Hostile takeovers have long been considered the quintessential disciplinary governance mechanism, but a similarly confrontational strategy has lately come to prominence by way of activist hedge funds that buy into poorly run firms and use the threat of hostile tactics to pressure management into accepting specific proposals to improve shareholder value.
This paper compares these two governance mechanisms within a unified framework where any outside investor — bidder or activist — faces a dual free-rider problem since target shareholders neither contribute to the cost of intervention nor sell their shares unless the price fully reflects the anticipated value improvement.
As bidders acquire control, dispersed shareholders free-ride ex ante by selling their shares only if the takeover premium incorporates the expected post-takeover gains. Acquiring those shares increases bidders’ incentives to improve share value afterwards, but paying the premium prevents them from recouping the costs of doing so. These unrecompensed costs are their costs of gaining control. Activism does not build on majority control. On the contrary, the point of the campaign is to compensate for the lack of it. The activist hence optimally limits her share purchase, balancing the benefit of gaining influence from additional voting rights against the cost of unrecompensed effort. The downside is that the endogenous limit on her equity stake caps her effort incentives, and when the value she creates under these incentives is too small, activism does not materialize.
Our key insight is that the profits from the two strategies exhibit opposite comparative statics with respect to the potential value improvement. When the potential value improvement is higher, takeovers become more expensive, whereas activism becomes more profitable. As a result, takeovers and activism are profitable in opposite parameter regions, with some overlap where they coexist as feasible intervention modes. We further show that activists can also add value by merely acting as takeover brokers. Moreover, such takeover activism is typically more profitable as well as socially more efficient than regular activism for two reasons. First, by acquiring fewer shares from free-riding shareholders, activists largely avoid the unrecompensed effort problem. Second, although the activists acquire a limited stake, this lack of ownership does not constrain post-takeover effort since the bidder acquires all shares in the negotiated merger. Interestingly, these features our analysis identifies as advantageous—limited ownership and short-term involvement—are those that are often touted as arguments against activism.
Our theoretical analysis has implications for returns across different types of activism and the co-evolution of activism and M&A. First, takeover activism should exhibit higher returns than other forms of activism. Second, takeover activism generates efficiency gains at the extensive and intensive margin: it enables takeovers that otherwise would not occur and replaces some tender offers with more efficient mergers. Hence, institutional changes that facilitate activism should not cause a decrease in M&A. Rather, it should lead to a concurrent (1) increase in campaigns, (2) increase in total M&A activity, and (3) decline in hostile bids. This broadly matches patterns observed since the 1990s.