +20) event window and find no reversal in prices in the succeeding year of activism. The announcement related positively significant abnormal returns have signaled the market participants to reconsider traditionally prevailing thinking on activist investing. Recently, Becht et al. (2014) analyze stock performance across regions, including Asia, Europe, and North America, and report that the US market responds most to fund disclosures about 6.9% for ({20, +20) event window or 41 days.
Related to long-term performance in targets firms, the empirical evidence, however, is mixed and largely subjects to the sample frame and composition. In a seminal study, Brav et al. (2008) analyze the two-years post-activism changes in firms and find that targets have outperformed the non-targets in terms of profitability and payout when matched at industry/size/book to market value. In addition, they also find that at the governance level, targets experience higher CEO turnover following the activism. Boyson and Mooradian (2011) using a relatively longer panel from 1994 to 2007, and document that target firms’ value improved when measured using Tobin’s Q over the course of activism. Moreover, targets significantly reduced the excess cash thus showing the consistency in the widespread idea that activists reduce the agency costs of managerial discretion. Contrary to these findings, some studies report either adverse effects or no improvement in the target firms following the activism. Klein and Zur (2006), for instance, do not find evidence of improvement in firms’ accounting measures of performance. Instead, targets experience a decline in earnings per share (EPS), return on assets (ROA), and return on equity (ROE) in the succeeding fiscal year. However, post-activism targets’ excess cash reduced substantially and distributed among shareholders as dividends. The mixed findings on long-term effect along with significant abnormal returns in the short-run suggest that the shareholders perceive benefits to reducing agency costs of excess cash and short-term investments.
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