PRICE PRESSURE OF TRADING AND EQUITY PRICES IN HEDGE FUND ACTIVISM

• Date: 01 March 2020
• Published date: 01 March 2020
• Author: Atanas Mihov
• DOI: http://doi.org/10.1111/jfir.12203

The Journal of Financial Research Vol. XLIII, No. 1 Pages 153–184 Spring 2020

DOI: 10.1111/jfir.12203

PRICE PRESSURE OF TRADING AND EQUITY PRICES IN HEDGE FUND

ACTIVISM

Atanas Mihov

The Federal Reserve Bank of Richmond

Abstract

In this article, I offer and examine a price pressure hypothesis, which states that stock

prices of activism targets temporarily deviate from fundamentals. Increased demand

for target stocks upon the formation of activist positions exerts upward pressure on

targets’stock prices in the short term. Such effects are driven by illiquid stocks

whose prices are sensitive to order‐flow imbalances. When activists use private

transactions, price pressure effects are muted. As buying pressure subsides and

reverses over the long run, targets’stock prices decline proportionately to

predisclosure accumulations, driven again by illiquid stocks. These price dynamics

have important implications for activists’block‐formation strategies and, more

generally, shareholder activism.

JEL Classification: G12, G23

I. Introduction

Over the past couple of decades, hedge funds have established themselves as a new

breed of shareholder activists equipped with suitable financial incentives and

organizational structures for pursuing activist agendas. Activism has emerged as a

new corporate governance mechanism that brings about operational, financial, and

governance reforms in corporate businesses. Research has largely concurred that

hedge‐fund activists create value for the target firms’shareholders and their own

investors, as evidenced by the positive short‐and long‐term returns around and after

the announcement of activism (Brav et al. 2008; Klein and Zur 2009).

The traditional view of returns to activism suggests that the activism

announcement premium reflects the value of proposed changes adjusted for the

probability of activism success (Brav et al. 2008; Greenwood and Schor 2009). In the

longer term, target firm value might react to the failure of activist agendas.

Alternatively, activism can create value through improving the company as a going

The author thanks Dominique Badoer, Alon Brav, Nicole Boyson, Mark Flannery, Joel Houston, Yvonne

Kreis, Leming Lin, Ani Manakyan, Robert Mooradian, Andy Naranjo, Nimal Nimalendran, Jay Ritter, Raluca

Roman, Michael Ryngaert, Matt Souther, and Mihail Velikov for helpful comments and suggestions. The author

additionally thanks Alon Brav for providing data. Jeffrey Cheng, Martin Debresu, and Cooper Killen provided

excellent research assistance. A significant portion of this research was conducted while the author was with the

Department of Finance, Insurance, and Real Estate at the University of Florida. The views expressed in this

paper do not necessarily reflect those of the Federal Reserve Bank of Richmond or the Federal Reserve System.

All mistakes are those of the author alone.

153

© 2019 The Southern Finance Association and the Southwestern Finance Association

concern by instituting changes in management or by inducing management to institute

operational, financial, or governance reforms (Brav, Jiang, and Kim 2015; Clifford

2008; Klein and Zur 2009).

A concurrent channel that has remained largely unexamined is that activism

targets’prices also reflect price pressures associated with hedge‐fund trading. Activist

investors usually build big positions quickly, which entails shifts in the demand for

target companies’stocks. These demand shifts are potentially strong enough to affect

stock prices if the demand and supply curves of stocks are not perfectly elastic. This

leads to a positive relation between hedge funds’buys and predisclosure stock returns.

The run‐ups, however, are expected to be transient and reverse in the future as buying

pressure subsides and demand shifts reverse upon hedge‐fund exits. I refer to these

price dynamics as the price pressure or trading hypothesis.

A priori, it is unclear whether hedge‐fund trading significantly affects the

prices of target companies. Anecdotal evidence suggests that activists have been able to

avoid detection and quickly take big stakes in targets without tipping off management

or other market participants.

1

Furthermore, recent studies show that hedge funds take

into account and strategically try to minimize the expected price effects of their trading.

Norli, Ostergaard, and Schindele (2015) and Mihov (2016) find that stock liquidity

increases the probability of activism and that activists accumulate more ownership in

firms with liquid stock. Gantchev and Jotikasthira (2018) provide evidence that

institutional selling of stocks raises firms’probabilities of becoming activist targets by

providing camouflage for the activists’ownership block formations. More generally,

Collin‐Dufresne and Fos (2015) show that activists choose to trade during times of

higher liquidity.

2

Altogether, this research suggests that hedge funds strategically

choose targets and exploit variations in their stock liquidity, which could substantially

diminish and potentially eliminate price effects associated with activists’trading.

I test the trading pressure hypothesis in this article. My analysis rests on a

reporting rule enforced by the U.S. Securities and Exchange Commission (SEC).

Section 13D of the 1934 Securities Exchange Act requires beneficial owners of more

than 5% of any class of a company’s traded securities, who have an interest in

influencing the management of the company, to disclose their ownership and intent.

Investors have to comply within 10 days of crossing the 5% threshold.

3

An activist

hedge fund can thus accumulate shares unperturbed only before reaching this

threshold. Upon reaching it, the fund has a short period, 10 days, to acquire additional

shares to reach an optimal position before it publicly discloses activism through a

Schedule 13D filing with the SEC (at which point the target stock price corrects to

1

See Andrew Ross Sorkin, “For Activist Investors, a Wide Reporting Window,”New York Times (May 19,

2014), https://www.cnbc.com/2014/05/20/for‐activist‐investors‐a‐wide‐reporting‐window.html.

2

This evidence is consistent with the predictions of Maug (1998) and Kahn and Winton (1998) that

liquidity facilitates interventions in which the shareholder activists can hide their trades and profit from informed

trading by transacting in shares at prices that do not yet incorporate the future increase in company value created

by their privately known actions.

3

Large passive investors qualify to file the more abbreviated and less burdensome Schedule 13G that grants

a longer period to disclose ownership.

154 The Journal of Financial Research

reflect market expectations of the improvements in value from the hedge‐fund

intervention). Because a fund has only a limited time to build an optimal ownership

position before disclosure, its ability to exploit variations in stock liquidity over time or

spread trades over longer time horizons is constrained. The hedge fund’s demand for

the target’s stock and the associated acquisition activity should thus put upward

pressure on prices before disclosure, which should subsequently reverse over the

longer term as demand subsides and activists exit.

I hand collect a comprehensive sample of activist hedge‐fund trades in the

periods leading up to Schedule 13D filings. Using data from 1994 to 2006, I document

strong empirical associations between activists’stock acquisitions, measured as a

percentage of shares outstanding, and activism target companies’stock returns. I first

show that target companies that experience heavier predisclosure acquisition volumes

by hedge funds also experience higher stock price appreciations in the cross‐section of

activism campaigns. A one‐standard‐deviation increase in the percentage of shares

purchased during the [−10,−1] trading‐day period relative to Schedule 13D filing is

associated with a 1.8%–2.2% positive return of the activism target firm over the same

period. I then show that the postdisclosure stock price returns of targets in campaigns

with larger predisclosure accumulations significantly underperform the postdisclosure

stock price of targets in campaigns with smaller predisclosure accumulations.

Consistent with a trading pressure explanation, the target price run‐ups associated

with hedge funds’predisclosure buying activity fully reverse after activism disclosure.

4

A natural extension of the trading pressure hypothesis is that the price effects

of hedge‐fund trading should be more pronounced for illiquid companies with inelastic

demand curves and a high price impact of trading. I test this proposition and find in a

second set of results that targets’stock liquidity affects the link between hedge‐fund

acquisition intensity and target stocks’price dynamics. Consistent with a price pressure

channel, the relative stock price run‐ups before disclosure and return underperformance

after disclosure are driven by illiquid target companies whose prices are sensitive to

order‐flow imbalances.

Finally, I show that the venue where hedge funds acquire shares matters for the

price impact of predisclosure accumulations. I provide evidence that when hedge funds

build ownership through private (as opposed to open‐market) transactions, the price

impact of their acquisitions is muted. Furthermore, the size of predisclosure

acquisitions through private (vis‐à‐vis open‐market) transactions is subsequently not

associated with significant long‐term stock performance effects after activism

disclosure. This last set of results not only is interesting from a strategic perspective

regarding activism block formation but also constitutes an implicit falsification test, as

private transactions are often intended and designed to minimize price impact.

4

Although my results on predisclosure target stock price appreciations support a price pressure hypothesis,

they are also consistent with adverse selection models of the price effects of informed trading (e.g., Kyle 1985).

According to these models, however, the predisclosure price increases are permanent and should not reverse over

time. My results on the price performance of activism targets after activism disclosure are thus important to

differentiate between Kyle (1985) and my proposed trading pressure channel.

155Price Pressure of Trading and Equity Prices