In recent years, hedge funds' successful interventions in some large public companies have revealed their critical role in the corporate governance landscape in the United States and Europe. Due to public opinion, this new form of shareholder activism is accompanied by much polemic. This study examines the nature of hedge fund activism, the types of them, and the market’s perception of interventions in the United States. Starting with a distinction between shareholder activism by traditional institutions, and activism performed by hedge funds, the study elucidates why the latter may be more effective in monitoring management, and reduce agency costs. Analysing the Schedules 13D filed with the U.S. Securities and Exchange Commission, the study provides a classification of activists’ demands into ten distinct categories, arguing that hostile forms of activism are not central for hedge funds, and some more aggressive types of activism are possibly used as a negotiating tool to achieve the activist’s agenda. Using the event study methodology, the author estimates the stock returns around the announcement date. For a better understanding of hedge fund activism, and their demands on target companies, the reader will find two original Schedule 13D filings accompanied by letters to the management. Finally, the paper concludes on a view of the subject through the prism of the 2007/ 2008 financial crisis, outlining some trends in the aftermath of the financial market turmoil.

Textprobe: Chapter 2.1, Activism by traditional institutions: The history of shareholder activism starts in the middle 1980s and emerges as a response to developments in the United States corporate control market. In consequence of the abrogation of restrictive takeover laws in many U.S. states in 1982, many company managers sought out new takeover defences to secure control over their firms. Some of the new defensive tools included antitakeover charter amendments, poison pills and restrictive state antitakeover laws. Hence, by the late 1980s the majority of the firms had adopted such measures and created huge obstacles to hostile takeover attempts. This also implied that some existing capital market mechanisms for replacing firm managers had almost stopped functioning” (Karpoff, Malatesta, & Walkling, 1996, p. 368). Consequently, many dispersed individual investors started to submit shareholder proposals on corporate governance, including proposals to eliminate defensive tactics against takeovers or to enhance board independence (Romano, 2001). At the same time, large institutional investors, like pension and mutual funds, began their activist involvement in corporate policies using Rule 14a-8. These proposals were precatory resolutions and related to various corporate governance issues, such as poison pills, confidential voting, and board structure, rather than to specific aspects of a firm’s business or management (Kahan & Rock, 2006). However, the views on benefits of this type of activism are mixed. Shleifer and Vishny (1986) document the fact that large shareholders may be able to effectively monitor the management of listed companies, thus providing a solution to the free-rider problem. Among other factors, they show that large shareholders used takeover mechanisms to discipline the management, which was possible, however, only in the years without the above-mentioned antitakeover measures. On the other hand, a competing view sustains the idea that shareholder proposals made by traditional institutions are unlikely to cause significant policy changes or have any valuable effect on firm performance (Karpoff, Malatesta, & Walkling, (1996), Black (1998), Romano (2001). Just as the success of activism by hedge funds is attributed to their unique organizational structure, so the failure of value-increasing activism is explained by the organizational characteristics of traditional institutional investors. Institutional investors, like public pension funds and mutual funds, are subject to regulatory and structural constraints that limit their scope of shareholder activism. Accordingly, Black (1990) argues that mutual funds, for instance, face conflicts of interests because many of them manage the corporate pension plans and thus have business ties with portfolio companies that would be jeopardized by activism. As institutions widely open to the public, mutual and pension funds are regulated by the Investment Company Act of 1940, which imposes a series of further restrictions. For instance, they are subject to diversification requirements that make concentrated ownership in a single company impossible. This is important because only large holdings of voting rights enable shareholders to put pressure on management and pursue individual requirements. Additionally, they have restrictions on shorting, borrowing, and investing in illiquid securities (Brav et al., 2008). The fund managers of traditional institutions lack significant personal financial incentives to engage in interventions, since they have restrictions on charging substantial performance fees (Rock, 1991). Given all these constraints, Clifford argues that activist threats by pensions and mutual funds are not viewed as credible by target firm management, and therefore the market” (Clifford, 2008, p. 325), making a reduction in agency costs doubtful. Chapter 2.2, Activism by hedge funds: On the contrary, given their organizational characteristics and regulatory environment, hedge funds could be more appropriate institutions to effectively perform shareholder activism. Hedge funds became a major corporate governance phenomenon in the mid-2000s (Armour & Cheffins, 2009) and are likely to remain an important and controversial feature of the legal and financial landscape for some time to come” (Macey, 2008, as cited in Armour & Cheffins, 2009, p. 1). Hedge funds are pooled, privately organized investment vehicles, not available to the general public and, importantly, avoid the Investment Company Act of 1940 by having a small number of sophisticated investors (Brav et al., 2008). Hedge funds are not required by law to maintain high levels of diversification and therefore, they can take much larger positions in one single company. Hedge funds are usually not bound by liquidity constraints and are able to lock-up” their funds for extended periods of two years or longer (Kahan & Rock, 2006). This feature is important insofar as some activist campaigns may require the holding of large, illiquid positions for longer periods of time. Furthermore, since hedge funds are permitted to apply much higher leverage and to make use of derivative instruments, they can acquire significant effective ownership in target companies (Clifford, 2008). An important characteristic of hedge funds is the manager’s strong incentive structure. Typically, hedge funds charge a fixed annual fee of 2% of their assets and a performance fee of 20% of the fund’s annualized returns. Given this remuneration structure, hedge fund managers have much greater incentives to conduct value-increasing activism, despite the high costs of intervention (Kahan & Rock, 2006 Clifford, 2008). Additionally, Brav et al. (2008) argue that the fund managers undergo less conflict of interest than managers of traditional investment institutions, as they do not sell financial products to the firms whose shares they hold. Finally, hedge funds are considered to have higher negotiating power with the firm’s management, due to their ability to acquire the company if they are dissatisfied with the operating or governing competence of management. In most cases, however, hedge funds use these threats as a tactical tool, while they seldom follow through with the takeover transaction. Clifford (2008) shows that funds which have threatened to buy out a company often reach arrangements with the firm’s management and achieve all or some of their stipulated demands. Thus, unlike traditional institutions, hedge funds represent a credible threat to their targets and make activism efforts more effective. Characterizing hedge fund-style activism, Armour and Cheffins (2009) describe it as offensive” shareholder activism, in the sense that hedge funds lacking a significant stake in a company acquire one offensively” assuming that valuation failures will be corrected to maximize shareholder returns and with the intention of press management to make changes if it opposes doing so. In contrast, the defensive” activism performed by other institutional investors aims to protect through intervention the shares already held. Hence hedge funds, rather than investing and passively waiting for the market to self-correct, take the initiative by agitating the management for changes in order to boost shareholder value. Similarly, Kahan and Rock describe the different approach to activist intervention adopted by hedge funds and traditional institutional investors as follows: Mutual fund and public pension fund activism, if it occurs, tends to be intermittent and ex post: when fund management notes that portfolio companies are underperforming, or that their governance regime is deficient, they will sometimes become active. In contrast, hedge fund activism is strategic and ex ante: hedge fund managers first determine whether a company would benefit from activism, then take a position, and then become active. It represents a blurring of the line between risk arbitrage and battles over corporate strategy and control” (Kahan & Rock, 2006, p. 35). Viewed from the perspective of efficient market theory, hedge fund activists appear to exploit market inefficiency and generate superior returns if and when prices return to fundamental values” (Allen, Myers, & Brealey, 2008, p. 369). In this case market inefficiency is associated with information asymmetry, bad management and other agency related problems. Further, some authors (Brav et al., 2008) interpret activist investing as a new form of arbitrage, maintaining that in efficient markets, abnormal returns on activist investing should persist only when an activist has superior information about the value of the firm that is supposed to be out of the control of the investors and unknown to the market. Interventions by activist investors could potentially affect the value of the firm by their action. Consequently, the announcement of activists’ investments in a company may signal to the market their private information about the value of the targeted firms. In general, this kind of arbitrage activity can make markets more efficient as market prices reflect additional information. Given all the distinguishing features of hedge fund activism mentioned above, it appears that they are the new forces of corporate influence (rather than control, as evidence will show later on) and as long as their gains exceed the cost of interventions, they will have sufficient incentive to engage in activism. The next step is therefore to see how exactly hedge funds proceed when engaging in activism.

• Corporate Governance

• Schedule 13D

• Event Study

• Economy

• Stock Market

• Announcement Date

• financial crisis

Mihaela Butu, born in Chisinau, Moldova in 1984, holds a degree in Economics and Business Administration from the Goethe University in Frankfurt and a degree in International Relations and European Studies from the University of Bucharest, Romania. She gathered her professional experience through internships in the areas of Investment Banking/M&A and Asset Management in Frankfurt as well as internships at the Romanian National Commission for UNESCO and the Institute of Educational Science in Bucharest. The author first became fascinated by the hedge fund industry during her participation in a seminar at the University of Frankfurt, where she examined hedge fund regulation in the aftermath of the 2008 financial crisis. Her strong interest in hedge funds and their operations encouraged her to explore more about this industry by analysing hedge fund activism.