Governance under the Gun: Spillover Effects of Hedge Fund Activism

Hedge fund activism has become pervasive in today’s corporate landscape. In response to activist demands, targeted firms have been shown to raise shareholder payout, boost return on assets and asset utilization, improve capital deployment and production efficiency, increase innovation output, and strengthen governance. These positive effects often come at the expense of managers and directors who see a sharp reduction in their compensation and a higher likelihood of being replaced. Anecdotal evidence suggests that executives of yet-to-be-targeted firms are taking the threat of activism seriously and adopting a proactive approach in assessing potential vulnerabilities before an activist emerges.

In our paper, we provide large-scale evidence in support of what the popular media calls “do-it-yourself activism” or “activist fire drill.”  We show that managers of untargeted peer firms view the rise of activism in their industry as a threat, and undertake real policy changes to mitigate that threat.  These changes mirror those advocated by activists, and are in the direction of reducing agency costs (e.g., increasing shareholder payout) and improving operating performance (e.g., increasing asset turnover).  We find that these changes are indeed effective at fending off activists both by fixing problem areas that the activists often focus on and by raising the firms’ valuation which makes it more costly for an activist to enter.

Our results establish that the impact of activism reaches beyond the firms being directly targeted and may have been underestimated previously.  These positive externalities are a critical but missing ingredient in the hotly contested debate on whether hedge fund activism is good for the economy.  Just as importantly, our findings also establish the threat of activism as a new disciplining force in the marketplace. We show that the threat of activism has the same effects as the threat of hostile takeovers in the past but works differently – peer firms learn from the perceived mistakes and corrective actions of activist targets and, in order to avoid becoming the next target, preemptively correct potential vulnerabilities. Our study contributes to a better understanding of shareholder activism as a governance device.