In 2010, Roger Carr, then-chairman of British confectionery Cadbury, waged a grueling five-month battle before losing control of the company to Kraft Foods.  “At the end of the day,” he said, “there were simply not enough shareholders prepared to take a long-term view of Cadbury and prepared to forgo short-term gain for longer-term prosperity.”

In response to the deal, the Guardian newspaper asked whether it was time to regulate hedge funds’ activities to protect premier UK companies from inefficient takeover bids. Hedge funds held 5 percent of Cadbury at the time of Kraft’s bid, and, according to Roger Carr, short-term hedge fund traders owned 31 percent of the company in the deal’s final stage, making it extremely hard for the target to stop the takeover. The transaction was eventually completed at a valuation of 11.5 billion pounds, nearly 51 percent of which was paid in cash.

A common fear is that the involvement of hedge funds with short-term investment horizons harms long-term investors and other stakeholders in target firms. But the actual impact of hedge funds on the terms, outcomes, and efficiency of mergers and acquisitions is largely unknown. Scholars have focused predominantly on activist hedge funds, which sometimes take a long-term stake in companies. Yet they control less than 5 percent of the total assets managed by the hedge fund industry. More traditional hedge funds manage 95 percent of those assets, and they have a largely short-term focus.

Scholars have observed that, on average, hedge funds turn over their holdings twice as quickly as mutual funds do.[1] From the TASS database, we also find that hedge funds operate only around six years, on average. In this context, it may be hard for a typical hedge fund to employ a long-term investment strategy.

In our recent  study, we analyze a sample of about 2,000 merger transactions announced between 1994 and 2009 involving listed firms in the U.S. We investigate whether short-termism of non-activist hedge funds significantly affects merger terms, and how their involvement  affects long-term target shareholders’ interests.  At the outset, we find that hedge fund holdings are substantial— on average they hold 9 percent of total shares outstanding of the target firm at deal announcement; and the average hedge-fund holdings in in the top quartile is as high as 24 percent. Being short-term investors, non-activist hedge funds are normally not interested in holding company shares for long periods or intervening in company affairs. Rather, they seek liquidity and fast deal resolutions.

We find that the proportion of deal price paid in cash significantly increases with the percentage of a target hedge funds hold. In the presence of multiple market imperfections (e.g., price uncertainty, transaction costs, and liquidity risk) hedge funds strongly prefer cash over stock payment. Our evidence also suggests that hedge funds actively solicit cash payment. It is easier for a smaller number of funds to coordinate actions; hence smaller groups of hedge funds holding targets are even more successful than larger groups of funds in obtaining cash payment, keeping the level of total holdings unchanged.  We also find evidence that hedge funds’ desire for cash payment is stronger if the bidding firm has less liquid stock, supporting our hypothesis about the liquidity preference of short-term hedge fund investors. Notably, holdings of other institutional investors (who are likely to have longer investment horizons) lead to a lower percentage of cash offered if the bidder’s stock is less liquid, highlighting the different interests of short-term and long-term target investors.

The tension between long-term investors and short-term hedge funds is also high when an overvalued bidder wants to acquire a more accurately valued target using its own stock. Selling the firm and accepting the stock of the overvalued bidder certainly harms long-term shareholders. The short-term hedge fund investors, however, may take advantage of the offer and cash out with a quick profit. Therefore, they are less opposed to such offers than are long-term target investors. We find that hedge fund shareholders of targets are more inclined than institutional investors to accept the overvalued stock as payment; that is especially true for hedge funds with higher portfolio turnover and shorter investment horizons.

Hedge funds vary, however. A particular sub-group worth special attention is event-driven hedge funds, which simultaneously take long positions in a target firm and short positions in the bidding firm. To close the positions and profit from this strategy, the funds eventually need to buy back the bidder’s stock in the open market. As a result, they prefer stock payment over cash, especially if the bidder’s stock is illiquid or overvalued.

Our findings on merger premium further reveal the conflict of interests between hedge fund investors and long-term shareholders. Although higher hedge fund holdings increase the proportion of cash payment, they do not improve premiums or returns upon the announcement of a target, contradicting the expectation that cash payment increases merger premium. Previous studies (e.g., Gilson, Scholes, and Wolfson, 1988; Vladimirov, 2015) demonstrate that cash payment is more costly for target shareholders. For example, target shareholders must pay capital-gains tax immediately after receiving a cash payment. Therefore, shareholders often require a higher premium if a cash offer is made. However, hedge funds’ desire for liquidity renders the target shareholders unable to secure a higher premium for cash offers. Hedge funds are willing to trade a higher expected premium for more liquidity.  We also find that hedge fund holdings increase the probability of a tender offer and reduce deal duration, further highlighting the short-term investment horizon of hedge funds.

Our large-sample analysis reveals that hedge fund holdings in target firms significantly affect merger terms in a way that is likely to be inefficient for long-term shareholders of target companies. Hence, the involvement of hedge funds with short-term investment horizons should be subject to additional scrutiny by other investors and regulators during merger negotiations.

ENDNOTE

[1] Griffin and Xu (2009).

REFERENCES

Boyson, N. M., N. Gantchev, and A. Shivdasani (2017). Activism mergers. Journal of Financial Economics 126 (1), 54-73.

Gilson, R.J., M.S.  Scholes, and M.A. Wolfson (1988). Taxation and the dynamics of corporate control: The uncertain case for tax motivated acquisitions.

John C. Coffee, Jr. (Ed.), Knights, Raiders, and Targets, The Impact of the Hostile Takeover. Oxford University Press.

Griffin, J. M. and J. Xu (2009). How smart are the smart guys?: A unique view from hedge fund stock holdings. Review of Financial Studies 22 (7), 2531-2570.

Vladimirov, V. (2015). Financing bidders in takeover contests. Journal of Financial Economics 117 (3), 534-557.

This post comes to us from Ning Gao and Olga Kolokolova, senior lecturers at the University of Manchester, and Achim Mattes at Credit Suisse. It is based on their recent article, “Does Hedge Fund Short-Termism Shape Up Merger Payment?” available here.