Tuesday, May 3, 2011

Review of Extreme Value Hedging: How Activist Hedge Fund Managers Are Taking on the World

I recently posted an academic finance paper called "Agency Problems in Public Firms: Evidence from Corporate Jets in Leveraged Buyouts", which offered evidence that executives at public companies waste money on corporate jets. Public ownership creates an agency problem, where long-only mutual funds are asleep at the switch because they have hundreds of positions.

Two ways of solving the agency problem are private equity firms, which link ownership and management, and activist hedge funds, which pressure management into better behavior. I picked up a survey of hedge fund activism called Extreme Value Hedging: How Activist Hedge Fund Managers Are Taking on the World.

It is a pretty good survey of activism, although there is not much in the book that will be a surprise to a sophisticated investor.

Perhaps the most interesting takeaway is how stubbornly the institutional investors (e.g. long only mutual funds, pension funds) resist and stall the efforts of activists to reform companies. There is a conflict of interest, because the institutional managers are often trying to win business from the companies they own, like lucrative retirement account management business. Mutual funds face limits on the concentration of their investments, so even if they wanted to buy a big stake in a company and  pressure for change, they wouldn't be allowed to.

I give this one a 2/5. You can tell it was written by a journalist, because it was light on empirical data like prices, valuation metrics, rates of return from activist strategies, etc. There are useful academic articles on hedge fund activism. For example,

Activism that targets the sale of the company or changes in business strategy, such as refocusing and spinning-off noncore assets, is associated with the largest positive abnormal partial effects, at 8.54% and 5.95%, respectively (the latter figure is lower than the overall sample average because most events target multiple issues). This evidence suggests that hedge funds are able to create value when they see large allocative inefficiencies. In contrast, we find that the market response to capital structure-related activism—including debt restructuring, recapitalization, dividends, and share repurchases—is positive yet insignificant. [2008]
Also, here's a fascinating paper showing that activism in the enforcement of bondholder rights increases when interest rates increase, because
Alas, [t]he remedy scheme for violations of bondholders rights - in particular, the centrality of the acceleration remedy - introduces its own set of imperfections. When treasury interest rates have increased or the stock price of a company that has issued convertible bonds has declined, acceleration generates a windfall: bondholders receive compensation in excess of the harm associated with the violation. In these cases, activists will spend excessive resources in detecting and pursuing potential claims and companies have excessive incentives to stave off potential violations. When treasury rates have declined, the tables are turned, and bondholder rights are underenforced.
Bondholder activism was a big deal circa 2006, because the options backdating scandals led to technical defaults for which holders could demand acceleration. [In the end, the companies would pay consent fees in exchange for waivers by the holders.]

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