How Lenders React When Activists Target Borrowers

A number of recent news stories have recounted the quick and dramatic changes that activist hedge funds trigger in the companies they target. In the Atlantic magazine, for example, a 2016 article describes DuPont’s decision to cut 10 percent of its workforce in response to an activist campaign by investor Nelson Peltz and his company Trian Fund Management. The recent saga involving David Loeb’s Third Point hedge fund and Campbell Soup illustrates the typical pattern where activist investors take a small but meaningful stake in a target company and demand significant say over the strategic and financial policies of the target.

Most academic studies show that, on average, when an activist hedge fund discloses its equity stake, there is a significant increase in the stock price of the target. Researchers have reported average excess returns ranging from 5 percent to 12 percent. However, it is not clear what generates these almost instantaneous increases in shareholder wealth. Scholars have provided conflicting explanations.  Brav et al. (2008) argue that the operational improvements imposed by the activists make their targets more valuable. Rational equity investors anticipate such future improvements, and at the announcement of activist intervention, they bid up the value of equity. Klein and Zur (2011), on the other hand, offer a less benign explanation closer in spirit to the darker portrait painted in some news stories. They show that the announcement of an activist investment is associated with a significant decrease in the value of targets’ bonds. Based on this finding, they argue that shareholder gains are simply a wealth transfer from the target’s debtors rather than newly created value. A similar assessment was also reflected in a 2015 report by Moody’s arguing that activism is rarely good news for creditors of the targeted firm.

These interpretations yield opposite predictions about how the lenders to a target firm should adjust the terms of their loans when their borrower is targeted by an activist hedge fund. If activists increase operational efficiency, resulting in a more profitable firm, lenders will decrease the interest rates on the loans after an activist gets involved. On the other hand, if activists focus largely on extracting wealth from other stakeholders, lenders will increase the loan rates of the target to compensate themselves for such wealth expropriation. In a new paper, we provide empirical evidence on which interpretation provides a fuller explanation of how lenders adjust loan terms in response to the targeting of a borrower by an activist investor. We exploit the cross-sectional variation in equity price response to the announcement of an activist involvement. We show that on average, loan interest rates go up significantly for targeted firms. However, we also find that this increase is exclusively limited to the sub-sample of targets that experience the highest stock price reaction to the news of hedge fund activism. Our evidence suggests that for firms generating large increases in equity value, part of the wealth creation may arise from wealth transfer from debt-holders.

The use of bank loans to study the source of shareholder-wealth creation due to an activists’ involvement provides some unique advantages over the earlier study of Klein and Zur (2011), who show that bondholders react negatively to the news of an activist intervention. However, their sample is limited to targets that have a bond outstanding at the time of the activist event.  We know that only a very small fraction of firms have bonds outstanding. For example, Faulkender and Petersen (2006) report that bond issuance is uncommon even for large public companies. This makes it difficult to generalize the findings of Klein and Zur (2011) to all forms of debt. In our paper, we address this limitation by focusing on bank loans, which are relatively more common than bonds. We provide new evidence on how lenders adjust credit contract terms for borrowers that have been targeted by an activist hedge fund.

We use a matching procedure to create a control sample of loans made to non-targeted firms. Thus, for every target loan that was outstanding at the time of the activist intervention, we identify a “matching” loan made to a non-targeted firm in the same industry, issued within 180 days of the target firm’s loan. In addition, the matching loan is similar to the loan of the targeted firm with respect to the loan spread, type, and maturity. This procedure allows us to conduct a difference-in-differences (DiD) test, as it isolates the impact of hedge fund activism. Arguably our approach yields stronger causal inferences and provides a more robust estimation of the effect that activists have on bank loans. We find that the interest rate charged on loans goes up by almost 36 basis points if a firm is targeted by an activist hedge fund. Similarly, the likelihood of lenders demanding collateral for their loans increases by 10 percent. Thus, these results suggest that lenders worry about being taken advantage of and respond by tightening the loan contract terms.

We also find a wide cross-sectional variation in the responses of lenders to the hedge fund targeting. Our second contribution is to use a mechanism that can help explain the cross-sectional heterogeneity in evolution of loan terms in the post-activist period. We use the response of shareholders to the activist announcement as our unbiased predictor of value gain for the shareholders. Existing studies have documented significant positive cumulative abnormal returns (CAR) around the date that activist involvement is announced. However, there is considerable variation in how equity holders respond to the news.  For example, Brav et al. (2008) report a median CAR of 4.6 percent, but the 25th and the 75th percentile values range from -5.3 percent to 17.3 percent, respectively. Though the average CAR is 7.2 percent, more than 30 percent of target firms experience a negative CAR. We argue that the stock market reaction provides an unbiased forecast of total value that is likely to accrue to the shareholders from the future actions of the activist. The assumption of using event-study based market reaction to gauge the potential value creation is well established in finance research. This assumption yields a clean empirical prediction about the response of lenders. If the bulk of shareholder value creation is driven by activists’ actions that improve the operating performance of the firm, both the lender as well as the shareholders will benefit. This explanation implies that loans made after the activist intervention will carry more favorable terms, including lower interest rates. Alternatively, if the equity CAR is largely determined by wealth expropriation of debt-holders by shareholders, subsequent loans will reflect this higher credit risk. We find that the equity CAR is a significant predictor of interest rates charged on subsequent loans. We find that target firms where shareholders’ CAR is over 10 percent pay an additional 47 basis points on their loans in the post-activist period compared with the loan in the preactivist period. Since the sample average of loan spreads is 240 bps, this translates into an economically significant increase of almost 20 percent in the cost of new loans. For targets that did not experience large announcement CARs, there is no significant change in the loan spreads of the loans contracted in the pre- and post-activist periods. Our findings provide strong evidence that for activist intervention announcements where equity holders gain a significant amount, the source is likely to be wealth transfer from the creditors.

This post comes to us from Professor Sandeep Dahiya at Georgetown University; Issam Hallak, an economist at the European Commission Joint Research Center; and Thomas Matthys, a post-doctoral researcher at Vlerick Business School. It is based on their recent article, “Targeted by an Activist Hedge Fund, Do the Lenders Care?,” available here.