Activist hedge funds and the corporation.

Author:Cremers, Martijn

The long-term effects of hedge fund activism are controversial. Some empirical studies document that activism is associated with increased long-term firm value, suggesting that activists can better discipline management. Other studies, however, challenge these results, arguing that the incorporation of possible selection effects exposes activism as detrimental to long-term firm value.

This Article contributes to this ongoing debate, producing novel empirical evidence on the relationship between activist campaigns, the financial value of firms, key governance arrangements, and corporate legal rules. We first document qualitative evidence that untargeted "control" firms sharing similar characteristics to targeted firms perform better in the long term than the target firms, and then show that hedge fund activism is associated with increased risk-taking but has no significant impact on managerial incentives. These combined findings provide support for the view that the substantial private gains hedge funds realize through activism come at the expense of long-term firm value, rather than from increased managerial accountability.

Consistent with these results, we further show that defensive mechanisms matter for deterring hedge fund activism only as long as they provide an effective higher-level constraint to protect a firm's commitment to long-term value creation, such as when they are premised on shareholder consent or embedded in a managerial-friendly legal environment. This would explain why staggered boards and incorporation in states with more anti-takeover statutes can deter future activist interventions, while the poison pill, surprisingly, does not. The Article concludes with recommendations to enhance the deterrent effect of current defensive mechanisms against short-term hedge fund activism.


TABLE OF CONTENTS INTRODUCTION I. HEDGE FUND ACTIVISM AND FIRM VALUE: WHERE DO WE STAND? A. Theories of Hedge Fund Activism 1. The Managerial Agency View 2. The Traditionalist View 3. The Limited Commitment View B. Empirical Studies 1. Short- Term Event Studies 2. Long-Term Effects of Activism 3. Matching and Hedge Fund Activism II. QUALITATIVE EVIDENCE A. Control Activism B. Governance Activism III. HEDGE FUNDS, RISK-TAKING, AND EXECUTIVE COMPENSATION A. Data Description B. Corporate Risk-Taking C. Executive Compensation IV. HEDGE FUNDS AND SHAREHOLDER COMMITMENT A. Defensive Measures and Hedge Fund Activism B. State Anti-Takeover Statutes C. Delaware and Managerial States D. Staggered Boards and Poison Pills V. POLICY CONSIDERATIONS A. Fixing the Activist B. Fixing the Target CONCLUSION APPENDIX TABLE A APPENDIX TABLE B INTRODUCTION

Are activist hedge funds a "force for good," targeting underperforming companies to bring about increased managerial accountability? Or are they professional arbitrageurs driven by short-term self-interest whose market power allows them to benefit at the expense of others? These questions relate not just to hedge fund activism itself, but pertain to the more fundamental debate over the appropriate division of authority between a corporation's boards and its shareholders, a debate that has occupied corporate law scholars for decades. (1) Activist hedge funds have reframed that debate in the past ten years, ostensibly bringing about a new class of "empowered shareholders" whose distinguishing trait is routine reliance on the proactive use of governance levers to achieve near-term investment objectives. (2) It follows that if activist hedge fund campaigns could be shown to have beneficial effects for firm performance--as shareholder advocates argue--this would challenge the traditional board-centric model featuring limited shareholder governance rights. Conversely, if hedge fund activism were to emerge empirically as detrimental to targeted firms, this would undermine the case for shareholder empowerment, in spite of the increased favor it has received among both policymakers and market players in recent years. (3)

This Article sheds light on the long-term effects of hedge fund activism, as well as their broader implications, using novel empirical evidence that bears on the relationship between the financial value of firms, activist campaigns, and key corporate governance arrangements and legal rules. This empirical evidence documents results supporting the view that the substantial private gains hedge funds realize through activism come at the expense of long-term firm value, rather than from the activists' ability to hold managers more accountable. We therefore argue that shareholder advocates' calls for reforms designed to advance the role, rights, and involvement of shareholders in corporate governance--based on the alleged benefits of hedge fund activism for firm performance (4)--should be rejected as unsupported by the data.

Theoretically, the shareholder advocates' view that hedge fund activism provides value-maximizing governance inputs rests on the assumption that shareholders, as the corporation's residual claimants, are better placed than potentially "captured" boards to control the classic problem of managerial moral hazard. (5) Viewed through this lens, activist hedge funds emerge as the champions of dispersed and diversified shareholders, who are less able to effectively use their governance rights to control this problem. (6) In stark contrast, traditionalists defending the centrality of the board of directors argue that hedge funds are impatient investors, whose interventions are directed at boosting a target's short-term stock price, potentially at the expense of long-term value creation, rather than at bringing about increased managerial accountability. (7)

In response, shareholder advocates have traditionally dismissed short-termism concerns as theoretically weak in light of the pervasiveness of the moral hazard problem. (8) However, as two of us have argued elsewhere, this counterargument fails to consider an additional principal-agent problem that arises in the shareholder-manager relationship--the shareholders' "limited-commitment problem." (9) Because of their informational disadvantage vis-a-vis firm insiders, shareholders--all shareholders as a matter of fact--may be unable to tell whether poor short-term firm outcomes (e.g., low current earnings) signal managerial underperformance or the undertaking of attractive long-term investments whose benefits will not materialize until later. As a result, in response to such poor short-term outcomes, shareholders may rationally decide to vote to remove the directors and managers or advocate some other drastic corporate changes such as the sale of the company. Fearing this sort of shareholder retribution, managers may thus develop inefficient incentives for short-termist strategies. (10) Within this theoretical framework, short-termism emerges as a much more pervasive problem than shareholder advocates acknowledge. Further, activist hedge funds naturally exacerbate the shareholders' limited commitment problem, as they are more likely than other shareholders to intervene upon observing a short-term decline in earnings.

Motivated by the theoretical debate's contradictory claims, empirical studies on hedge fund activism have mainly focused on the impact of activist hedge fund campaigns on firm value. (11) In particular, the latest frontier of these studies is the investigation of long-term valuations after the start of an activist hedge fund campaign. Indeed, attempting to measure long-term valuations is the only method that can address the main challenge raised by the critics of activism, according to which hedge funds would profit from activism at the expense of a firm's long-term value. (12) Notably, in a recent study that had large echoes in the press, Lucian Bebchuk, Alon Brav, and Wei Jiang documented evidence they argue rejects this claim. (13) Using a dataset of approximately 2,000 interventions during the period 1994-2007, they concluded that the performance of the hedge funds' targets on average continued to increase for up to five years after the start of the hedge fund campaigns. (14)

However, a primary challenge for empirical studies is to avoid selection effects that bias a dataset. (15) Selection effects refer to the possibility that any observed change might be attributable to omitted factors that are related to the selection of the data--in this case to the fact that activist hedge funds do not randomly select which firms to target in their campaigns. Because the study by Bebchuk et al. (the "BBJ study") documented that activist hedge funds tend to target companies that have been relatively poorly performing prior to the activist intervention, (16) the possibility of selection effects seems particularly salient. For example, the observed subsequent improvements in firm value of the targets could be attributable to efforts undertaken directly by these firms to turn around performance, rather than to any disciplining effect from the activist hedge fund campaign itself.

In response to this concern, two of us, along with Erasmo Giambona and Eric Wang, have reexamined the long-term association of hedge fund activism and firm value in a recent study (the "CGSW study") that uses the same (though extended through time) dataset of the BBJ study but adopts a "matching" procedure. (17) Using this empirical methodology, which is widely recognized as a primary way to address selection issues, (18) the long-term financial performance of firms targeted by hedge funds is compared to the long-term performance of a set of "control" firms. (19) These firms are "matched" (i.e., selected) because they share essential characteristics with the targets in the period before the start of the activist hedge fund campaign, but they have not (yet) been targeted by activist hedge funds. (20) Using matching, the CGSW study finds that firms targeted by activist hedge funds saw smaller gains in value in the years...

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