Jayanthi Sunder, Shyam V. Sunder, and Wan Wongsunwai
Debtholder Responses to Shareholder Activism: Evidence from Hedge Fund Interventions
Review of Financial Studies | Volume 27, Issue 11 (Nov 2014), 3318-3342

With the separation of ownership and management in the typical modern corporation, shareholder activism provides a mechanism for dissatisfied owners to voice their concerns with the current management and attempt to make changes in the company. With dispersed ownership, activism by individual shareholders is rarely effective. An exception to this is when the activists are financially savvy hedge funds.

Increasingly, activist hedge funds have been thrown into the limelight following high profile interventions in household name companies. Other than management and shareholders, another important stakeholder in these corporations are lenders. When powerful shareholders such as hedge funds seek to make changes in the way a company is run, a natural question is how and to what extent debtholders are affected, since they constitute a stakeholder group with more limited control rights than either management or equityholders.

How do lenders react, on average, to hedge fund interventions?

In a related study, Klein and Zur (RFS 2011) document a negative reaction in prices of existing bonds when filings are first reported to the SEC by activist hedge funds. The average negative abnormal bond return of –3.9% stands in sharp contrast to the significant positive abnormal stock return, with estimates ranging from 7% to 10%.

Whereas existing providers of debt capital are relatively powerless in the face of activist shareholder interventions, new lenders have the ability to tailor new loan contracts which take into account the borrower's new circumstances. Banks, in particular, are sophisticated lenders who can infer activist intentions, and they can use price and non-price contract features to manage risk in lending. Using a sample of hedge fund interventions between 1995 and 2009 and the bank loans obtained by targeted companies in periods before and after intervention, we find that, on average, banks increase the interest rates of new loans taken post intervention, by 30 basis points (bps). This indicates that shareholder activism by hedge funds is detrimental to debt holders. However, the average effect disguises significant variation in the underlying changes in loan spreads. We also find that the type and mix of covenants in loan contracts become more stringent, consistent with our findings for loan spreads.

Do lenders ever benefit?

Greenwood and Schor (JFE 2009) document several objectives pursued by activist hedge funds, which can have different impacts on debtholders. In particular, one class of actions (which we categorize broadly as being about improving governance in the target firm) ought to benefit both shareholders and debtholders. We focus on two such actions. The first are outright attempts to replace an entrenched, valuedestroying CEO, in which case we observe decreases in loan spreads, amounting to 27 bps on average. The second type of governance-related action which is often encountered in hedge fund interventions are attempts to block merger transactions. In these types of interventions, the average loan spread decreases by 32 bps. For these two classes of interventions, it appears that shareholder intervention is viewed positively by debtholders.

Under what circumstances might lenders be worse off?

In addition to blocking mergers, activist hedge funds also intervene to attempt to force the firm into being acquired. Greenwood and Schor find that such interventions account for most of the positive abnormal stock returns which occur on announcement of activism by hedge funds (made public through mandated filings with the SEC). Several prior studies suggest that takeovers are usually viewed negatively by lenders to the acquired firms because of increased financial risk in targeted firms (for example, Cremers, Nair, and Wei (RFS 2007) and Chava, Livdan, and Purnanamdam (RFS 2009)). As expected, we find a very significant increase in loan spreads in these firms, to the tune of 78 bps. Another frequent demand by shareholder activists is for increased payouts, in the form of special dividends or share repurchases. All else equal, such changes in capital structure resulting in reduced stakes by equityholders is clearly not in debtholders' interest. We find an average increase in loan spreads of 34 bps for this type of intervention, reflecting the negative effect of such demands on the target firms' creditors.

What was different during the financial crisis years (2007-2009)?

Our sample covers activist interventions from 1995 to 2009. Since we are comparing loans before and after interventions, a large fraction of loans falling in the financial crisis period (2007-2009) would be classified as post-intervention. Any characteristics of loans specific to the financial crisis period which systematically differ from non-financial crisis periods could therefore affect interpretation of our results. In order to address these concerns, we conduct separate analyses of the two time periods, and the crisis period analysis shows that lenders' responded more negatively to takeover and financial restructuring actions, while the positive reactions to managerial entrenchment related actions were somewhat muted but still consistent with the overall sample. These findings are broadly consistent with the shock to financial markets resulting in greater conservatism on the part of lenders during the crisis period.

Does the strength of pre-existing lender protection matter?

We consider several measures of pre-existing takeover risk and managerial entrenchment in the target firms to examine whether they are correlated with loan spread changes. In line with our expectations, in firms pushed by the activist hedge funds into being acquired, the increase in loan spreads is higher when the firm was less vulnerable to being taken over prior to intervention. Similarly, in cases where the hedge funds' objective is to reduce managerial entrenchment, the decrease in spreads in greater for firms with ex- ante greater entrenchment.

We conduct several additional analyses in which we document a coinsurance effect, the data suggesting that takeovers involving acquirers with better credit quality than the target are associated with a reduction in loan spreads, a result which goes in the opposite direction to the overall increase in loan spreads which we observe for cases involving the activist-targeted firm being pushed into being acquired.

Conclusion

In conclusion, this paper contributes to a better understanding of the consequences of hedge fund shareholder activism as viewed from debtholders' perspective. We show that different objectives pursued by activists have different implications for debtholders, and we specify different sets of circumstances in which the effects are either beneficial or adverse. Thus, shareholder activism does not always exacerbate bondholder-shareholder conflicts of interest. In particular, when shareholder activists address shareholdermanager agency problems and reduce the credit risk of the target firm, debtholders view the actions favorably.


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