In a paper published in February this year, Entrepreneurial Shareholder Activism: Hedge Funds and Other Private Investors, April Klein and Emanuel Zur examine recent “confrontational activism campaigns” by “entrepreneurial shareholder activists” and conclude that such strategies generate “significantly positive market reaction for the target firm around the initial Schedule 13D filing date” and “significantly positive returns over the subsequent year.”
The paper confirms our view that the filing of a 13D notice by an activist hedge fund is a catalytic event for a firm that heralds substantial positive returns in the stock.
Klien and Zur define an entrepreneurial shareholder activist as “an investor who buys a large stake in a publicly held corporation with the intention to bring about change and thereby realize a profit on the investment,” which seems quite broad. They define “confrontational activist campaign” very narrowly, including only campaigns beginning with the filing of a 13D notice in which the activist’s clear purpose is to redirect managements’ efforts without working with or communicating with management:
The redirections stated in the Schedule 13D purpose statement include (but are not limited to) seeking seats on the company’s board, opposing an existing merger or liquidation of the firm, pursuing strategic alternatives, or replacing the CEO. We exclude 13D filings that are filed because the investor is “unwilling to give up the option of affecting the firm” (Clifford (2008, p. 326)). We also exclude 13D filings if the investor states an interest in working with or communicating with management on a regular basis. These restrictions limit our analyses to activist campaigns that can be characterized as aggressive or confrontational. (Emphasis added)
Klien and Zur find that such strategies generate significant positive stock returns:
Specifically, hedge fund targets earn 10.2% average abnormal stock returns during the period surrounding the initial Schedule 13D. Other activist targets experience a significantly positive average abnormal return of 5.1% around the SEC filing window. These findings suggest that, on average, the market believes activism creates shareholder value. Our findings are consistent with those of Holderness and Sheehan (1985), who document significant price increases for firms targeted by “notorious” corporate raiders of the late 1970s and early 1980s, and also with those of Bethel, Liebeskind, and Opler (1998), who show similar results for firms targeted by individuals, rather than corporate or institutional large shareholders. The positive abnormal returns also are consistent with the work of Brav et al. (2008), who find positive market reactions for a sample of confrontational and nonconfrontational hedge fund Schedule 13D filings. Furthermore, our target abnormal returns do not dissipate in the 1-year period following the initial Schedule 13D. Instead, hedge fund targets earn an additional 11.4% abnormal return during the subsequent year, and other activist targets realize a 17.8% abnormal return over the year following the activists’ interventions.
One particularly interesting observation in the paper is the distinction between the strategies of hedge funds on one hand and other investors (individuals, private equity funds, venture capital firms, and asset management groups for wealthy investors) on the other. Klien and Zur believe that hedge funds address the “free cash flow problem:”
Under this theory, firms can reduce agency conflicts between managers and shareholders by reducing excess cash on hand, and by obligating managers to make continuous payouts in the form of increased dividends and interest payments to creditors. Consistent with this view, hedge fund targets initially have higher levels of cash on hand than do other entrepreneurial activist targets. In addition, hedge fund activists frequently demand that the target firm buy back its own shares, cut the CEO’s salary, or initiate dividends, whereas other activists do not make these demands. Consequently, over the fiscal year following the initial Schedule 13D, hedge fund targets, on average, double their dividends, significantly increase their debt-to assets ratio, and significantly decrease their cash and short-term investments.
In contrast to the hedge funds, the other investors seek to “redirect investment strategies:”
In their initial Schedule 13Ds, they most frequently demand changes in the targets’ operating strategies. Consistent with these requests, when comparing hedge fund and other entrepreneurial activist targets, we find significant differences in changes in R&D and capital expenditures in the year following the 13D filing, with the other entrepreneurial activist targets experiencing significant declines in both parameters.
We believe that Klien and Zur’s finding that confrontational activism campaigns by entrepreneurial shareholder activists generate significant positive returns in the 12 months following the filing of the 13D notice is further compelling evidence for Greenbackd’s investment strategy.