Corporate governance and hedge fund activism

Corporate Governance and
Hedge Fund Activism
By
Shane Goodwin

Shareholder Activism & Corporate Defense 2
Agenda
 Overview
 History of Shareholder Activism
 Defining the Activist Landscape: Setting the Stage
 Literature Review
 Hypothesis Development
 Econometric Methodology
 Data and Empirical Testing
 Conclusion and Discussion

Shareholder Activism & Corporate Defense
Conventional Wisdom and Anecdotal Evidence…
3
For society as a whole, further empowering hedge funds with
short-term holding periods subjects Americans to lower long-
term growth and job creation…due to excessive risk
taking…when corporations maximize short-term profits.
Leo Strine, Chief Justice of the Delaware Supreme Court
Columbia Law Review, March 2014
Hedge-fund activism destroys jobs….such short-term
strategies may be good for shareholders, but aren’t good for
employees — or the economy as a whole.
Larry Fink, CEO BlackRock
December 12, 2014

History of Institutional Activism
Corporate “raiders”
strike fear into
corporations
Relatively
benign
shareholder
environment
Activist AUM reaches
new highs
 Activists use war chests to
expand into new sectors
(energy, mining)
 Target larger targets
(Apple, Microsoft)
1990s
1980s
Early2000s
Late2003
2006—2007
2012—present
Late1990s—2000
Tyco/WorldCom/Enron
scandals
 Investors and
governments begin to
focus on “corporate
governance”
 The profile of ISS rises
A new asset class is born
as some hedge funds
begin to re-brand
themselves as “activists”
Bill Ackman launches
Pershing Square Capital
November2005
Nelson Peltz launches
Trian Fund Management
September15,2006
Trian wins seminal
proxy fight against
large cap U.S. target
Heinz thanks to the
support of ISS and
“mainstream” investors
Activists have high success rate in affecting
change, especially at US targets
Europe is seen as a new
frontier for activism
 High-profile activist
campaigns (Cadbury
Schweppes and HSBC)
May29,2008
Pardus Capital wins
seminal proxy fight at
Atos Origin, a French
target
Global
recession
Global financial
meltdown causes
activists to
retrench, especially
from Europe
2008—2009
Recovery and expansion: Activists
restructure and the asset class
matures
May17,2012
Pershing Square
defeats "Club
Canada" in seminal
proxy fight against
Canadian Pacific
Speculation activists
will re-enter Europe
and target Asia and
Australia
2014
May14,2013
Third Point targets Sony
July1,2011
Australia establishes the
“two strike” rule to hold
directors accountable for
executive salaries and
bonuses
December2012
Shinzō Abe establishes
“three arrows” Japanese
economic policy of fiscal
stimulus, aggressive
monetary easing and
structural reforms
Source: FactSet and news articles.
Macro event
Micro event
4
~30% Institutional Ownership >70%
1980s Today

Institutional Shareholder Activism
Era of Governance-focused Activism
1985 – 2000
Era of Economic-motivated Activism
2000 – Present
ISS founded
1985
“New Kids on the Block”
Hedge Fund Activists
Council of Institutional
Investors Formed
Institutions Support
Dismantling of Defenses
Increase in Shareholder
Proposals
Emergence of “Corporate Raider”
(i.e. Carl Icahn, T. Boone Pickens)
Focus of my
Dissertation
Governance-focused activism facilitated the proliferation for the economically-
motivated activist to launch successful campaigns

Evolution of Hedge Funds
($ in Billions)
More Hedge Funds + AUM = More Hedge Fund Activism
Source: HFR
0
2,500
5,000
7,500
10,000
12,500
$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
NumberofFunds
AssetsUnderManagement
Assets Under Management Number of Funds
~$120 billion AUM
by Activists

Capital allocated to activism is increasing
$19
$29
$48
$55
$32
$36
$47
$51
$66
$93
$120
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Source: HFR and 13D Monitor as of December 31, 2014.
Hedge Fund Activism is Gaining Momentum
Estimated activist fund AUM ($ in billions)
Redemptions, asset
deflation
New high water
mark
CAGR = 19.9%
7

338
321
280
236
197
153
124
102
82 72
57
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
8
266
227
171
143
107
84
65
51
38 35 29
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Governance Activism Has Weakened Structural Defenses
Decline driven by shareholder proposals
Source: Shark Repellent
S&P 500 Poison Pills in Force
S&P 600 Poison Pills in Force

50 52
66
42
86
80
63
47
56
34
17
72.0% 71.2% 71.2%
66.7% 65.1%
58.8%
50.8%
72.3%
87.5%
82.4%
94.1%
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Proposals % Passed
269
237
207
181 172 164
146
126
89
60
49
259 256
242 233 225
208
193 187
176
165
149
368 363
352
332
311
300 296 295 291 285 279
9
Classified Boards
Declassifications Proposals
Increased support during 2011, 2012,
2013, and YTD 2014 proxy seasons
Board Declassification: Significant Support in Recent Years
Source: Factset
S&P 500 S&P 400 S&P 600

110
142 137
158 161
323
538
648
568
425
443
427 438
424
513
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Activist campaigns have increased
Source: SharkRepellent.
Note: Includes US campaigns as of December 31, 2014.
The birth of modern-day
hedge fund activism
Activist campaigns (2000 – 2014)
10
Data undercounts campaigns because increasingly common, private campaigns
are not tracked

605962
45
6464
8583
95
30
80
71
95
25
20
106
52
50
89
94
120
72
60
58
101
110
31
117
Consumer Financial Healthcare Industrials Natural Real Estate Tech,
Retail Institutions Resources Media
& Telecom
4Q13 13F 1Q14 13F 2Q14 13F 3Q14 13F
Source: Shark Repellent, Thomson, public filings
1
Includes public campaigns at U.S. companies over $0.5bn market cap
New/Incr. Positions
4Q13 13F 459
1Q14 13F 503
2Q14 13F 487
3Q14 13F 549
44
59
63
82
101
2010 2011 2012 2013 2014
… Enabling Them To Take More Positions… … And Launch More Campaigns
1
.
More Positions and More Campaigns
11

30
36 34
29
14
30 32 29
2
1 2
5
2
4
5
3
68
83 88
61
66
40
50
53
100
120
124
95
82
74
87 85
2007 2008 2009 2010
Seeking majority
(1)
2011 2012
Seeking minority
2013 2014
Seeking 50%
Proxy contests have remained relatively flat…
(40%)
18%
(2%)
30%
30% 27% 31%
17%
41% 37% 34%
Number of proxy contests
Source: SharkRepellent data as of December 31, 2014.
Notes: Campaigns where formal notice of dissident proxy is publicly disclosed.
(1) Seeking more than half of the Board seats.
12

41
[10]
45
[4]
40
[3]
42
[3]
39
[1] 26
[3]
38
[7]
47
[5]
27
[4]
27
[5]
38
[6]
19
[3]
23
[0]
22
[1]
18
[4]
13
[1]
32
48
47
34
20
26
31 25
100
95
82
74
87 85
2007 2008 2009 2010 2011
Withdrawn
2012
Went to Vote
2013 2014
Settlements
41% 32% 44%38%
35%
48% 44%
55%
“Settlement fever”
125
120
… but, settlements are on the rise
Note: Bracketed numbers represent campaigns that were settled or withdrawn after an ISS recommendation.
Includes nominations as part of a hostile bid.
13
The expense and bandwidth requirements of a full campaign are onerous

14 16
21
13 7
9
24
19
7
4
11
2
2 4
1
1
25
37
24
25
12 17
17
11
46 57 56 40 21 30 42 31
2007 2008 2009 2010 2011 2012
Dissidents win minority seats sought
(2)
2013
Incumbent wins
(3)
2014
Dissident win majority of seats sought
(1)
Shareholder support for dissident nominees has significantly increased
46%
35%
57%
38%
43% 43%
60%
Dissidents
won at
least one
Board seat
50% of the
time
65%
Includes nominations as part of a hostile bid
Vote results
(1) Includes winning half of the seats sought and campaigns which were settled prior to a vote and after an ISS recommendation was issued.
Includes campaigns that were settled prior to a vote and after an ISS recommendation was issued.
Includes campaigns that were withdrawn prior to a vote and after an ISS recommendation was issued.
Includes five campaigns settled post ISS recommendation: Sotheby’s, Intevac, Hudson Global, Rand Logistics, and Cardica.
(2)
(3)
14
Anecdotal evidence indicates many investors wonder “what’s the harm?” of
seating a shareholder “watch dog” on the board

Nobody is too big, too popular or too successful
15

Fight went
definitive
(2)
Fight went the
distance
(3)
2
1
3 3
1
2
2
1
4
1
1
1
1
4
4
10
10
14
12
2
8
6
3
14
Includes nominations as part of a hostile bid
ISS vote recommendations
17
10
15
3
12
11
2007 2008
ISS supports majority board change
2009 2010
ISS supports 50% board change
18 17
2011 2012
ISS supports minority board change
6 13
2013 2014
ISS supports management
17 14
ISS seems increasingly willing to support majority change
12% 7%
25%
33%
36%
18 22
11 17 8 10 4 8 11 11
Note: SharkRepellent data as of December 31, 2014.
(1) Campaign under which dissident publicly discloses it delivered formal notice to the company that it intends to solicit proxies.
(2) Dissident filed a definitive proxy.
(3) Proxy fight outcome decided by a shareholder vote.
16
14
17
ISS supported majority and 50% board change increased in 2014, and remains
above pre-2013 levels

Alliances Among Activists / Hedge Funds – “The Wolf Pack”
17
Source: FactSet, company filings and press releases
Perry Corp
Sarissa Capital Management
Soros Fund Management
Glenview Capital Management

U.S. corporate cash remains above historic levels
Source: Federal Reserve U.S. corporate balance sheet data as of December 31, 2014.
1,385
1,265
1,496
1,519 1,519
1,641
1,677
1,649
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Avg.
$1,613
Corporate liquid assets
($ in billions)
2,000
1,895
1,693
18
24%

Activist Hedge Funds Pursue Multiple Strategies, Often in Combination
M&A
Activism
19
Balance
Sheet
Activism
Governance
Activism
Operational
Activism
The easiest activist strategy – quick capture of a takeover
premium provides attractive returns over a short term using
leverage
 Demand strategic alternatives review (“sell the company” activism)
 Spin-off divisions to unlock “hidden” value
 Influence merger (“bumpitrage”) or block deals (“snap-back
trade”)
An easy strategy – run a simple screen to identify targets
 Return capital to shareholders (share buyback, special dividend)
 Relies on accommodating markets
 Coming back? Sell-side studies on record high cash on balance
sheet
A means to an end – not an end in itself
 Run a proxy fight to replace directors
 Replace directors outside of AGM calendar
The hardest strategy, and hence rarest – requires industry
experience and patience
 Improve top and bottom lines
 Change management, including direct attack on CEO
 Focus on cost structure (SG&A, R&D), and ROIC
Activists look for opportunities to effect change that can result in short or long-term increases
in shareholder value
Easiest
Hardest
StrategicImplementation

Shareholders Believe Activism Can Create Value in the Aggregate
Dedicated
Activist Funds
Continue to
Attract New
Investments
20
Activism Can
Thrive in All
Market
Environments
No Company is
Immune
Shareholders
Take a Balanced
View
 Activist funds have the money and the mandate
 $2 billion Pershing Square SPV to invest in a single company (Target)
 CalPERS has invested more then $4 billion in 10+ activist funds
 New funds being formed (Corvex, Casablanca, etc.)
 Two popular tools in the activist tool box (“sell the company” and balance
sheet activism) rely on accommodating markets
 But weaker markets provide more activist targets, as investors search for alpha
 Domestic large caps are not immune: Apple, Microsoft, P&G, Nupart
 European activism: TNT, National Express, Cookson, Implenia, Actelion,
Danisco, ABN Amro, Generali
 Asian activism is not as prevalent, but is starting to appear (e.g. Olympus)
 The agency problem: directors may rent seek, or fail to move quickly
 The collective action problem: dispersed shareholder base
 Short termism: seek to encourage long-term investment and prudent risk taking

The Activist Playbook
Stock Accumulation
Public Communications
Shareholder Proposals
Contested Proxy Solicitation
Least Aggressive
Most Aggressive
“ActivismontheCheap”
Overarching tactical goal is to create and exploit divisions between management /
Board / institutional shareholders – prey on company disunity and disorganization
Private Communication – “The Ask”

Activism Results in Superior Returns for the Hedge Funds...
22
Select Shareholder Returns vs. S&P 500
43%
31%
24% 24%
18% 16%
13% 13%
10% 10% 8% 8% 8% 6%
3%
0%
(2%)
(7%) (9%)
(21%)
(42%)
BiglariCapital
JANA
PershingSquare
OliverPress
NewcastlePartners
Starboard
Southeastern
Relational
ValueAct
ThirdPoint
Clinton
Trian
BaringtonCapital
Elliott
BeckerDrapkin
Greenlight
Icahn
SteelPartners
DiscoveryGroup
BreedenCapital
Harbinger
Number of
13D Filings:
8 22 16 4 16 57 23 17 62 42 19 8 24 46 9 15 78 81 39 7 37
Average α: 7.3%
Source: 13D Monitor
Activism Continues to Emerge as an Asset Class as Returns Outperform

 Evolving governance regime is derived from federal legislation, SEC rulemaking, state corporate
legislation, stock exchange rules, shareholder proposals, “best-practice” standards and judicial
decisions, principally those of the Delaware Court of Chancery.
Risk Management Executive
Compensation
Board Structure Director Elections Takeover Defenses
• Enhanced Risk
Management
Disclosure
• Board
Responsibility for
Risk Management
and Risk Failures
• Mandatory Board-
level Risk
Committees
• CEO Succession
Planning
Disclosure
• Say-on-Pay
• Say-on-Golden
Parachutes
• Cut Backs on
Golden Parachutes/
Eliminate Gross-
Ups
• Clawbacks
• Enhanced
Compensation
Disclosure
• Independent
Compensation
Committees and
Consultants
• Separate
Chair/CEO
• Director
Independence
• Elimination of
Classified Boards
• Enhanced Board
Structure
Disclosure
• Board Diversity
Policy Disclosure
• Direct
Shareholder
Communication
with Independent
Directors
• Majority Voting
• Shareholder Proxy
Access
• Eliminate Broker
Discretionary
Voting
• Enhanced
Candidate
Qualifications
Disclosure
• Eliminate
Shareholder Rights
Plans
• Eliminate Classified
Boards
• Lower Threshold for
Shareholder-
Initiated Special
Meetings
• Permit
Shareholders to Act
by Written Consent
• Eliminate
Supermajority
Voting Provisions
Governance-Focused Activists
23
Economic activists tend to use governance as a means to an economic end

 Corporate social responsibility is a major concern for companies and boards.
 Numerous “environmental and social” Rule 14a-8 shareholder resolutions proposed
during the 2014 proxy season, including:
 Political contributions and activity
 Environmental issues (including climate change, energy, other) and sustainability
 Human rights
 Board diversity
 Animal welfare
 Sexual orientation nondiscrimination/EEO reporting
 Enhanced focus on political spending in light of the Supreme Court’s 2010 Citizens
United decision (and affirmation in 2012).
 ISS voting policy on social and environmental proposals is on a case-by-case basis
considering whether implementation is likely to enhance and protect shareholder value
 United Nations blueprint to promote human rights in the conduct of global business.
Social-Agenda Activists
24

 Economic activism is now an established part of the capital markets, takeover and governance scene
 Generally, economic activists do not seek to take over a company but advocate “value
maximizing” activity, often short-term oriented (e.g. share repurchases, spin-offs, balance sheet
and business strategy adjustments); however, more situations where activists are seeking control
of the board
 Economic activism is made more effective by governance activism, which eliminates structural
defenses
“Value Maximization” Demands Other Strategic Demands
• “Break up” plays: spin-offs, split-ups, sell divisions / non-core
assets
• Return of capital (share repurchases; special
dividends; leveraged recapitalization)
• Advocate for sale of company
• Management change
• Board change (“withhold vote” campaign or short-
slate / full-slate proxy contest)
• New business strategies/initiatives
• New capital structure / capital allocation
• Compensation reform
• Monetize assets (e.g., real estate; IP) through complex
structuring
• Block a transaction or initiative (or new terms)
Economically-Motivated Activists: Hedge Funds
25

Directors are Coming Under Fire
1
Long Tenure
Perceived or Real
Conflict of Interests
Other Boards
(i.e., Over-boarded)
Lack of Industry Expertise
Lack of Economic
Ownership
The Impact of Activism on Board Composition
26
Activists are increasingly assembling slates of directors with a mix of
seasoned executives, corporate governance notables, and others with
“investor” perspective

Literature Review

Theoretical Foundations of Shareholder Activism
28
 The underlying theoretical foundation in the study of shareholder activism is agency theory. The
central tenet of agency theory is an overarching concern about the divergence of interests between
principals and agents (Berle and Means, 1932; Jensen and Meckling, 1976).
 The presumption of opportunistic behavior by managers gave rise to agency theory, which was further
enhanced by the work of Jensen and Meckling (1976) and Fama and Jensen (1983) who posit that
managers may misuse corporate causing principal-agent issues. As a result, agency theory logic
would suggest that shareholder activism is one external control option for owners who are
dissatisfied with the management of their assets.
 Some argue that the board of directors has not done a good job in their role as monitor and failed to
remove underperforming executives (Lorsch & Maciver, 1989; Mace, 1986; Weisbach, 1988). In
addition, Jensen and Smith (1985) argue that managers are more likely to minimize risk, engage in
short-term investments and employee growth strategies to increase their compensation as well as
their job security.
 Shareholders have three options: (1) sell their shares, (2) passively continue to hold their shares in the
hope that things will improve over time, or (3) continue to hold their shares and attempt to
influence the firm. Option three is the path chosen by shareholder activists. However, activism is not
costless and only shareholders with the knowledge and resources can attempt to “voice” their
displeasure with underperforming corporations (Shleifer and Vishny, 1986; Admati et al., 1994).
 Critics claim economically-motivated shareholder activists may have different objectives for their
target firms than other shareholders. However, active board engagement is supported and endorsed
by other shareholders since an activist would need the voting support of the majority of the
shareholders.

Literature Review
29
 One possible solution to mitigate agency cost is for shareholders to actively monitor the firm’s
management. However, while monitoring may reduce agency and improve firm value, this effort is
not without cost and the benefits from monitoring are enjoyed by all shareholders (Grossman and
Hart, 1980).
 Shareholders that serve as active monitors of firm management to provide a disciplinary
mechanism is not a new concept. Gillan and Starks (2007) define shareholder activists as “investors
who, dissatisfied with some aspect of a company’s management or operations, try to bring about
change within the company without a change in control.” Tirole (2006) provides the following
definition: “Active monitoring consists in interfering with management in order to increase the value of
the investors’ claims.”
 Theory predicts that large shareholders should be effective monitors of the managers of publicly listed
firms, reducing the free-rider problem ((Shleifer and Vishny (1986) and Grossman and Hart (1980)).
Earlier studies show that when institutional investors, particularly mutual funds and pension
funds, follow an activist agenda, they do not achieve significant benefits for shareholders (Black
(1998), Karpoff (2001), Romano (2001), and Gillan and Starks (2007)).
 Unlike mutual funds and pension funds, hedge funds are able to influence corporate boards and
managements due to key differences arising from their organizational form and the incentive
structures.

Literature Review
30
 Brav, Jiang, Partnoy, and Thomas (2008) find that the announcement of hedge fund activism
generates abnormal returns of more than 7% in a short window around the announcement.
 Recent research by Bebchuk, Brav and Jiang (2013) find statistically meaningful evidence that the
operating performance of target firms improves following activist interventions but no evidence to
support the claim that short-term improvement was at the expense of long-term performance.
 The proxy contest process is a meticulously regulated election mechanism which can be invoked
when “one group, referred to as ‘dissidents’ or ‘insurgents’ attempt to obtain seats on the
firm’s board of directors currently in the hands of another group, referred to as ‘incumbents’ or
‘management’” (Dodd and Warner, 1983).
 Venkiteshwaran, Iyer and Rao (2010) conducted a detailed study of hedge fund activist Carl Icahn’s
13D filings and subsequent firm performance and found significant share price increases for the target
companies (of about 10%) around the time Icahn discloses his intentions publicly. Additionally, the
author’s found a significant number (1/3) of Icahn’s targets ended up being acquired or taken private
within 18 months of his initial investment. The shareholders of those companies earned abnormal
returns of almost 25% from the time of Icahn’s initial investment through the sale of the
company.

Literature Review
31
 Determinants of Shareholder Activism
• Prior Firm Performance
• Firm Size
• Free Cash Flow
• Board of Director Characteristics
• Ownership Structure
 Active Monitoring by Shareholders
 Efficacy of Shareholder Activism
• Impact on Firm Performance
• Short-term Market-based Firm Performance
• Long-term Market-based Firm Performance
• Accounting-based Firm Performance

Hypothesis Development

Hypothesis 1: Determinants of Hedge Fund Activism – Firm Performance
33
 Numerous studies that use various market and accounting-based financial measures to test firm
performance to determine the vulnerability of a target firm by an activist hedge fund.
 However, short interest ratio (i.e., shares sold short) as a measure of a target firm’s performance has not
been used to determine a company’s vulnerability regarding hedge fund activism.
 According to Asquith et al (2005), shares sold short, as a percentage of shares outstanding, have more
than doubled in the last 20 years. In dollar terms, the increase is more than twentyfold. Shareholders,
particularly large blockholders, may induce good managerial behavior by exiting and pushing down stock
prices when bad managerial actions are taken (e.g., Admati and Pfleiderer, 2009; Edmans, 2009; Edmans
and Manso, 2011).
 Can short selling be used as a proxy for managerial misbehavior? Short sellers are known to be
informed (Senchack and Starks, 1993; Asquith et al. 2005; Cohen et al. 2007; Boehmer et al., 2008) and
highly motivated to attack bad firms (e.g., Karpoff and Lou, 2010; Hirshleifer et al., 2011). Short selling
appears to discipline managers and reduce their incentives to manipulate (Massa et al., 2013). Massa et
al (2013) claim that shareholders can rely on the external disciplining mechanism of short selling instead
of engaging in direct monitoring of managers.
 I posit that short selling is a signal of increased agency cost and is a proxy for expected future firm
performance that can be used by activist hedge funds to identify potential targets to serve as a
disciplinary mechanism to monitor management via board representation.
Hypothesis 1: There is a significant positive correlation between hedge fund
activism and an increase in the short-interest position experienced by target
firms ex-ante an activist intervention.

Hypothesis 2: Determinants of Hedge Fund Activism – Inside Ownership
34
 Three studies looked at insider ownership as a determinant of shareholder activism. Bethel et al. (1998)
found that firms with low insider ownership are more likely to be targeted among blockholders. Bizjak
and Marquette (1998) and Akyol and Carroll (2006) studied proxy resolutions directed at poison pill
removal and both found that insider shareholding was negatively associated with activists’ efforts to
remove poison pills via proxy resolutions and negotiations.
 Little is known about how ownership characteristics of firms lead them to be targeted by shareholder
activists. Bethel et al. (1998) definition of “blockholder” was any group owning five percent (5%) or
more. This included pension funds, banks and other investors. They did not delineate between activist
and non-activist investors.
 Since hedge fund activists ultimately reply on the support of other shareholders, I assert that many
activist hedge funds target firms with nominal “corporate inside” ownership.
 I define “corporate inside” ownership as equity securities that are beneficially owned by the company’s
officers and directors and I exclude any institutions or non-company officers and directors that are
considered insiders by SEC since they are beneficial owners of more than ten percent of a class of the
company’s equity securities.
 Hedge fund activists target companies with nominal “corporate ownership” for two primary reasons.
First, it will ensure an increased likelihood of success if a management team cannot “block” a proxy
voting contest and, second, it supports the narrative that a management team with nominal ownership is
entrenched and not acting in the best interest of the owners.
activism and nominal “corporate inside” ownership.

Hypothesis 3: Activist Hedge Fund Intervention – Board Representation
35
 Shleifer and Vishny (1997) explain that “corporate governance deals with the ways in which the
suppliers of finance to corporations assure themselves of getting a return on their investment.”
 The fundamental feature of corporate governance is shareholder’ right to elect directors to represent
their interests.
 Shareholders can discipline directors through proxy contests. During the 1980s, dissident shareholders
more often relied on hostile tender offers to effectuate change at a target firm. However, during the last
decade activist shareholders have relied more often on proxy contests. More importantly, hedge fund
activists are the primary initiators of proxy contests, launching 812 (63%) of all proxy fights since 1995.
Activist hedge funds face limited regulatory constraints and can be effective in exploiting the
proxy-contest mechanism (Brav, Jiang, Partnoy, and Thomas, 2008).
 There have been many studies with respect to proxy contests, but there is a void in the literature
regarding activist hedge fund seeking board representation to act as a disciplinary mechanism to
monitor management.
Hypothesis 3: There is a significant positive correlation between board
representation of an activist hedge fund ex post an intervention and nominal
“corporate inside” ownership.

Hypothesis 4: Active Hedge Fund Monitoring – Ex Post Intervention
36
 While the topic of shareholder activism is not new, the topic of hedge funds as activists is rather new.
 Activist hedge funds have been the most prominent and successful proponents of institutional shareholder
activism in recent decades (Gillan and Starks 2007). Boyson and Mooradian (2011) noted that the idea of
hedge funds as activists is in direct contrast with their image as short-term, opportunistic investors
 Short-term Effects of Active Monitoring. Theory predicts that large shareholders should be effective
monitors of the managers of publicly listed firms, reducing the free-rider problem ((Shleifer and Vishny
(1986) and Grossman and Hart (1980)). Yet the evidence that large shareholders increase
shareholder value is mixed. In two recent surveys, Karpoff (2001) and Romano (2001) conclude that
activism conducted by large institutional shareholders (i.e., pension funds and mutual funds) has had little
impact on firm performance. Karpoff, Malatesta, and Walkling (1996), Wahal (1996), and Gillan and Starks
(2000) report no persuasive evidence that shareholder proposals increase firm values, improve operating
performance or even influence firm policies.
 Brav et al (2008) is the only credible study conducted to test empirically the short-term effects of activist
hedge funds on target firms. Using data set from 2001 to 2006, the authors find that activist hedge funds
in the U.S. proposed strategic, operational, and financial remedies and attain success or partial success in
two-thirds of the cases.
Hypothesis 4: There is a significant positive “initial” market reaction on the
announcement date that a hedge fund dissident shareholder has been granted
board representation to function as a disciplinary mechanism to monitor
management

Hypotheses 5 and 6: Active Hedge Fund Monitoring – Ex Post Intervention
37
 Long-term Effects of Active Hedge Fund Monitoring. Activist hedge funds have been the most
prominent and successful proponents of institutional shareholder activism in recent decades (Gillan and
Starks 2007). Very few studies on the impact of hedge fund activism and short-term performance of
target firms. Importantly, there are no credible studies in the finance literature with respect to hedge
fund activism and its long-term implications (greater than one year) of the target firms’ long-term
shareholders and the long-term operating performance of those firms.
 Bebchuk, Brav and Jiang (2013) found that contrary to the claim that hedge fund activists adversely
impact the long-term interests of organizations and their shareholders, there is evidence that activist
interventions lead to improved operating performance in the five years that follow the interventions.
Consistent with their previous research, the dataset used by Bebchuk, Brav and Jiang (2013) is
primarily constructed from Schedule 13D filings
Hypothesis 5: Hedge fund activism generates statistically significant long-
term value for the target firms and its long-term share when they function as a
Hypothesis 6: Hedge fund activism generates statistically significant
improvement in long-term operating performance for the target firms and its
long-term share when they function as a disciplinary mechanism to monitor
management via board representation.

Econometric Methodology

Endogeneity
39
 According to Roberts and Whited (2012), one of the most important and ubiquitous issues
confronting studies in empirical corporate ﬁnance is endogeneity.
 Endogeneity is essentially a correlation between the explanatory variables and the error
term in a regression – which leads to biased and inconsistent parameter estimates that
make reliable inference virtually impossible.
 Endogeneity can be caused by three circumstances
1. Omitted Variables
2. Measurement Error
3. Simultaneity
 The potential biased effects of endogeneity leads to:
1. Rejecting a hypothesis that in fact is true (Type I Error)
2. Fail to reject a hypothesis that in fact is false (Type II Error)

Endogeneity
40
 Potential sources of endogeneity in the study of hedge fund activism.
1. Timing with respect to the announcement of board representation by an activist hedge fund. If
not handled correctly, this endogeneity can invalidate results concerning the market’s short-run
reaction.
Potential Solution: Search news events around the announcement date and eliminate
confounding news.
2. Target firm characteristics – a hedge fund’s decision to target a firm. This endogeneity may
present a problem while comparing activism targets to firms not targeted by activism, since
these firms likely differ from each other in both observable and unobservable ways.
Potential Solution: Research design will reduce this problem, since to appear in my sample, a
firm must already be a target of hedge fund activism.
• Conditional upon being a hedge fund activism target with respect to the control group.
• Select a control sample to deal with unobserved heterogeneity in hedge fund manager skill
or technique.
• Construct a Control Group of all hedge fund activist campaigns that did not result in board
representation during the same period.

Endogeniety – The Problem at its Core
41
 Consider the following main equation of interest:
 yi = β0 + β1x1i + β2x2i + ··· + βk xki + γqi + vi
 Here qi is the unobserved variable (such as confounding events at the
time of the activist intervention) and vi is the traditional error term
 If we omit qi the equation transforms into:
 yi = β0 + β1x1i + β2x2i + ··· + βk xki + ui
 where ui = γqi + vi
 If cov(qi ,xj ) /= 0 where j ∈ 1,2,...,k, then cov(ui ,xj ) /= 0
 We violate one of the OLS assumptions ---tthis is the endogeneity
problem which represents a potential bias

Endogeniety – Bias and Instrumental Variables (IV) Regression
42

 One cannot consistently estimate any of the βjs, when ui is correlated
with any of the regressors
 Each of the βjs consists of the ’true’ βj + an omitted variables bias
 γ > 0 and cov(xi ,qi ) > 0 leads to an upwards/positive bias in stimates
(e.i., the effect of xi is overestimated)
 Instrumental variables (IV) regression is designed to control for
unobserved heterogeneity
 IV regression is designed to correct the esimates in the main equation
as an effect of the unobserved

“Sample Selection Bias” – Omitted Variables Endogeneity
43
 An important problem of causal inference is how to estimate treatment effects in observational studies,
situations in which a group of units is exposed to a well-defined treatment (i.e., shareholder activism,
board representation) but no systematic methods of experimental design are used to maintain a control
group.
 It is well recognized that the estimate of a causal effect obtained by comparing a treatment group with
a non-experimental comparison group could be biased because of problems such as self-selection or
some systematic judgment by the researcher in selecting units to be assigned to the treatment.
Potential Solution:
 Propensity Score Matching. Matching involves pairing treatment and comparison units that are
similar in terms of their observable characteristics. When the relevant differences between any two
units are captured in the observable (pre-treatment) covariates, which occurs when outcomes are
independent of assignment to treatment conditional on pre-treatment covariates, matching methods
can yield an unbiased estimate of the treatment impact.
 The motivation for focusing on propensity score matching methods is that the dimensionality of the
observable characteristics is high. Propensity score matching methods, are especially useful under
circumstances with many variables, because they provide a natural weighting scheme that yields
unbiased estimates of the treatment impact.
 I use propensity score matching to address self-selection bias by constructing two control
groups (Control Group I : Target Firms that “won” the proxy fight against Hedge Fund Activists
and Control Group II : Board representation by Non-Hedge Fund Activists.)

Fixed Effects Model (FE)
44
Target Firm-specific Effects Model
 I assume that there is unobserved heterogeneity across target firms captured by ai
 The main question is whether the target firm-specific effects ai are correlated with the
regressors. If they are correlated, I will use a fixed effects model.
 The FE model allows the target firm-specific effects ai to be correlated with the
regressors x
 I include ai as intercepts
 Each target firm has a different intercept term and the same slope parameters.
 I recover the target firm specific effects after estimation as:
 In other words, the target firm-specific effects are the leftover variation in the dependent
variable that cannot be explained by the regressors.
 Time dummies can be included in the regressors x.

Endogeneity – Econometric Techniques
45
 The combination of complex decision processes facing ﬁrms and limited information
available to researchers ensures that endogeneity concerns are present in every corporate
finance study.
 I reviewed the sources of endogeneity — omitted variables, simultaneity, and measurement
error — and their implications for inference.
 I used the following econometric techniques aimed at addressing endogeneity problems
including:
• matching methods; and
• panel data methods

Empirical Test and Results
46
Cross-Sectional Firm Operating Performance
Tobin’s Q= (Market value of assets) / (Replacement cost of assets)
Return on assets (ROA) = (EBIT * (1-tax rate)) / ((Total Assets(t) + Total Assets(t-1)) / 2)
ROIC = (EBIT * (1-tax rate)) / ((Total Debt + Preferred Equity + Total Common Equity)(t)) +
((Total Debt + Preferred Equity + Total Common Equity)(t-1)) / 2)
ROE = Net Income / ((Total Common Equity + Preferred Equity + Total Minority))
Financial Leverage (Total Debt to Capital) = Total Debt / (Total Preferred Equity + Total
Common Equity+ Total Debt + Minority Interest)(t)) + ((Total Common Equity + Preferred
Equity + Total Minority Interest)(t-1)) / 2)
Payout Ratio (Common Dividends + Preferred Dividends) / Net Income
CAPEX / Sales = Total Capital Expenditures / Total Revenues

Empirical Test and Results
47
Long Term Stock Returns
Capital Asset Pricing Model (CAPM), the standard procedure is to estimate an “alpha,” the
average excess return that is not explained by co-movement with the market. Specifically, we
estimate for each firm i an alpha using the following regression:
Fama-French-three-factor asset pricing model, the standard procedure is to estimate an
“alpha,” the average excess return that is not explained by the three market-wide factors
identified in by Fama and French (1993). We estimate for each firm i an alpha using the
following regression:
Fama-French-Carhart four-factor asset pricing model, the standard procedure is to
estimate an “alpha,” the average excess return that is not explained by the four market-wide
factors identified by Fama and French (1993) and by Carhart (1997). We estimate for each
firm i an alpha using the following regression:
rit -rf =ai +β1RMRFt +Eit
rit-rf =ai+βi1RMRFt+βi2SMBt +βi3HMLt+Eit
rit -rf =ai +βi1RMRFt +βi2SMBt +βi3HMLt +βi4M0Mt +Eit

Buy-and-hold abnormal returns (BHAR) Approach
48
 In recent years, following the works of Ikenberry, Lakonishok, and Vermaelen (1995), Barber and Lyon
(1997), Lyon et al. (1999), the characteristic-based matching approach (or also known as the buy-and-
hold abnormal returns, BHAR) has been widely used.
 Mitchell and Stafford (2000) describe BHAR returns as “the average multiyear return from a strategy of
investing in all firms that complete an event and selling at the end of a pre-specified holding period
versus a comparable strategy using otherwise similar nonevent firms.”
 An appealing feature of using BHAR is that buy-and-hold returns better resemble investors’ actual
investment experience than periodic (monthly) rebalancing entailed in other approaches to measuring
risk-adjusted performance.
 Once a matching firm or portfolio is identified, BHAR calculation is straightforward. A T- month BHAR
for event firm i is defined as:
BHARi (t, T) = Pt = 1 to T (1 + Ri,t) - Pt = 1 to T (1 + RB,t)
  
  nBHARBHARt
or
nCARCARt
iiBHAR
iiCAR
//
//





  I test empirically the significance of each coefficient using the following equation:
 I constructed multiple BHAR portfolios of stocks from 1990-2014 for the Treatment Group, both
Control Groups and Matching Firms.

Calendar-time portfolio approach (Jensen’s alpha)
49
 The calendar-time portfolio or Jensen-alpha approach to estimating risk-adjusted abnormal performance
is an alternative to the BHAR calculation using a matched-firm approach to risk adjustment. Jaffe (1974)
and Mandelker (1974) introduced a calendar time methodology to the financial-economics literature, and
it has since been advocated by many, including Fama (1998), Mitchell and Stafford (2000) and Brav and
Gompers (1997).
 The distinguishing feature of the most recent variants of the approach is to calculate calendar-time
portfolio returns for firms experiencing an event, and calibrate whether they are abnormal in a multifactor
regression. The estimated intercept from the regression of portfolio returns against factor returns is the
post-event abnormal performance of the sample of event firms.
 I implemented the Jensen-alpha approach for a five year period during the pre-event (i.e., prior to the
dissident / activist board seat grant date) and then post-event annually for a five year period.
 In each calendar month over the entire sample period, a portfolio was constructed comprising all firms
experiencing the event within the previous month. The portfolios are rebalanced each month and an
equal or value-weighted portfolio excess return will be calculated. The resulting time series of monthly
excess returns is regressed on the CAPM market factor and the three Fama-French (1993) factors as
follows:
Rpt – Rft = αp + βp (Rmt – Rft) + βp,SMBSMBt + βp,HMLHMLt + εpt
Where;
Rpt is the equal or value-weighted return for calendar month t for the portfolio of event firms that experienced the event within previous T years,
Rft is the risk- free rate,
Rmt is the return on the CRSP value-weight market portfolio,
SMBpt is the difference between the return on the portfolio of “small” stocks and “big” stocks;
HMLpt is the difference between the return on the portfolio of “high” and “low” book-to-market stocks;
αp is the average monthly abnormal return (Jensen alpha) on the portfolio of event firms over the T-month post-event period,
βp is the beta (the sensitivities) of the event portfolio to the three factors.

Data and Empirical Testing

Primary Research Question
51
Primary Research Question
• My dissertation addresses two fundamental questions with respect to
hedge fund activism:
1. What are the determinants of hedge fund activist interventions
and the characteristics of the Target Firms? and;
2. Does hedge fund activism create long-term value for Target
Firms and their long-term shareholders?
Hedge-fund activism destroys jobs….such
short-term strategies may be good for
shareholders, but aren’t good for employees
— or the economy as a whole.
Larry Fink, CEO BlackRock
December 12, 2014
For society as a whole, further empowering
hedge funds with short-term holding
periods subjects Americans to lower long-
term growth and job creation…due to
excessive risk taking…when corporations
maximize short-term profits.
Leo Strine, Chief Justice of the Delaware Supreme Court
Columbia Law Review, March 2014

Data and Methodology
52

Characteristics of Target Firms and Activist Campaigns (1990-2014)
53

Target Firm Outcome Ex Post Hedge Fund Intervention
54
Hedge Fund Activism vs. HF Board Representation
CEOChangeSaleorMerger

Hypothesis 1: Determinants of Hedge Fund Activism – Short Selling
55
activism and an increase in the short-interest position experienced by target
firms ex-ante an activist intervention.
Short Interest Ratio isdefined as:
Short Interest Ratio =
Shares Sold Short
Total Shares Outstanding
(5.1)
Note: Short interest reflects the Target Firms short position on the last business day of the each month. The short interest data was collected via FT
Interactive and Compustat which includes all positions from the New York Stock Exchange, American Stock Exchange, and NASDAQ. The data was
aggregated and merged into my shareholder activist dataset using GVKEY and CUSIP firm identifiers. All potentially unbounded variables are winsorized
at the 1% and 99% extremes.

56
Target Firms vs. Matched Firms and Industry Composites
(Ex Ante and Ex Post Activism Event)

57
Change in Short Interest Position of Target Firms Ex Ante Activist Intervention
(Hedge Fund Activism versus Non-Hedge Fund Activism)
This table reports the change in Short Interest Position of Target Firms of hedge fund and non-hedge fund activist interventions between t-6
and t-1 the event. The Short Interest Ratio is defined as (Shares Sold Short / Total Shares Outstanding). All potentially unbounded
variables are winsorized at the 1% and 99% extremes. The significance level, which was determined by the t statistic, is asymptotically
normal for paired differences.
Coefficients marked with *** are significant at the 1% level, ** at the 5% level and * at the 10% level.

58
Change in Short Interest Ratio Relative to Other Vulnerability Variables

59
Notwithstanding the statistically significant evidence to support an
increase in the absolute magnitude of the Target Firms short
interest position, there is NO statistically significant evidence with
respect to the marginal “change” of the Target Firm’s short interest
position ex ante a Hedge Fund intervention.
Therefore, based on the empirical testing, I “fail” to reject the
null hypothesis and I cannot conclude There is a significant
positive correlation between Hedge Fund activism and an increase
in the short-interest position experienced by Target Firms ex ante
an activist intervention.
Conclusion

60
activism and nominal “corporate inside” ownership.
This table reports the Quarterly Corporate Ownership of Target Firms one month ex ante for both Hedge Fund and Non-hedge Fund activist interventions. The ownership data is from the
FactSet/LionShares database, which provides portfolio holdings of both institutional and individual investors. FactSet compiles ownership information from public filings by investors (such as 13-F
filings, Form 3 and Form 4), company annual reports, stock exchanges, and regulatory agencies around the world. The SEC ”Corporate insiders” as a company’s officers and directors, and any beneficial
owners of more than 10% of a class of the company’s equity securities registered under Section 12 of the Securities Exchange Act of 1934 – must file with the SEC a statement of ownership regarding
those securities. The data in the table excludes any institutions or noncompany officers and directors that are required to file with the SEC because they are beneficial owners of more than 10%
of a class of the company’s equity securities. Institutions are defined as professional money managers, including mutual fund companies, investment advisors, pension funds, bank trusts, and insurance
companies. All potentially unbounded variables are winsorized at the 1% and 99% extremes. t statistics in parentheses. The significance level, which was determined by the t statistic, is
asymptotically normal for paired differences.

61
Quarterly Corporate Ownership of Hedge Fund Activist Interventions
(Robustness Check)

62
The results of the empirical testing show a statistically meaningful
correlation between Hedge Fund activism and nominal “corporate
inside” ownership.
I report a statistically significant difference. Therefore, I reject the
null hypothesis to conclude There is a significant positive
correlation between hedge fund activism and nominal
Conclusion

63
This table reports the Quarterly Corporate Ownership of Target Firms one month ex ante for the Treatment Group and both Control Groups. The Treatment Group is all Target Firms that granted at least
one board seat to a dissident Hedge Fund, Control Group I is defined as Target Firms of all proxy fights campaigns that did not result in board representation during the same period and Control Group
II is comprised of Target Firms that granted at least one board seat to a Non-hedge Fund dissident shareholder during the same time period. The ownership data is from the FactSet/LionShares database,
which provides portfolio holdings of both institutional and individual investors. FactSet compiles ownership information from public filings by investors (such as 13-F filings, Form 3 and Form 4), company
annual reports, stock exchanges, and regulatory agencies around the world. The SEC ”Corporate insiders” as a company’s officers and directors, and any beneficial owners of more than 10% of a class of the
company’s equity securities registered under Section 12 of the Securities Exchange Act of 1934 – must file with the SEC a statement of ownership regarding those securities. The data in the table excludes any
institutions or noncompany officers and directors that are required to file with the SEC because they are beneficial owners of more than 10% of a class of the company’s equity securities. Institutions are
defined as professional money managers, including mutual fund companies, investment advisors, pension funds, bank trusts, and insurance companies. All potentially unbounded variables are winsorized at
the 1% and 99% extremes. t statistics in parentheses. The significance level, which was determined by the t statistic, is asymptotically normal for paired differences.

64

The results of the empirical testing show a statistically meaningful correlation
between board representation of a Hedge Fund Activist and nominal “corporate
inside” ownership (t−3 months) ex post the Board Seat Grant Date. In contrast,
Control Group I and Control Group II are not statistically significant and
Target Firms that “won” the proxy fight against Hedge Fund Activists report
positive coefficients with respect to “corporate inside” ownership.
Therefore, I find statistically significant support to reject the null hypothesis to
conclude there is a significant positive correlation between board representation of
an activist hedge fund and nominal “corporate inside” ownership (t−3 months) ex
post the Board Seat Grant Date.
Conclusion

Hypothesis 4: Active Hedge Fund Monitoring – Ex Post Intervention (Short-term Returns)
66
Hypothesis 4: There is a significant positive “initial” market reaction on the
announcement date that a hedge fund dissident shareholder has been granted
board representation to function as a disciplinary mechanism to monitor
management

The empirical results indicate that activism is perceived favorably by the stock market,
with strong evidence of short-term increases in a Target Firms’ stock price. Within my
dataset of sample Target Firms, certain types of activism are strongly positively related
to short-term stock performance.
Target Firms of Hedge Fund activists that seek board representation generate
positive and statistically significant stock performance relative to Target Firms that did
not receive the disciplinary effects of hedge fund monitoring.
Therefore, I find statistically significant support to reject the null hypothesis
and conclude that there is significant positive “initial” market reaction on the
announcement date that a hedge fund dissident shareholder has been granted board
representation to function as a disciplinary mechanism to monitor management.
Hypothesis 4: Active Hedge Fund Monitoring – Ex Post Intervention (Short-term Returns)
Conclusion

Hypotheses 5: Active Hedge Fund Monitoring – Ex Post Intervention (Long-term Returns)
68
Hypothesis 5: Hedge fund activism generates statistically significant long-
term value for the target firms and its long-term share when they function as a
Buy and Hold Portfolio Approach
Calendar-time Portfolio Approach

69
Wilcoxon Matched-Pairs Signed-Ranks TestofTreatment andControlGroups

70
Calendar-time Portfolio Approach

The foregoing results suggest that Hedge Fund Activist seeking board
representation generate positive “alpha” (α) around event time for
Target Firms and the positive abnormal returns do not revert up to a five
years ex post the board seat grant date.
Therefore, the evidence clearly refutes the market over-reaction
hypothesis and supports the hypothesis (H5) that Hedge Fund
Activism creates long-term value for Target Firms and its long-term
shareholders when they function as a disciplinary mechanism to monitor
Conclusion

Hypotheses 6: Active Hedge Fund Monitoring – Ex Post Intervention (LT Op. Performance)
72
Hypothesis 6: Hedge fund activism generates statistically significant
improvement in long-term operating performance for the target firms and its
long-term share when they function as a disciplinary mechanism to monitor

73

74

75

76
Treatment Group vs. Control Group I

77
Treatment Group vs. Control Group II

I find that Target Firms significantly under-perform Matched Firms and a
composite of industry peers ex ante a Hedge Fund Activist obtaining at least one
board seat. These findings are consistent with previous literature. However, these
Target Firms demonstrate a dramatic improvement post intervention, up to five
years ex post the board seat grant date. Many of these results are statistically
significant relative to Matched Firms.
The results indicate that Hedge Fund activists that seek board representation
have been successful in improving operating performance, increasing payouts,
enhancing corporate governance and reducing agency costs of Target Firms. I find
no evidence that there is a reversal in operating performance. Overall,
the Treatment Group experiences better operating performance five
years ex post board representation then Control Group I.

Conclusion / Contribution
79
 Over the past two decades, hedge fund activism has emerged as new
form of corporate governance mechanism that brings about operational,
financial and governance reforms to a corporation.
 Many prominent business executives and legal scholars are convinced
that the entire American economy will suffer unless hedge fund activism
with its perceived short-termism agenda is significantly restricted.
 Shareholder activists and their proponents claim they function as a
disciplinary mechanism to monitor management and are instrumental in
mitigating the agency conflict between managers and shareholders.
 The vast majority of shareholder activism literature is predicated on
Schedule 13D filings. However, I assert that the optimal dataset to
empirically test the long-term effects of shareholder activism should be
based on board representation of target firms by a shareholder activist.

Conclusion / Contribution
80
 My research fills the important void with respect to the shareholder
activism initiated by hedge funds. Novel approach to inside
ownership and short-interest positions as instrumented variables that
predict a target firm’s vulnerability
 Expansive, hand-collected dataset and unique empirical research
design methodology with respect to board representation will fill the
important void in the literature regarding the long-term efficacy of hedge
fund activists serving as a disciplinary mechanism on the firm by actively
seeking board representation to monitor management.
 My findings will suggest that hedge fund activism generates long-term
value for target firms and its long-term shareholders when they function
as a shareholder advocate to monitor management through active
board engagement.

Extension of Research and Future Publication Opportunities
81
Extension of Research
• Corporate governance and shareholder activism remains an
important topic of debate for scholars and practitioners
• There are several extensions of research to be considered:
• Managerial ownership vs institutional ownership
• Board representation vs. board control
• Analyst Sell recommendation as predictive variable
Future Publication Opportunities
• Academic Journal
• Practitioner Journal
• Legal Journal (already requested by Columbia Law Review)

Questions?

Corporate governance and hedge fund activism

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