Hedge funds and other activist shareholders are taking an increasingly active role in monitoring and influencing the decisions of public companies. While the specifics of activist campaigns vary, it’s generally a simple process: An investor buys a large equity stake in the target company and then pressures management and the board to take an action that they believe will increase the value of those shares. This pressure is necessary because the actions often go against the private interests of management, such as being acquired by another company which typically ends the employment of the current CEO and board. Activists can help overcome this agency friction in the acquisition market. Put simply, shareholder activists may act as facilitators in the M&A market, increasing the opportunity for takeovers.
However, shareholder activists can also use their power to pressure management to improve operations or the board to fire an underperforming CEO. In this way, activism acts as a disciplinary mechanism to improve the incentives of entrenched management. This type of activism may substitute for the classic disciplinary takeover, or acquisitions motivated by the desire to fire management that is not representing the interests of shareholders. Thus, activists may decrease merger activity by displacing the need for disciplinary takeovers, or they may increase it by acting as facilitators in the takeover process.
In a new paper, we seek to answer the question: Do shareholder activists promote mergers and acquisitions or do they replace M&A as a way to discipline managers? Our answer is: both. Our estimates indicate that activism makes some value-creating deals more likely, but it also improves stand-alone firm performance, reducing the need for takeovers. Therefore, while we find that activists break down the frictions to takeover, the result is that overall M&A volume is virtually unchanged. However, shareholders benefit from activists because the threat of activism improves CEO incentives.
Our Approach
We build a model in which an activist can intervene in two ways, first by making it easier for a board to replace an underperforming CEO, and second by reducing insider–shareholder misalignment in takeover negotiations. We also allow the activist to have private (noisy) information about future investment opportunities and the potential surplus from being acquired. This private information affects whether a campaign is launched and how the market reacts to an entry announcement.
We use a structural model that accounts for the effects of activism on targeted firms but also the threat of activism on the decisions of insiders. The mere possibility of a campaign can change managers’ effort and board behavior, an equilibrium effect that a traditional reduced-form approach would miss.
Our model includes a broad set of features of the activism and takeover markets. We then use detailed data on firm performance, CEO turnovers, activist campaigns, and takeovers to find the parameters that best allow the model to match the data. The model matches a wide array of empirical features, suggesting it captures the salient features of the environment.
Marginal Effects of an Activist Campaign
Before considering the economy-wide effects of the threat of activism on firm outcomes, we quantify several interesting effects of activist campaigns.
Deals become more likely but occur at a lower price. When an activist is involved, we find that agency frictions decrease, and takeovers on the margin of viability are more likely to be completed. At the same time, because takeover negotiations are less distorted by insider incentives, the price the acquirer must pay tends to be lower. In our estimates, takeovers with an activist present result in a bid premium that is 13.7 percent (5.2 percentage points) lower than it would have been without the activist.
Who gains from reduced takeover premiums? The answer is nuanced. For deals that would have happened anyway, target shareholders lose a small amount of value because the premium is lower. But for the subset of deals that only occurred because the activist reduced frictions, targets gain a lot. Averaging across all takeovers that occur during campaigns, the increased probability of completion adds about 1.23 percent of value while the lower premium subtracts about 0.78 percent, leaving a +0.44 percent net effect for targets in those completed deals. Crucially, that average masks a strong split: In the roughly 7 percent of deals that are marginal to activism, target shareholders gain about 15.7 percent; in the remaining 93 percent, they lose about 0.75 percent on average due to the lower premium. On average across all campaigns, improved opportunity for M&A adds only about 6 basis points (i.e., 0.06 percent) of value for shareholders.
Improved operations matter more for shareholder. By weakening a CEO’s entrenchment, an activist campaign meaningfully increases management effort and productivity. In our estimates, an average campaign raises productivity by 1.17 percent and target shareholder value by 0.35 percent. That pattern echoes the broader literature’s finding that turnover rates are often too low from shareholders’ perspective; activism helps correct that.
The Economy-Wide Effects of Activism
By modeling the underlying incentives of management and the board, we are able to estimate how the threatof activism affects the decisions of the entire population of firms, not just targets of an activist campaign.
The threat of activism adds significant value. Average equity value for all potential targets is about 0.33 percent higher than in a counterfactual economy that excludes activists. This applies to all firms, not just targets of a campaign, making the aggregate effect quite large despite infrequent activist intervention (about 4 percent of firms are the target of a campaign each year). The economy-wide benefit arises entirely from better-effort incentives and higher productivity – not from the activists’ potential to increase takeover opportunities.
Why doesn’t overall M&A activity increase? We find evidence that activists do a good job of reducing agency frictions in takeover negotiations, increasing the likelihood that two firms can successfully merge, all else being equal. Thus, when campaigns occur, activists reduce frictions and facilitate deals. But the presence of activists in the economy also improves the behavior of management even outside of an active campaign. The discipline that activism imposes on insiders increases stand-alone value and shrinks the potential surplus from a takeover, so some deals on the margin no longer make sense. In our baseline, this latter “substitution” channel crowds out about 0.8 percent of total M&A volume – almost exactly offsetting the increased activity from the facilitation channel – so aggregate deal volume is essentially unchanged.
Externalities matter. These offsetting forces don’t affect targets and acquirers symmetrically. When activism crowds out a deal, acquirer surplus disappears – a negative externality of activism. But because activism also helps some marginal deals to be completed, in other cases there is a positive externality. In our estimates, the positive effect dominates: Net aggregate surplus from M&A rises by about 0.22 percent due to activists. That is a social benefit that activists generate that is captured by potential acquirers rather than target shareholders or activists.
Superior Information or Improvements through Intervention
On average, the share price increases when an activist announces its position. This could reflect a combination of two, non-mutually exclusive, effects. First, share price may increase because activists can improve firm outcomes. Alternatively, activists may have better information than the market does. For example, they may have insights about takeover opportunities not yet reflected in the share price and launch a campaign in advance of that information becoming more widely known. In this case, the activist doesn’t affect outcomes, but entry is correlated with the revelation of this positive information. Our model allows us to separate this correlation from issues of causality.
We find that the positive return on the announcement of activist entry is largely driven by activist’s’ better information. Their entry is correlated with positive opportunities for the firm that would occur even if they did not enter. Most of this good news is about potential takeovers. In other words, we find evidence that activists have some superior information about the potential for a buyout.
This does not mean that activist intervention is unimportant. The threat effect that increases economic productivity exists only if intervention is effective. Indeed, when we reduce the activist’s information advantage in the model, entry falls and shareholders end up worse off; the information advantage helps solve the classic free-rider problem in activism, where costs are concentrated but benefits are dispersed.
Conclusion
We study the direct and indirect effects of shareholder activism on corporate outcomes and shareholder value. Activist campaigns facilitate takeovers and improve management incentives, aligning CEOs more closely with shareholders’ interests. Importantly, the influence of activism extends well beyond the firms that are directly targeted: The mere threat of intervention adds significant value for shareholders across the economy. Policymakers should take these broad disciplinary effects into account when considering changes to the regulation of activism. Limiting activist engagement could weaken one of the key mechanisms that promote management accountability and efficient M&A activity.
This post comes to us from professors Francesco Celentano at the University of Lausanne and Swiss Finance Institute, and Oliver Levine at the University of Wisconsin – Madison. It is based on their recent paper, “Shareholder Activism, Takeovers, and Managerial Discipline,” available here.