Activist funds, leverage, and procyclicality

Mike Burkart and Amil Dasgupta

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: We provide a theoretical framework to study blockholder activism by funds who compete for investor flow. In our model, activists are intrinsically able to raise the value of target firms through monitoring. Competition for investor flow induces them to enhance the returns generated by monitoring by raising external funding at the level of the target firm. We adopt a microfounded approach to account for the lack of macro-state contingency in such financing contracts and show that debt is optimal for raising external funding. When good funds are sufficiently better than bad funds, competition for flow can generate excessive leverage which fosters debt overhang in low macroeconomic states and shuts down activist effort. As a result, investing in activist hedge funds is more desirable when macroeconomic prospects are good. Our model thus links the observed procyclicality of activism with documented increases in the leverage or payouts ratios of target firms. In addition, the model generates several new testable implications and reconciles seemingly contradictory evidence on the wealth effects of activism for shareholders and bondholders.

JEL-codes: G23 G34 (search for similar items in EconPapers)
Pages: 47 pages
Date: 2014-04-02
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http://eprints.lse.ac.uk/119029/ Open access version. (application/pdf)

Related works:
Working Paper: Activist funds, leverage, and procyclicality (2015)
Working Paper: Activist Funds, Leverage, and Procyclicality (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:119029

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