External monitoring and returns to hedge fund activist campaigns

• Date: 01 January 2020
• DOI: http://doi.org/10.1002/rfe.1071
• Author: Matthew E. Souther,Ryan Flugum
• Published date: 01 January 2020

Rev Financ Econ. 2020;38:97–140. wileyonlinelibrary.com/journal/rfe

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© 2019 University of New Orleans

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INTRODUCTION

External monitoring of the firm has long been framed as an effective mechanism to reduce agency conflicts and ultimately

increase firm value (see, e.g., Jensen and Meckling (1976)). These external monitors, typically institutional investors or stock

analysts, observe firm management and intervene when the manager is acting suboptimally.1

The consequences of these inter-

ventions is broad with prior studies producing strong empirical evidence that greater levels of analyst coverage and institutional

ownership are correlated with better corporate governance, reduced agency conflicts, and better stock performance.2

More recently, hedge fund activists have become involved in monitoring firm management, aggressively seeking opportuni-

ties to increase firm value. The activist targets a firm by taking a large ownership stake; they then typically proceed by electing

new firm leadership or influencing incumbent management to reorganize some aspect of firm o

perations. The activist, and more directly, existing shareholders will only benefit from this intervention and reorganization if

the end result is an increase in firm value. Furthermore, existing literature would suggest that opportunities to create substantial

increases in firm value are present primarily among firms having inadequate monitoring, due to either an absence of traditional

Received: 15 February 2019

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Revised: 4 June 2019

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Accepted: 18 June 2019

DOI: 10.1002/rfe.1071

ORIGINAL ARTICLE

External monitoring and returns to hedge fund activist

campaigns*

RyanFlugum1

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Matthew E.Souther2

*Ryan Flugum is from the Department of Finance, College of Business Administration, University of Northern Iowa, CBB 303, Cedar Falls, IA 50614;

email: ryan.flugum@uni.edu; tel: (319) 273–2976. Matthew Souther is from the Department of Finance, Darla Moore School of Business, University of

South Carolina, Office 456I, Columbia, SC 29208; email: matthew.souther@moore.sc.edu; tel: (803) 777–4929. We greatly appreciate the comments from

Debarati Bhattacharya, Matthew Glendening, Rachel Gordon, Joel Harper, John S. Howe, Timothy Kruse, Risa Kumazawa, Erik Lie, Michael O’Doherty,

Gokhan Sonaer, Adam Yore, and Brian Walkup. We also thank seminar participants at the University of Missouri, the University of Tulsa, Duquesne

University, the University of Northern Iowa, the 2017 Midwest Finance Association Conference, and the 2017 Financial Management Association

Conference.

1College of Business Administration,The

University of Northern Iowa, Cedar Falls,

Iowa

2Darla Moore School of Business,

University of South Carolina, Columbia,

South Carolina

Correspondence

Ryan Flugum, College of Business

Administration, The University of Northern

Iowa, Cedar Falls, Iowa, USA.

Email: ryan.flugum@uni.edu

Abstract

Firms targeted by hedge fund activists experience significantly higher returns when

there are fewer external monitors in place at the target firm. Using analyst coverage

and institutional ownership as measures of external monitoring presence, we find

that low‐monitored activist targets experience abnormal returns 17.52% above that

of high‐monitored targets in the 2‐year period following the initial campaign start

date. The significant effect of external monitoring remains after controlling for target

firm and activist characteristics. We also document improved operating performance

and an increased monitoring presence at low‐monitored target firms across the same

2‐year period, consistent with the observed market performance.

KEYWORDS

Hedge fund activism, analyst coverage, institutional ownership

JEL CLASSIFICATION

G3; G23; G34

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FLUGUM and SOUTHER

monitors (i.e., analysts or institutions) or limited focus from these investors. For example, Kempf, Manconi, and Spalt (2017)

show that periods of distraction among the institutional owners of a firm precede periods of poor stock performance. Their

study suggests that monitoring influences the stock performance of firms. Consequently, as it pertains to our study, hedge fund

activism may be a more effective mechanism for increasing firm value when there is an inadequate monitoring presence.

External monitors may be instrumental in the process by which hedge fund activists seek to increase firm value. External

monitors can be an influential advocate for the activist throughout a campaign. For example, Chung and Teo (2012) and

Klein et al. (2014) find evidence that analysts provide favorable recommendations to firms bought and sold by hedge funds in

general. Moreover, a common strategy used by hedge fund activists is the threat or initiation of a proxy contest. Not only does

Fos (2016) find these proxy contests to generate short‐ and long‐term abnormal returns, these contests are more likely to involve

firms having high institutional ownership—a consequence of the shareholder support that is needed for a successful outcome.

Consistent with this notion, Appel, Gormley, and Keim (2018) and He & Li (2018) both find evidence suggesting that active

and passive institutional owners support hedge fund activists, ultimately increasing the likelihood that the activist will achieve

their campaign objectives. Additionally, the hedge fund activist literature frequently cites high institutional ownership as a key

characteristic for predicting which firms will eventually become subject to a hedge fund activist campaign (Brav et al., 2008;

Gantchev & Jotikasthira, 2017). In many cases, hedge fund activists use both existing and potential institutional shareholders

to form “wolf packs” that collectively support the efforts of the hedge fund activist (Coffee & Palia 2016; Wong 2016; He &

Li, 2018; Becht et al., 2017).

The evidence supporting the view that analysts and institutions are effective monitors having a preference for well‐governed

firms suggests that, in some cases, hedge fund activism may not be an effective tool to add substantial value for existing share-

holders. If hedge fund activism is a substitute for traditional monitoring or if existing external monitors simply prefer firms that

are already well governed, then shareholders of firms having fewer external monitors in place will benefit more from a hedge

fund activist campaign. Our study investigates this natural link between the existing monitoring presence and the subsequent

benefits to shareholders from hedge fund activist campaigns. Specifically, we determine whether a firm’s level of analyst

coverage and institutional ownership are useful proxies for assessing how beneficial hedge fund activism will be for existing

shareholders, in the form of improved stock performance and firm operations.

Using a sample of hedge fund activist campaigns occurring during the years 2001–2014, we find that hedge fund activist

campaigns involving firms (henceforth referred to as “targets”) having fewer external monitors in place experience greater im-

provement to stock and operating performance. Our findings are persistent when considering the target’s size‐adjusted analyst

coverage and institutional ownership as measures of external monitoring activity. Additionally, we construct a “monitoring

index” that considers the target’s size‐adjusted levels of analyst coverage and institutional ownership jointly.

Conditional on the target firm’s degree of external monitoring presence at the hedge fund activist target date, we find sub-

stantial heterogeneity in the market‐adjusted buy‐and‐hold abnormal returns (BHARs) that are generated over the course of

the activist’s campaign. In particular, there is an economically and statistically significant spread between the average BHARs

of portfolios formed on the basis of the target’s degree of size‐adjusted external monitoring presence. Over the days t−10 to

t+25 (t the start date of the activist campaign), we find that firms with low analyst coverage earn short‐term BHARs that are

1.19% higher than firms with high analyst coverage, on average. Similarly, when comparing target firms with the lowest level

of institutional ownership to those with the highest, the spread in short‐term BHARs is an economically and statistically signif-

icant 4.08%, on average. Using our monitoring index, BHARs are 2.22% higher for low versus high monitoring index portfolios.

While we find significant differences in short‐term returns, the effects of external monitoring become more apparent in the

long term. Using returns occurring over the months t−1 to t+ 24, where t is the initial target month, the spread increases to

an economically and statistically significant 18.29%, 23.43%, and 17.52% for the analyst coverage, institutional ownership, and

monitoring index portfolios. The magnitude and significance of these return differences remain after controlling for a wide

range of firm and hedge fund activist campaign characteristics in a multivariate setting.

Alternative channels through which we can observe the benefits of hedge fund activism are by improvements in the fun-

damentals and corporate governance of the firm. Prior research suggests that existing monitors will improve the operating

efficiency of the firm (Chen, Harford, & Lin, 2015; Harford et al., 2018; Appel, Gormley, & Keim, 2016). Therefore, we con-

jecture that the same relation between the ex ante external monitoring presence of a firm and subsequent stock performance is

present when we consider changes in fundamentals. That is, the degree of improvement in a target firm’s operating efficiency

and firm value over the course of a hedge fund activism campaign is decreasing in the level of external monitors in place. We

indeed find that this is the case. For example, the average change in return on assets (ROA) within our high monitoring portfo-

lio from the year before the activist’s arrival to the year after is an economically and statistically significant 2.40% lower than

the corresponding change in ROA within the low monitoring index portfolio. We find similar economically and statistically

significant differences among our high and low monitoring index portfolios when we consider changes in cash flow to total

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assets and Tobin’s q. Moreover, these effects are robust to the consideration of various firm‐specific and hedge fund activist

campaign characteristics.

Shareholders can also benefit from hedge fund activism through improvements to the governance of the firm. We identify

improvements in corporate governance by analyzing quarterly changes in the monitoring base of our target firms. A hedge

fund activist’s arrival draws the attention of many market participants since their arrival signals potential value that the market

has yet to realize. Consequently, we expect increases in target firm institutional ownership and analyst coverage, especially for

target firms with low ex ante monitoring levels. Our results confirm this hypothesis. We find the greatest improvements in mon-

itoring take place among targets in our low monitoring index portfolio. We find these improvements primarily with increases

in institutional ownership. Compared to the quarter before the activist’s arrival, low monitored targets experience increases in

institutional ownership ranging from 1% to 2% in the following four quarters, on average. Conversely, high monitored targets

experience decreases in institutional ownership and analyst coverage ranging from 3% to 16% over the following four quarters.

These effects are statistically significant and are evident across both univariate and multivariate settings.3

To further support our results, we complete three robustness tests. First, using a buy‐and‐hold approach with the market

return as a benchmark is limiting in the sense that we do not account for firm characteristics that have been shown in the asset

pricing literature to explain variations in returns. Therefore, we consider a cumulative abnormal return (CAR) approach using

four different asset pricing models: The Fama–French three‐factor model, the Carhart four‐factor model, a four‐factor liquidity

model consisting of the Fama–French three factors combined with the Pastor and Stambaugh liquidity factor, and the Fama–

French five‐factor model (Fama & French, 1996; Carhart, 1997; Pástor & Stambaugh 2003; Fama & French, 2015). For each

firm, we estimate a factor model over a precampaign window and use the estimated factor loadings to determine the abnormal

returns that are generated over the campaign. Our results are robust to this approach with the low monitoring index firms gen-

erating higher CARs than the high monitoring index firms over the long‐term windows we consider.

Second, we construct a propensity score matching sample and adopt a difference‐in‐difference approach as an alternative

way to address the endogeneity concerns of our findings. Although we rely on a comprehensive set of controls throughout our

multivariate tests, unobservable characteristics among firms in the low monitoring portfolio may be causing their superior per-

formance rather than the efforts of the activist. We therefore identify a matching firm for each target, requiring the match not

only share a similar degree of target probability (i.e., closest propensity score) but also be in the same industry and have similar

levels of analyst coverage and institutional ownership as their respective target.4

We then compare the BHAR of our target

firms to the BHAR of their respective matches. We find only firms in the low monitoring portfolio have statistically significant

outperformance from their matches at monthly horizons reaching 12months following the activist’s arrival. More importantly,

the difference in the outperformance of firms in the low monitoring portfolio compared to their high monitoring counterparts

is positive and statistically significant through the 6 months following the start of the campaign.

Our third robustness test considers the possibility that hedge fund activists find it easier to market a target firm for potential

acquisition if the firm has a lower external monitoring presence. Such a result would be consistent with Greenwood and Schor

(2009) and Boyson, Gantchev, and Shivdasani (2017), who find that a majority of the short‐ and long‐term BHARs generated

by hedge fund activists are driven by those firms that are acquired in the 18months following the initial 13D filing month.

However, when we exclude the target firms that are acquired in our sample, we continue to find that a lower ex ante external

monitoring presence leads to higher BHARs both in the short‐term and long‐term horizon.5

We make two primary contributions to the hedge fund activist literature. First, we show that a firm’s existing external

monitoring presence, as measured by the level of analyst coverage and institutional ownership, is significantly related to the

abnormal returns and improvements in operating performance and corporate governance that are generated during an activist

campaign. Second, our findings suggest that the benefits which some firms experience from hedge fund activism are not en-

tirely unique from the effects of traditional external monitoring by institutional owners and analysts. That is, from the perspec-

tive of existing shareholders of firms already having a strong external monitoring presence, hedge fund activism acts more as a

substitute than a value‐adding endeavor.6

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DATA

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Activist sample

We construct our sample of hedge fund activist campaigns using the Audit Analytics (AA) and SharkRepellent databases. Each

database has unique attributes that, when combined, give us a comprehensive hedge fund activist sample. Although AA con-

tains only Form 13D and 13D/A filings with the SEC, SharkRepellent collects activist campaign information using a broader