Hedge Fund Activism Shows Firms a Better Path
Hedge funds are like the new sheriffs in town in terms of corporate governance. The rise of shareholder activism is apparent from concerns about Apple's cash hoard and teens' smartphone overuse to railroad company CSX being "required" to make a leadership change. New insights are revealed in a study about the mergers and acquisitions strategy of firms that are targeted by shareholder activists. Finance Professor Nickolay Gantchev of SMU Cox and co-authors show that activism deters empire-building acquisitions of targeted firms, an often value-destructive force in public companies.
The growing influence of activists in global capital markets has prompted financial economists to research the drivers of shareholder activism and its role in shaping financial strategy and outcomes. From the end of 2009 to the beginning of 2015, 15% of the firms in the S&P 500 index encountered an activist campaign. Around 50% of S&P 500 firms had an activist on their share register over the same period. The activist trend has been so pervasive that corporate governance experts have suggested: “No recent development has influenced firms’ strategic and financial decision-making as profoundly as the surge in the shareholder activism following the global financial crisis.”
"In terms of governance, mutual funds, pension funds and unions have ceded their role in actively monitoring firms to hedge funds," notes Gantchev. Hedge funds, now leading the charge often with activist campaigns, typically own 5-10% of the listed company, their target. "Hedge funds achieve better outcomes and improve the firms they target," says Gantchev. "They are less constrained as investors, have fewer conflicts of interest, and better incentives to improve the firm's performance."
Empire-building firms are natural targets for activists, according to Gantchev. "Activism and mergers and acquisition (M&A) activity are intertwined," Gantchev observes. "The M&A strategy of a firm is one of the reasons why they get targeted in the first place. If a company has had low returns from past acquisitions or a high number of recent acquisitions, it is more likely to be targeted by activists." This visible, public aspect of the company reveals how management performs and is taken into account by activists.
Activist investors target firms that overinvest in unproductive acquisitions, the authors observe. They studied activist campaigns from 1994-2011 and merger data from 1990 - 2015. They found that some of the targeted firms become merger targets themselves. However those remaining independent exhibit a more disciplined M&A strategy following activism. The study shows that an activism target is about 15% less likely to engage in a takeover in the three-to-four years after activism. This lower M&A likelihood is observed especially in cash bids. Gantchev and co-authors say this is consistent with prior research findings: activists frequently demand a reduction in excess cash and an increase in leverage (debt) at their targets, which limits their availability of capital to pursue acquisitions.
Importantly, activists also influence the quality of the deals undertaken. Compared to firms without activist involvement, recent activist targets receive higher announcement returns from the fewer acquisition bids they make after activism. Specifically, these acquirers have three-day announcement returns that are 1.4% higher, compared to firms that are not activist targets. Their deals also outperform acquisitions by non-targeted firms by 11% over the two years after the announcement, even though they do not pay less for their targets.
"The market believes this [activity by activists] is value increasing," Gantchev surmises. "Investors think these acquisitions are better because of the prior engagement of an activist." The result of better performance years later confirms this positive role of activists.
Activists affect the M&A strategy of their targets, resulting in more disciplined capital policies from their campaigns. Gantchev concludes: "Firms with activist influence tend to buy better firms in the future. Put differently, once a firm is targeted by an activist, it tends to have a better M&A strategy."
The study's results suggest that activists perform an important governance role in the market by disciplining inefficient acquirers. Hedge fund activism lowers the value destruction associated with empire building, and ultimately adds more lasting value for shareholders.
The paper "Do Activists Turn Bad Bidders into Good Acquirers?" is authored by Nickolay Gantchev, Southern Methodist University, Cox School of Business; Merih Sevilir, Indiana University, Kelley School of Business; and Anil Shivdasani, University of North Carolina, Kenan-Flagler Business School.
Written by Jennifer Warren.