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Hedge Fund Activism: An Empirical Analysis

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Hedge Fund Activism: An Empirical Analysis

Nicolo Colombo

17 Capital

December 22, 2009


This paper combines both theoretical evidence on hedge fund activism and empirical results obtained through an event study around the commencement of activism to show that the phenomenon is value-enhancing for shareholders. In particular, after defining what this form of arbitrage is, it is argued that hedge funds are best suited to engage in activism thanks to reduced conflict of interests, greater incentives to monitor, their size and less legal hurdles. Stock market reaction to announcement of activism is positive, as documented by a dataset of events from 2005 to 2008 that revealed a mean cumulative abnormal return of 4.38% on companies’ stock around the filing of Schedule 13Ds. Further analysis investigated activists’ stated goals, tactics adopted and whether the type of engagement was collaborative or hostile with existing management. Cross-sectional event study analysis by nature of approach resulted in higher abnormal returns in case of a hostile activist agenda.

Hedge Fund Activism: An Empirical Analysis – Introduction

“[…] Shareholder activists that corporate boards fear most today are hedge funds: unregulated pools of wealthy investors who take large positions in a few select companies, use their ownership position to pressure boards into strategies they claim unlock “shareholder value”. The result is often an anemic, over-leveraged company that lacks the funds to invest in long-term projects and that cannot weather economic downturn. […]. We should contemplate the possibility that increasing shareholder activism may be a cure that is worse than the disease, at least for the average investor.”

“Why Carl Icahn is bad for investors”

As it can be noted in the above commentary by UCLA Professor Lynn Stout, the phenomenon dubbed as ‘hedge fund activism’ has recently been the subject of debate in the academic, public and private sector. In particular, the focus has been oriented towards the assessment of actual benefits – accruing to shareholders – of such practice. Critics and regulatory bodies have oftentimes considered this kind of activism as a “value-destroying” practice, whose (supposedly) short-term bias inevitably damages a target’s company long-range planning and management’s strategic actions. Indeed, this view has progressively gained momentum in recent months, also because hedge funds (along with major investment banks) are negatively considered by general public the major culprits in the recent financial meltdown, too often engaging themselves in outrageous risky positions. Public anger at financial community at large has caused activists to retreat, resulting in a renewed “faith” in industrial businessmen and their ability to deliver value to shareholders. To be sure, “activism” – in the broader sense of the term – has been a constant characteristic in the corporate America’s DNA for at least two decades. Some major players who were active in the 1980s with large operations – the so-called corporate raiders who used to put pressure on “somnambulant” board of directors and eventually aimed at restructuring the company’s by often stripping its assets apart and selling them to achieve short-term gains, are still in the business, possibly facing a different environment and pursuing slightly different objectives.

The U.S. financial market represents an interesting environment where empirical evidence can be collected in order to substantiate the claim that hedge funds targeting companies to engage in activism practices are actually creating “value”. By building and analyzing a “home-made” database on hedge fund activism, we will be in the position to gain a deeper insight into the phenomenon with respect to the general current prevailing anecdotal evidence by simultaneously avoiding the problem of existing samples biases. More specifically, with a set of documented observations from 2005 to 2008 we will try to address such questions as With what objectives and through which strategies do hedge funds engage in activism? What is the market reaction to the announcement of activism? Additionally, through a classification of the attitude of engagement for each single event, we will shed some light on the abnormal returns to collaborative activism vis-à-vis a hostile (confrontational) approach. Two brief cases at the end of the paper offer some more background elements to the phenomenon.

Institutional Background

Hedge Funds : A Definition

Alfred Winslow Jones is credited with establishing one of the first hedge funds in 1949. That hedge fund invested in equities and used leverage and short selling to “hedge” the portfolio’s exposure to movements of the corporate equity markets. Significant changes occurred in the industry with respect to this second aspect, but the basic idea underlying hedge funds remains investment pooling. Investors buy shares in these funds, which then invest the pooled assets on their behalf. Although they seemingly operate like mutual funds, substantial differences can be found in their transparency, type of investors, investment strategies, liquidity, and compensation structure. As far as transparency is concerned, while mutual funds are subject to Securities Act of 1933 and the Investment Company Act of 1940 and must periodically provide the public with information on portfolio composition, hedge funds are usually set up as limited partnerships (i.e. not registered as an investment company under the Investment Company Act) and provide minimal information about portfolio composition and strategy to their investors only, as they do not register their securities offerings with Securities Act. Hedge funds have usually no more than 100 “sophisticated” investors, defined by minimum net worth and income requirements. They do not advertise to the general public (usually) and the minimum investment commitment lies in the 250,000 euro – 1,000,000 euro range. Hedge funds may effectively partake in any investment strategy (differently from mutual funds, which face limitations in using derivatives, leverage, and short-selling) and may act opportunistically as conditions evolve.

Hedge Fund Activism

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