Governance under the Gun: Spillover Effects of Hedge Fund Activism (Editor’s choice)
Nickolay Gantchev, Oleg R Gredil, Chotibhak Jotikasthira
Review of Finance, Volume 23, Issue 6, October 2019, Pages 1031–1068, https://doi.org/10.1093/rof/rfy035
The lead article in Volume 23, Issue 6 of the Review of Finance is Governance under the Gun: Spillover Effects of Hedge Fund Activism by Nickolay Gantchev, Oleg R Gredil, Chotibhak Jotikasthira.
Hedge fund activism has become pervasive in today’s corporate landscape. In response to activist demands, targeted firms have been shown to improve their performance and governance. These positive effects often come at the expense of managers and directors who see a drop in their compensation and a higher likelihood of being replaced. Ample anecdotes suggest that executives of yet-to-be-targeted firms feel threatened, and often seek the help of external advisers to monitor activism in their industry and perform “periodic fire drills” to address any potential vulnerabilities before an activist emerges.
Despite abundant anecdotes, it is challenging to formally establish that the threat of activism induces changes in the policies of non-targeted peers. In our new paper, we identify the effects of activism threat on the policies of non-targets by exploiting the interaction between two sources of variation – (i) an industry-level measure of activism Threat based on the amount of new capital available to activists to target firms in an industry, and (ii) a firm-level measure of Threat perception based on the connections of the firm’s directors to recent activism targets. Our assumption is that as activism intensity increases in an industry, firms whose directors perceive higher personal costs of dealing with activists are more likely to make preemptive improvements to avoid becoming the next target.
We find that an interquartile increase in activism Threat doubles the targeting frequency in an industry, and that in periods of high Threat, non-targets with high Threat perception undertake real policy changes that mirror those advocated by activists, such as increasing leverage, payout and return on assets, and decreasing capital expenditures and cash. The magnitude of these improvements is about one-third to two-thirds of those observed at activist targets, and most significant among firms that are vulnerable to activism. Our findings are not driven by product market effects, or more generally by common industry shocks.
Both the expectation and the realization of policy improvements are reflected in the threatened peers’ valuations – an interquartile increase in Threat raises firm valuation by approximately 2.4% over three years, about a third of what we observe at the targets following activism. Finally, we show that the policy improvements are effective at fending off activists. As Threat increases in an industry, firms generally experience an increased probability of being targeted but such effects are significantly mitigated among firms that proactively correct their policy shortcomings.
Our paper provides novel large-scale evidence of the disciplinary effects of activism threat, implying that the impact of shareholder activism reaches beyond the firms being directly targeted. Such positive externalities have been an important but missing ingredient in the hotly contested debate about whether hedge fund activism is good or bad for the economy. As shareholder activism has become one of the most salient forces influencing firms’ strategic and financial decisions, studying its spillover effects is critical to fully appreciating its overall societal impact