In recent years, an increasingly popular strategy among hedge fund activists has been to acquire seats on the boards of target companies. These board seats are held by what we refer to as “activist directors,” who may be affiliated with the activists or nominated by them. However, obtaining board representation has costs, which include the direct costs of getting board representation and the risk of staking one’s reputation on the company’s future performance. Additionally, board positions come with fiduciary responsibilities to all shareholders, and access to inside information may limit the ability of activists to trade the stock of targets.
Hedge fund activists are nonetheless still eager to obtain board representation. Some speculate that “introducing individuals into the boardroom who are sympathetic or at least open to the changes sought by the activist is an intermediary step that often facilitates such changes” (Bebchuk et al., 2020). However, since activist directors rarely constitute a majority of the board, they must still persuade other directors of the merits of any course of action. One possible reason for seeking board representation is that access to private information is required to identify the optimal course of action; the activist director can provide advice with better information by gaining board representation.
Thus, studying the actions of firms with activist directors can provide new insight into the reasons and the effects of hedge fund activism. In a recent paper, we examined the characteristics of activist directors, the circumstances surrounding their appointments, and their impact on the board.
Activist Directors – Characteristics
Of the 3,259 activism events targeting U.S. companies from 2004 to 2016, we identify 1,623 activist directors appointed to boards through proxy fights or settlements. About 40 percent of activist directors are directly employed by hedge fund activists (affiliated directors), while the remaining are sponsored or supported by the activists (unaffiliated directors). Activist-affiliated directors are on average nine years younger than other activist directors, more likely to possess finance and accounting skills, and much less likely to be female (only 1 percent). Activist directors were also found to quickly assume important roles on the board and tended to receive more support in their initial elections compared with other incoming directors.
Furthermore, our study finds that activists hold stock in a target firm for a median of approximately 2.2 years when their demands do not include board representation. This holding period increases to 2.4 years when the activists appoint unaffiliated directors and further increases to 3.2 years with affiliated directors. This suggests that activists with board representation may be considered long-term investors.
Activist Directors – Determinants
Our research shows that activists are more likely to demand or acquire board representation if the firm has higher levels of institutional ownership, a smaller market capitalization, worse stock market performance, and, in particular, lower dividend payouts. Furthermore, we find that the demands the activists can make as board members, such as divestiture, removal of takeover defenses, and changes in compensation, are associated with a higher likelihood of requesting a board seat and obtaining one.
Activist Directors – Consequences
The appointment of activist directors has a number of possible consequences for firms. Our analysis shows that board representation by activists is generally associated with more divestitures, fewer acquisitions, more frequent CEO turnover, higher payouts, greater leverage, lower capital expenditures, and less R&D spending. Notably, we find that activist-affiliated directors have a particularly strong association with higher payouts, with a coefficient equal to nearly 15 percent of EBITDA, as well as lower R&D spending. Furthermore, we find that having an activist director can increase the success rate for attempts to block mergers and acquisitions, induce divestiture, and increase shareholder payouts. We find, however, that activist-director events are associated with a lower likelihood of the target firm being acquired relative to other activism events, suggesting that, when activists acquire board representation, their impact is not primarily about the “ability of activists to force target firms into a takeover” (Greenwood and Schor, 2009).
The results of our research additionally show that, following the appointment of activist directors, target firms improve operating performance, evidenced by a 1.8 percentage-point increase in return on assets over five years. Moreover, when activist-affiliated directors are appointed, the improvement in operating performance is even more significant, with returns on assets rising by an additional 1.5 percent to 3.2 percent two to five years after the announcement. There is also a positive risk-adjusted market reaction around the announcement of activism, with returns ranging from 3.0 percent to 3.7 percent from -1 to +1 trading days. The market also responds positively to the appointment of activist directors, with market-adjusted returns of 1.1 percent for affiliated directors and 1.0 percent for unaffiliated directors from -1 to +1 trading days around the announcement.
However, it is important to note that these effects may not always be beneficial to shareholders. For example, lower R&D spending could be seen as either curtailing excessive investments or not making productive investments and focusing on the short term. Nevertheless, the relatively long-term holding periods in cases where activists become directors, positive stock market effects, and long-term operating performance improvements seem to contradict the notion that activist directors are short-term focused.
Overall, our study provides new insights into the determinants and the consequences of hedge fund activism, particularly regarding activist directors. Our research shows that activist directors are associated with significant strategic and operational actions by firms. With the SEC’s recent adoption of rules that may make it easier for activist directors to join boards, it seems likely that activist directors will continue to play an important role in the governance of public U.S. firms. Thus, it is important to understand the increasingly important phenomenon of hedge fund activism and the role of activist directors in driving changes at targeted firms.
This post comes to us form professors Ian D. Gow at the University of Melbourne, Sa-Pyung Sean Shin at National University of Singapore Business School, and Suraj Srinivasan at Harvard Business School. It is based on their recent article, “Activist Directors: Determinants and Consequences,” available here.