Shareholder activism is growing in popularity across the world and appears to deliver mostly benign results for firms and stockholders. However, testing the effects of activism is problematic. For at least 30 years, researchers have recognized the difficulty of causal inference when examining ownership and performance. Perhaps activists systematically target firms that are poised to improve anyway or select liquid stocks to cheaply acquire blocks. Despite a body of empirical evidence on the positive effects of activism, critics continue to warn of dangers: Activists hunt in highly-motivated and well-resourced wolf packs that exploit regulatory loopholes; they focus on short-term financial metrics to the detriment of long-term value creation; and they extract gains that represent wealth transfers from other stakeholders, principally employees and creditors. In any event, the improvements an activist might deliver over the long-term, if acting alone with low incentives and resources and assigned to a random portfolio of firms, is not identifiable. Faced with uncertainty, should policy makers encourage or discourage block formation? What might the impacts be on small, entrepreneurial firms already weighing the costs of going public?
In a new paper, we attempt to address these issues by way of a natural experiment that allows us to separate selection from treatment effects. We perform a clinical study of a UK fund manager, Progressive Value Management Limited (the “fund”), which, through its closed-end funds, is a leading activist shareholder in UK smaller companies. The study covers the period 2008-2015. In contrast to a typical activist, our fund: (1) does not pick stocks, but instead receives a blind portfolio from investors, thereafter realizing value via a mixed strategy of voice and exit; (2) has low incentives (1 percent management fee and 10 percent performance fee), no additional resources (e.g. to finance campaigns or build stakes), and operates on London’s junior stock exchange (the Alternative Investment Market, or “AIM”) where tools available to activists are low; (3) acts behind-the-scenes, mostly without collaborating with other activists and never in a publicly hostile fashion, and undertakes long-term engagements (longer than two years on average); and (4) manages a broad portfolio of mainly illiquid, under-researched firms with significant founder or management ownership and few other stakeholders such as institutional investors, public bondholders, or employee representation groups. As a non-management entity holding large blocks of stock, our fund also fits the description of an outside monitor: (1) it has fewer regulatory constraints than investors such as mutual or pension funds; (2) it is not concerned about losing money-management business; (3) it has fewer agency problems of its own; and (4) its interests are more aligned with outside shareholders than managerial blockholders.
With full access to comprehensive private data, we examine ownership blocks above 4 percent (as a percentage of firm market value and fund portfolio size) and separate voice and exit activities. Within voice, we distinguish further among collaborative, mixed, and confrontational engagements. We find our fund engages firms with friendly outside blockholders and older chairmen, particularly when its dollar ownership is large and difficult to liquidate in the market. Contrary to many prior studies, weak near-term stock momentum or firm operating performance does not determine engagement. The duration of investments increases with voice and the degree of non-collaboration, with confrontational engagements lasting 750 days on average. Engagements are confrontational when the age difference between older chairmen and younger CEOs is greatest, suggesting the decision-making power within small firms is concentrated but potentially unstable. The majority of voice activities are behind the scenes and aimed at C-suites, seeking corporate restructuring (46 percent of cases) and board changes (36 percent of cases), with a high degree of successful outcomes (76 percent of cases).
To assess whether our fund’s engagements are value-enhancing, we conduct event studies on stock price impacts and run regressions on firm operating performance post-exit. In event studies, we find positive abnormal returns of 4-6 percent associated with objectives being met. This rises to 8-10 percent when events with confounding information are excluded. The largest returns are associated with restructuring events (14-16 percent) and in confrontational situations (7-10 percent). In regressions, engaged firms appear leaner (reduced total assets and employees) and stronger (improved return on assets and higher market-to-book ratios) one and two years after exit. Total IRR returns for the fund for the period are negative (-3.25 percent) but conceal positive returns to voice (+10.1 percent) and high returns in confrontational engagements (+35.2 percent). Event study outcomes contribute approximately 60 percent of voice returns. Reflecting the high risk of activism in small-cap stocks, the fund’s monthly Sharpe ratio is around 0.04.
If activism improves shareholder value, as our findings suggest, the question remains why small-cap firms in our study do not voluntarily pursue the strategies proposed by our activist. On one hand, many firms have poor corporate governance and entrenched owners or managers, indicating significant agency problems and a higher likelihood of not maximizing shareholder value. These problems are exacerbated by a lack of credible activism threat, prior to our fund receiving blocks. On the other hand, our activist possesses expertise that many small-cap firms may lack, and thus plays an important role in providing guidance on what constitutes best practice in the eyes of institutional investors. In this sense, self-regulation and investor engagement depend on each other.
What are the limitations of our clinical study? We examine a single fund, engaging mostly in AIM-listed firms during the period 2008-2015. Target firms are small, illiquid, under-researched, and sensitive to news flow. Hence, the event study and overall fund returns could be specific to this time period, to AIM’s auction-based trading system for illiquid securities, or to the small-cap market segment. Our activist is highly experienced, with a long track record of engagements in UK small-cap firms. The value that could be realized by another manager is unknown but likely lower. As investors in AIM firms become more discerning of well structured and professionally managed firms, or if enhanced legal tools become available to activists in the future, the returns to these strategies may be reduced.
We believe our study provides the first detailed evidence on the long-term impact of behind-the-scenes activism in UK small-cap firms, including unique controls for selection effects. Future researchers might examine the determinants of stock market reactions to activism in news-sensitive small-cap stocks and the links among market microstructure, risk-adjusted returns, and corporate governance in junior markets.
This post comes to us from Emmanuel Pezier, a researcher at Cass Business School, City, University of London, and a former investment banker at Goldman Sachs, JPMorgan, and other firms. It is based on his working paper, “Estimating the Long-Term Effects of Activism Using a Natural Experiment in UK Small-Cap Stocks,” available here.