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Academic analysis of increasing coordination among activist investors

 

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Source: The Harvard Law School Forum on Corporate Governance and Financial Regulation, February 9, 2015 posting

Wolf Pack Activism

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday February 9, 2015 at 9:00 am

Editor’s Note: The following post comes to us from Alon Brav, Professor of Finance at Duke University; Amil Dasgupta of the Department of Finance at the London School of Economics; and Richmond Mathews of the Department of Finance at the University of Maryland.

In our paper Wolf Pack Activism, which was recently made publicly available on SSRN, we provide a model analyzing a prominent and controversial governance tactic used by activist hedge funds. The tactic involves multiple hedge funds or other activist investors congregating around a target, with one acting as a “lead” activist and others as peripheral activists. This has been colorfully dubbed the “wolf pack” tactic by market observers. The use of wolf packs has intensified in recent years and has attracted a great deal of attention. Indeed, a recent post on this forum described 2014 as “the year of the wolf pack”.

The formation of a wolf pack may enable activist hedge funds to gain the significant influence that they appear to wield in target firms with relatively small holdings: According to recent research, the median stake of activist hedge funds at the initiation of an activist campaign is only 6.3%. Yet, the process by which a wolf pack form appears to be subtle, for at least two reasons. First, wolf pack activity appears to be ostensibly uncoordinated—i.e., no formal coalition is formed—a fact that is usually attributed to an attempt by the funds to circumvent the requirement for group filing under Regulation 13D when governance activities are coalitional (e.g., Briggs 2006). Second, wolf packs appear to form dynamically: Writing in this forum in 2009, Nathan describes the process of wolf pack formation as follows: “The market’s knowledge of the formation of a wolf pack (either through word of mouth or public announcement of a destabilization campaign by the lead wolf pack member) often leads to additional activist funds entering the fray against the target corporation, resulting in a rapid (and often outcome determinative) change in composition of the target’s shareholder base seemingly overnight.”

The subtle nature of wolf pack formation, combined with the prominence of this tactic, raises some questions of key importance to corporate governance: How can formally uncoordinated dynamic wolf pack activity work? What role does the lead activist play? What is the role of the peripheral wolf pack members? How do leaders and followers influence each other?

Our model addresses these questions. We consider multiple activists of different sizes: One large and many small. There is one lead activist who is as large as several small activists taken together and is better informed than the small activists. Our model involves two key components. The first component is a static model of “engagement” by activist investors, which may be interpreted to include talking with target management, making public statements, sponsoring and voting on proxy proposals etc. Successful engagement naturally involves a collective action problem: Engagement can only succeed if there is enough pressure on management, given the underlying fundamentals of the firm. To capture this collective action problem, we build on methodology for analyzing asymmetric coordination problems in Corsetti, Dasgupta, Morris, and Shin (2004). The second component is a dynamic model of block-building which anticipates the subsequent engagement process. A key aspect of our analysis is that the ownership structure of the target firm (the total activist stake and the size-distribution of activists) is endogenous and determines the success of activism, given firm fundamentals.

We first show that the concentration of skill and capital matters: holding constant total activist ownership, the presence of a lead activist improves the coordination of wolf pack members in the engagement game, leading to a higher probability of successful activism. This occurs solely because the lead activist’s presence implicitly helps the smaller activists to coordinate their efforts and become more aggressive at engaging the target, since in our model there is no overt communication among the activists and they all act simultaneously. An implication of this result is that, even when a significant number of shares are held by potential activists, the arrival of a “lead” activist who holds a larger block may be a necessary catalyst for a successful campaign, which is consistent with the activist strategies that are well documented in the empirical literature.

We next show the beneficial effect of the presence of small activists on a lead activist’s decision to buy shares in the target. In particular, the larger is the wolf pack of small activists the lead activist can expect to exist at the time of the campaign, the more likely it is that buying a stake will be profitable given the activist’s opportunity cost of tying up capital. Importantly, the expected wolf pack size consists of both small activists that already own stakes, and those that can be expected to purchase a stake after observing the lead activist’s purchase decision.

We also examine the dynamics of optimal purchase decisions by small activists. We find that the acquisition of a position by the large activist (in effect, a 13D filing) precipitates the immediate entry of a significant additional number of small activists. While these activists know about the potential for activism at the firm before the lead activist buys in, other attractive uses of funds keep them from committing capital to the firm before they are sure that a lead activist will emerge. Others with lower opportunity costs may be willing to buy in earlier, as the real (but smaller) chance of successful engagement in the absence of a lead activist provides sufficient potential returns. Thus, our model predicts that late entrants to activism will be those who have relatively higher opportunity costs of tying up capital. One potential way to interpret this is that more concentrated, smaller, and more “specialized” vehicles (such as other activist funds) may be more inclined to acquire a stake only after the filing of a 13D by a lead activist.

The full paper is available for download here.

 

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