Investor activism is an important mechanism by which a company’s shareholders can affect corporate decisionmaking. To legally compel corporate managers to change policies, activist investors must engage in proxy fights during which they solicit support for their proposals from other shareholders. Proxy fights involve significant costs and therefore are infrequent: 91 percent of the activist campaigns in our sample do not involve proxy fights. Given the infrequency of proxy fights, a natural intuition would be that target managers rarely concede to activist demands. However, we show that activist campaigns without proxy fights are surprisingly effective. This leads to an important question: how do activist campaigns affect corporate policy despite the infrequency of observed proxy fights?

We argue campaigns by high reputation activists affect corporate policy by threatening, explicitly or implicitly, to initiate a proxy fight. Target managers settle with activists when the threat of a proxy fight is sufficiently credible, because proxy fights are costly to the firm and its managers. Rather than incur the costs of fighting, managers prefer to settle by increasing dividends, repurchasing shares, changing board composition, engaging in merger or acquisition activity, or enacting other changes to the firm’s operational, financial, or governance structure. This mechanism is summarized well by the following quote that describes the most hostile proxy contests during 2014:

What is also noteworthy about the 30 or so contests . . . is that with the exceptionof Trian, none of the biggest shareholder hedge fund activists . . . are involved. For the most part this is because companies settled quickly in the face of attacks by these giants. – New York Times DealBook 4/21/2015

For the threat of a proxy fight to be effective, target managers must believe the threat is credible, which we argue is related to the activist’s reputation in addition to simple observable characteristics like its size. We model reputation arising due to an information asymmetry in which managers do not know the activist’s costs associated with proxy fights (the activist’s “type”) and must infer it from observed behavior. We formally define reputation as the belief about an activist’s type conditional on previous interactions, as first suggested in Kreps and Wilson (1982) and Milgrom and Roberts (1982). The activist’s type encompasses the monetary costs, non-monetary costs such as effort, and any offsetting benefits such as enjoyment associated with proxy fights. Consistent with our model, prominent activists often make public statements advertising the low subjective costs of their proxy fights:

I enjoy the hunt much more than the “good life” after the victory. –Carl Icahn

We will pay any price, bear any burden, meet any hardship. –William Ackman, quoting John F. Kennedy when discussing a proxy fight with Target Corp.

In our model, an activist sequentially engages two management teams. In each engagement, the activist buys a portion of the target firm’s shares, and proposes a project that is potentially beneficial to shareholders but involves a private cost to the manager. The manager then decides whether to settle and incur the private cost to pursue the project, or refuse and risk provoking a proxy fight with the activist. Managers settle with high reputation activists because, conditional on having to do the project, the manager would rather not go through a proxy fight. Managers refuse low reputation activists because, if the activist decides not to fight, the manager avoids the costs associated with both the project and the proxy fight.

In addition to showing how reputation affects target managers’ decision to settle, our model illustrates how activists build reputation. Managers in the second activist campaign estimate the activist’s type based on the outcome of the first campaign. Therefore, activists without a strong prior reputation can improve their reputation by initiating a proxy fight. Activists with a sufficiently strong prior reputation, by contrast, are settled with by both managers. We therefore predict that activists with a recent track record of initiating proxy fights, or extracting settlements from targets, are more successful in future campaigns.

Activists in our model can also signal their type through the size of the stake they purchase in the target, which is costly because their demand for shares moves prices upwards. However, stake size alone is not a sufficient signal of reputation, because, if it were, managers would settle upon observing large positions, making the activist’s type irrelevant and attracting campaigns from weak as well as strong activists. We therefore predict that the fraction of the target firm the activist purchases is not related to campaign success.

We find strong empirical support for our model’s predictions using a sample of 2,199 activist campaigns, each initiated by an activist filing form 13-D with the SEC. Our first main result is that campaigns by high reputation activists are more successful even when they do not feature a proxy fight. To measure campaign success, we analyze corporate 8-K filings using S&P’s Capital IQ data and examine the propensity of activist targets to increase payouts, change management, change board composition, engage in a merger or acquisition, or otherwise reorganize. We construct two empirical proxies for activist reputation motivated by our model: a dummy variable indicating the activist recently engaged a different target firm in a proxy fight (Recent Fight), and the average success of recent campaigns by the activist that did not feature a proxy fight (Settle Rate).

We find campaigns are at least 28 percent more successful when the activist has a Recent Fight and 7 percent more successful when the activist has a one-standard deviation higher Settle Rate. These effects hold regardless of whether the campaign involves a proxy fight, supporting our model’s prediction that managers are more likely to settle with high reputation activists.

Our results show that reputation helps explain variation in activist campaign success across different categories of institutional investors. Consistent with the evidence in Gillan and Starks (2007) and Klein and Zur (2009), we find that hedge funds are more prolific and successful activists than those with different institutional structures. Kahan and Rock (2007), Yermack et al. (2010), Gantchev (2013), and others argue that hedge funds are more effective activists because they have fewer conflicts of interest, and because lighter regulation allows for lock-up provisions and greater portfolio concentration. We argue these characteristics make hedge funds more successful activists by allowing them the flexibility to build reputation and the time horizon to benefit from it. We provide empirical evidence supporting this channel by showing hedge funds have higher average Recent Fight and Settle Rate than other activists.

We also document the surprising result that campaigns in which the activist purchases a larger fraction of the target firm’s shares outstanding are no more successful than those in which activists purchase smaller stakes. Theories on large shareholders, for example in Shleifer and Vishny (1986) and Admati, Peiderer, and Zechner (1994), predict larger positions make shareholders better able to influence manager behavior. In our model, by contrast, because weak activists imitate the equilibrium quantity of shares purchased by strong activists, we predict larger positions have no influence on manager behavior. Instead, consistent with our empirical evidence, the only way activists successfully improve their reputation and induce managers to settle is by engaging in proxy fights.

Finally, we argue that even the observed 9 percent frequency of proxy fights in activist campaigns is puzzling in a static setting because more than half occur in campaigns where the activist’s position in the target is smaller than $50 million, meaning they would need the target firm’s stock price to rise 21 percent just to offset the $10.7 million cost that Gantchev (2013) estimates activists incur for proxy contests. Average target stock returns around proxy fights are far below 21 percent, with estimates ranging from 4 percent to 8 percent% (see Brav et al. (2008), Brav, Jiang, and Kim (2009), and Gantchev (2013)), suggesting many activists in our sample incur losses when engaging in proxy fights. While puzzling in a static setting, we show that in a dynamic setting activists sometimes initiate proxy fights when expecting a net loss as an investment in reputation that allows them to profit from settling with future targets. Our empirical evidence that campaigns by activists with a recent fight are more successful indicates this investment in reputation pays off.

In our empirical results, we address a natural alternative hypothesis: activists with a track record of proxy fighting, or being settled with, are better at picking stocks of companies that will subsequently institute the changes we measure as campaign success, regardless of whether the activist intervenes. Under this hypothesis, high reputation activist investors do not cause their targets to act through activism, but instead predict and profit from these actions as non-activist speculators. We address this possibility directly by estimating and controlling for the expected number of actions the target would take in the absence of the activist.

Another related hypothesis is that there are persistent differences in activist skill unrelated to reputation. This hypothesis would explain the correlation between the success rate of past non-proxy campaigns, Settle Rate, and future campaign success. However, this hypothesis would not explain why the propensity to engage in proxy fights, Recent Fight, predicts campaign success after controlling for past campaign success and other measures of activist skill. We further address this alternative, and the stock-picking alternative, by showing that variation in one activist’s reputation over time is positively related to variation in that activist’s campaign success.

This post comes to us from Professor Travis Johnson at the University of Texas at Austin and Nathan Swem, an economist at the Board of Governors of the Federal Reserve System. It is based on their recent paper, “Reputation and Investor Activism,” available here.