Three Essays in Hedge Fund Activism

In the first essay, I apply behavioral finance theories to hypothesize one reason why hedge funds choose to engage in activism. Specifically, I predict that if hedge funds see the purchase price of their passive positions as a reference point, then, when they are suffering absolute losses, they are more likely to switch and become activists. I find results consistent with my prediction, even after controlling for the underperformance of the target firms. This study presents new evidence about what causes hedge fund activism. The behavioral finance literature has documented that retail investors, professional traders, and mutual funds are reluctant to realize their losses. I contribute to this literature by showing that a further effect of the loss is to cause activism. The second essay examines the short-term incentives that activists are facing. The average announcement return to hedge fund activism is around 5%. Thus, activists that want to inflate their reported returns have incentives to initiate activism in target firms before the end of the reporting period. Our contribution is to document that activists engage in such opportunistic activism. Consistent with this, we find that activists are more likely to start their campaigns just before the end of the quarter. This heightened activity cannot be explained by increased news flow at the end of the quarter. In contrast to the typical positive market reaction to activist initiation, reaction to opportunistic activism is virtually zero. This is suggestive of activists initiating campaigns without completing their research on firms, which were potentially targeted for activism in the following quarter. The final essay investigates how activists are able to be successful despite typically owning a stake of 6-7% in the target firms. We hypothesize that activists have incentives to (implicitly) coordinate with other institutional shareholders and to use this collective firepower to force target firms to change. Our contribution is to document that such coordination is pervasive and is mutually beneficial. In nearly two-thirds of the campaigns, there is coordination between the activist and institutional investors. Coordination is more likely in large firms where the activists would not have sufficient capital to build a large stake. Activist hedge funds that coordinate with other institutional shareholders are more successful in their activism as reflected in higher abnormal returns over the duration of the campaign. We attribute causation by instrumenting for coordination with the geographic proximity between the activist and the institutional investors.