The Spillover Benefits of Hedge Fund Activism

(November 21, 2013) — Hedge fund activism—as a “monitoring mechanism”—had an extensive influence over corporate governance, returns, and policy beyond the firms being targeted, according to a study.

“This suggests that activist targeting has positive externalities on the industry rivals of targeted firms—suggesting previous studies may have underestimated the positive impact of activism,” Nickolay Gantchev, one of the study's authors, told aiCIO.

The authors of “Governance under the Gun: Spillover Effects of Hedge Fund Activism,” explored through an empirical study whether other firms in a targeted industry are affected by activists’ campaigns. The result? The “threat” of activist targeting not only existed industry-wide but also had a “disciplinary effect” on peer firms, according to Gantchev, Oleg Gredil, and Pab Jotikasthira of the University of North Carolina at Chapel Hill.

Activism threat, measured by the number of campaigns that occurred in the previous year in a single industry, has stirred “positive abnormal returns” in targeted firms as well as industry rivals, the study found. This phenomenon, measured in stock prices, could imply the market’s anticipation of improved valuations for firms in the same industry. 

This positive performance then translated into corporate policy and governance changes including increases in leverage and payout; declines in capital expenditures; and improvements in asset utilization, the authors found. Valuation gains tended to occur within two years of the “threat.”

The study also concluded the overarching effect of shareholder activism extended so far as to reduce a firm’s ex-post probability of becoming a target—an occurrence dubbed the “feedback effect.” Peer and rival firms preemptively make necessary governance and policy changes based on targeted companies, thereby making activists’ interventions unnecessary and more costly. 

“The effect of activism threat is very significant even after controlling for many firm characteristics that have previously been shown to affect targeting," Gantchev said. "Small undervalued firms with high institutional ownership and better than average liquidity," in particular, tend to attract hedge fund interest.

However, these preparations might not completely prevent future targeting, the authors said. A positive correlation existed between past activist campaigns and instances of future targeting within the same industry.

“As activists gain experience and confidence in an industry, managers of firms expect an increase in the probability that their firms will be targeted,” the report said. “Direct involvement with an individual target allows an activist to acquire experience in dealing with a specific type of problem or gain knowledge about common forces within the target’s industry."

The trend held particularly true for hedge fund activism, according to the study, which tends to lower CEO pay and while increasing CEO turnover at targeted firms.

CEO turnover was the goal of a recent campaign by Third Point founder Dan Loeb against auction house Sotheby’s. In a harshly-worded letter to its Chairman, President, and CEO, William Ruprecht, Loeb called publicly for his resignation.

Third Point is the company's largest shareholder with 9.3% of the outstanding shares. Loeb's letter claimed that the executive office needed new blood due to Sotheby's weak operating margins and a declining ability to withstand competition with rival house Christie's.

“We see little evidence justifying your 2012 total compensation of $6,300,399,” Loeb wrote. “Sotheby’s requires a CEO with sufficient knowledge of the global art markets to make critical decisions, who can move seamlessly around the globe building the business and strengthening client relationships. Respectfully, we do not see evidence that you are the right person to repair the Company and drive its growth in today’s dynamic global art market.”

Loeb is said to have already started the search for a new CEO.

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