Hedge fund activism is the latest rave in corporate governance. Activist hedge funds build stakes in target firms in order to press management for various changes. When managers are uncooperative, they may just be forced to step down. Lest you think only managers of small, not well-established firms have reason to fear, some of the most powerful managers in corporate America, for example the CEOs of Bob Evans, Hertz, Sotheby’s, Yahoo, etc., have all failed to avoid such fate. It appears that no firm is immune to the threat of HFA.
Managers, needless to say, have great incentive to avoid being targeted. Academic research on hedge fund activism, however, has overwhelmingly focused on the impact of actual interventions on target firms. For example, studies have shown that firms that undergo hedge fund intervention increase payout to shareholders and improve operating as well as stock performance. These studies potentially miss a significant part of the overall impact of hedge fund activism on the corporate world, as it is becoming increasingly clear that the mere threat of HFA, even if intervention never actually materializes, is sufficient to spur managers to action. For example, JP Morgan advises that “offense is the best defense” when it comes to dealing with potential activist hedge funds. Similarly, prominent corporate advisor Martin Lipton recommends advance preparation, including the creation of a team specifically to deal with hedge fund activism and proactively addressing shortfalls versus peer companies. It appears that managers are on the lookout for activist hedge funds and proactively seeking ways to dissuade engagement. Such anecdotal observations and research studies all paint hedge fund activism as a governance-enhancing mechanism—for target and non-target firms alike. The picture, however, may be missing a critical piece.
However unique the set of actions different managers take to avert intervention, the ultimate goal is to boost stock price. By wiping out the potential gains from intervention, which come from stock price appreciation, this is the most effective way to reduce the threat of hedge fund activism. Managerial efforts toward this end obviously benefit shareholders. But what about firms’ other stakeholders—how are they impacted when managers are under hedge fund activism threat? Despite the growing attention surrounding hedge fund activism, the research literature has been silent on this issue.
The objective of our recent study is precisely to investigate what happens to bondholders when caught in the crossfire between managers and activist hedge funds. Specifically, we want to know whether managerial actions to boost equity value in effort to avert hedge fund intervention involve compromising the interest of bondholders. The answer to this question would bring new and important insight into our understanding of hedge fund activism as a mechanism for corporate governance.
To carry out our investigation, we use a comprehensive sample of hedge fund activism events from 1994 to 2011 to help us determine the degree of firms’ exposure to HFA threat. We find that firms with greater (relative to those with less) ex-ante exposure to intervention threat experience higher bond yields, greater default probability, and worse bond and overall firm ratings, after their industries are hit with an abnormal degree of intervention activity. These can be explained by the tendency of such firms to increase leverage through share repurchases funded by using up cash reserves and selling assets. While these policy changes tend to be viewed as in governance-improving directions and therefore lead to positive stock market reactions, they could potentially jeopardize bondholders’ interests in the event of bankruptcy and therefore induce negative credit market reactions.
Furthermore, we find that when initiating loans, firms under HFA threat receive higher loan spreads and a greater number of restrictive covenants. In particular, they are restricted in the distribution of dividends to shareholders. Altogether, the evidence confirms our suspicion that managers under HFA threat might be tempted to transfer wealth from bondholders to shareholders in effort to avoid being targeted. Potential creditors, privy to such possibility, take additional measures to protect their interests when extending new loans to firms under HFA threat.
Finally, we find that the transfer of wealth from bondholders to shareholders is more serious in poorly governed firms, in firms that experience greater improvement to equity value, in years with more industry-wide interventions, and in years when a greater proportion of the industry-wide interventions are more hostile in nature, meaning the activist hedge funds deploy more aggressive engagement tactics. These results suggest that the extent to which the manager-bondholder agency problem is permitted to exist in the firm affects the degree to which bondholders’ interest is sacrificed when managers face intervention threat.
The debate over whether hedge fund activism is beneficial or harmful for the corporate world will only intensify as firms continue to be targeted for intervention and succumb to the wishes of activist hedge funds. The role of hedge fund activism as a valuable means of corporate governance is the primary argument against the call for increased regulation of the hedge fund industry. Before passing judgment on the issue, it is necessary to get as complete a picture of the impact of hedge fund activism as possible. Our evidence suggests that HFA affects even non-target firms, in such a way that benefits shareholders but hurts bondholders. Managers’ strategy in warding off potential interventions at least in part involves improving equity performance by appropriating wealth from bondholders.
The preceding post comes to us from Felix Zhiyu Feng, Assistant Professor of Economics and Assistant Professor of Finance (by courtesy) at the University of Notre Dame; Qiping Xu, Assistant Professor of Finance at the University of Notre Dame; and Heqing Zhu, Assistant Professor of Finance at the University of Oklahoma. The post is based on their paper, which is entitled “Caught in the Cross-Fire: Creditor Reaction to the Threat of Hedge Fund Activism” and available here.