Activist activity, which has been defined as an equity investor asserting control and influence for the benefit of equity investors, is not a new phenomenon but its pace has accelerated in recent years. Activist activity has increased 26 percent from last year’s first quarter.
While this activity has been largely regarded as positive for shareholders, the practice has unintended consequences for the corporation targeted, which invariably affects shareholders of all stripes. This is largely because of the nature of the companies targeted, which are typically perceived as weak or deficient and an activist hedge fund can leverage its stake to coerce management to take corrective action. However, it must be noted that activist hedge funds are primarily concerned with realizing a profit and the fact that a company is well-run will not deter it from pursuing an activist role. Naturally, the unintended consequences vary, based on the objectives of the activist fund.
One study sponsored by the Kellogg School of Management suggests that when the goal is to force the target to accept acquisition or increase dividends, lenders charge higher rates. Alternatively, when the activist’s objective is focused on stopping a takeover or blocking efforts to topple a well-established CEO, lenders typically offer more favorable terms.
Yet another study by Klein and Zur (2011) finds that on balance, activist intervention results in depressed bond ratings and returns because the effect of the intervention transfers wealth from bondholders to shareholders.
An argument can be made that activist hedge funds do not have the long term interests of the company on the radar. Rather, objectives target short term gains in time frames of less than a couple of years which can be to the detriment of real shareholder value as managers tend to refocus on short term gains in stock price.
Others believe that activist hedge funds that press for corporate share buybacks are actually engaging in a form of stock manipulation which bleeds capital from the corporation that might be better employed in creating value for the customer through research and development.
Still others have the view that activist hedge funds are too much of a distraction for senior management, diverting attention away from the actual management of the company.
Disruption Is Inevitable
One consequence of activist intervention has come from an unlikely source—rating agencies. For example, Casablanca Capital recently succeeded in seating six members on the board of Cliff Resources and, as a result, Moody’s cut the company’s rating from investment grade to speculative.
Clearly, activist hedge funds are disruptive. Whether or not this disruption is universally positive or negative will be the subject of debate for the foreseeable future. The truth is likely somewhere in between those two extremes.
Activist hedge funds have been around for many years, but since the implementation of Rule 10b-18 in 1982, the practice has become more prevalent especially as it relates to stock buybacks that are not in excess of twenty-five percent of the stock’s average daily trading volume (ADTV). Activists must recognize the potential for unintended consequences and act prudently while engaging in activist investing.