Influencing Control: Jawboning in Risk Arbitrage

• DOI: http://doi.org/10.1111/jofi.12721
• Author: WEI JIANG,TAO LI,DANQING MEI
• Date: 01 December 2018
• Published date: 01 December 2018

THE JOURNAL OF FINANCE •VOL. LXXIII, NO. 6 •DECEMBER 2018

Influencing Control: Jawboning in Risk Arbitrage

WEI JIANG, TAO LI, and DANQING MEI∗

ABSTRACT

In an “activist risk arbitrage,” a shareholder attempts to improve terms of an an-

nounced M&A through public campaigns. Activists target deals with low premiums

and those susceptible to managerial conflicts of interest, including going-private deals

and deals in which CEOs receive outsized payments. Activist arbitrageurs are asso-

ciated with a significant decrease in the probability that targets will be sold to the

announced bidders, and an increase in the premium paid, both ex post among sur-

viving deals and ex ante among all deals. Activist arbitrage serves as a governance

mechanism in M&A and earns higher returns than passive arbitrage.

INAN“ACTIVIST RISK ARBITRAGE,” A SHAREHOLDER who often acquires a significant

stake in a target company after an announced takeover attempts to block

the announced deal under its current terms. The dissident shareholder

threatens to vote against the deal and conducts public campaigns designed

to persuade other shareholders to do the same unless the target company’s

management team is able to improve the deal premium. In the presence of

such activists, deals are more likely to fail, but the average premium paid is

higher even taking incremental deal failure into account. This strategy, as

its name suggests, combines shareholder activism with a more traditional,

“passive” risk arbitrage approach. In particular, it serves both as a governance

remedy for shareholders who deem announced merger and acquisition (M&A)

∗Wei Jiang and Danqing Mei are at Columbia Business School. Tao Li is at the Warring-

ton College of Business, University of Florida. The authors have benefited from comments and

suggestions from two anonymous referees, the Editor (Michael Roberts), and an Associate Edi-

tor and from discussions with Patrick Bolton, Laura Field, Nick Gantchev, Oleg Gredil, Michael

Hertzel, Edith Hotchkiss, Yeejin Jang, Alexander Ljungqvist, Vladimir Mukharlyamov, Thomas

Noe, Pedro Saffi, Karin Thorburn, and Ralph Walkling. Participants at the following seminars

and conferences contributed valuable insights: Cambridge University, Columbia University, Fu-

dan University,Harvard University, PBC Tsinghua, the Swiss Finance Institute, the University of

Reading, the University of Washington, UT Austin, USC, Yale University, Goldman Sachs Asset

Management, PanAgora Asset Management, the AFA, the Utah Winter Finance Conference, the

Jackson Hole Finance Conference, the Academic Conference on Corporate Governance at Drexel

University,the Conference on Future Directions in Hedge Fund Research at the University of San

Diego, the SFS Cavalcade, the Consortium on Activist Investors, Corporate Governance and Hedge

Funds at Imperial College, the EFA, the FIRS, the ABFER, the NFA, the ECCCS Workshop on

Governance and Control, the FMA Europe, and the IFABS Oxford Conference. We thank Artem

Katilov, Klimenti Katilov, Yiting Xu, and Ying Zhu for excellent research assistance. The authors

do not have any potential conflicts of interest to disclose, as identified in the Journal of Finance’s

disclosure policy.

DOI: 10.1111/jofi.12721

2635

2636 The Journal of Finance R

deals approved by management/boards as inadequate, and as an investment

strategy for specialized investors, especially hedge funds.

Activist risk arbitrage is a relatively new and understudied form of share-

holder activism. While activist arbitrageurs were virtually nonexistent prior to

2000, they challenged about 10% of the proposed M&A deals in the mid-2000s,

with the rate stabilizing to about 5% toward the end of our sample period.

In general, institutional investor activism seeks to influence corporate policies

to bring about operational, financial, and governance improvements, but does

not aim for control (Brav et al. (2008a)). However, when an investor launches

an activism campaign in an attempt to change the course of an M&A deal in

process, the investor is trying to exert control. In this paper, we use a compre-

hensive sample of 277 activist arbitrage events among over 3,000 M&A deals

from 2000 to 2015 to study the determinants, motives, and consequences of

this new form of activism, and to analyze its interaction with the market for

corporate control.

Activist arbitrageurs choose their targets strategically. The probability of ac-

tivist involvement increases 3.2 percentage points (relative to the unconditional

probability of 6%) with every 1 standard deviation decrease in announcement

premium, controlling for deal characteristics. This result is consistent with the

commonly declared motive for dissent, namely, inadequate payment. Activists

are significantly more likely to disturb otherwise “friendly” deals, especially

going-private deals in which management is part of or affiliated with the ac-

quirers (with an incremental 3.1 percentage point increase in the probability of

targeting). Presumably, the concern with such deals is that a company’s board

and management team, having endorsed favored acquirers, may have failed

to perform due diligence by extracting optimal terms from the acquirers or by

soliciting competing bids.

Further tests support the governance motive for activist targeting. First,

we show that the odds of activist targeting increase more than 60% when a

merger agreement offers special severance payments to the target’s top man-

agement team contingent on successful deal completion, as this creates a con-

flict of interest whereby top management benefits disproportionately from sell-

ing the company to a particular acquirer. M&A deals in which CEOs receive

“excessive” compensation, a common proxy for poor governance, are also as-

sociated with increased risk of activist intervention. These results suggest

that activist risk arbitrage is a potentially important governance mechanism

that can be used to protect investors’ interests in corporate control changes

susceptible to management self-dealing or other managerial conflicts of

interest.

Activists’ attempts to block a deal, or to pressure management into ex-

tracting higher prices from a current buyer or soliciting multiple bids, are

associated with outcomes consistent with their means and goals. We find

that when activists are involved, the probability of deal completion, that

is, of a target being sold to an announced bidder, is 5.8 percentage points

lower (significant at the 5% level) relative to the full-sample completion

rate of 83.3%. When we look into the “black box” of each failed deal using

Influencing Control: Jawboning in Risk Arbitrage 2637

information from corporate filings, press releases, and news searches, we find

that activists likely played a role in about two-thirds of the failed deals in

which they were present. This occurs, for example, when their negative votes

turn out to be pivotal or a firm is eventually sold to an activist-recommended

third party.

Because they tend to hold minority stakes (typically 5% to 10%), activists

need to influence and persuade fellow shareholders to achieve their goals.

Their tactics, such as press releases that criticize management/deals and proxy

solicitations that propose alternatives to current deals, share commonalities

with general activist strategies aimed at operational or governance changes.

Because an M&A deal needs a majority (or supermajority) shareholder

vote to be passed, activists’ relationship with proxy advisory firms such as

Institutional Shareholder Services (ISS) is of particular interest because the

latter exerts considerable influence on the voting behavior of their institutional

investor clients (Ertimur, Ferri, and Oesch (2013), Malenko and Shen (2016)).

We find that ISS virtually never issues a recommendation against a deal

unless there is public dissension by shareholders. Moreover, such negative

recommendations, which comprise 28% of ISS recommendations in our sample,

are invariably issued following activist announcements (with a median delay

of 48 days). A negative ISS recommendation is associated with a 21 percentage

point decrease in the probability of deal completion. Taken together, these

results suggest that ISS serves as an important proxy voting intermediary for

activism against an M&A deal.

Nevertheless, shareholders of target companies, including activists them-

selves, are better off following completed rather than failed deals because stock

prices often revert to preannouncement levels after a deal is called off. This

implies that, for the activist arbitrage strategy to be viable, incremental deal

failure needs to be more than offset by a positive premium revision in sur-

viving deals. It is thus good news, for outside shareholders, that the presence

of activists is associated with a premium revision of 3.4 percentage points

across all deals (including failed ones), or 4.3 percentage points conditional on

deal completion. Moreover, only minor delays (of about 10 to 14 days) occur in

activist-involved deals between the announcement date and deal completion.

It is also reassuring, for acquirers, that activism on the opposite side does not

leave acquirer shareholders worse off relative to similar deals in the M&A mar-

ket: average abnormal stock returns for acquirers are actually higher (albeit

insignificantly so) than matched deals during the period from just before deal

announcement to deal resolution.

In sum, activist arbitrageurs earn significant positive returns after adjusting

for common risk factors, and they earn overall higher average returns than

passive risk arbitrageurs, which compensates for “jaw pain” as well as for the

assumption of higher deal risk. The four-factor adjusted cumulative abnormal

returns (CARs) for activists amount to 4.9% to 5.4% per deal, compared to 2.2%

for passive arbitrageurs matched to the same time window. The calendar-time

portfolio approach yields a monthly four-factor alpha of 1.60% compared to

0.51% for the passive arbitrage strategy (the difference is significant at the 5%