Back in the 1980s there was a vigorous debate as to whether the merger mania of that era was creating new value. We are now starting to see the same issue being raised in the context of hedge fund activism, as in a recent study by Felix Zhiyu Feng, Qiping Xu and Heqing Zhu:
The objective of our recent study is precisely to investigate what happens to bondholders when caught in the crossfire between managers and activist hedge funds. Specifically, we want to know whether managerial actions to boost equity value in effort to avert hedge fund intervention involve compromising the interest of bondholders. The answer to this question would bring new and important insight into our understanding of hedge fund activism as a mechanism for corporate governance.
To carry out our investigation, we use a comprehensive sample of hedge fund activism events from 1994 to 2011 to help us determine the degree of firms’ exposure to HFA threat. We find that firms with greater (relative to those with less) ex-ante exposure to intervention threat experience higher bond yields, greater default probability, and worse bond and overall firm ratings, after their industries are hit with an abnormal degree of intervention activity. These can be explained by the tendency of such firms to increase leverage through share repurchases funded by using up cash reserves and selling assets. While these policy changes tend to be viewed as in governance-improving directions and therefore lead to positive stock market reactions, they could potentially jeopardize bondholders’ interests in the event of bankruptcy and therefore induce negative credit market reactions.
Finally, we find that the transfer of wealth from bondholders to shareholders is more serious in poorly governed firms, in firms that experience greater improvement to equity value, in years with more industry-wide interventions, and in years when a greater proportion of the industry-wide interventions are more hostile in nature, meaning the activist hedge funds deploy more aggressive engagement tactics. These results suggest that the extent to which the manager-bondholder agency problem is permitted to exist in the firm affects the degree to which bondholders’ interest is sacrificed when managers face intervention threat.
As regular readers know, I'm skeptical of hedge fund activism. Yet, I'm also skeptical of these sort of wealth transfer analysis. In my book Mergers and Acquisitions, I argue that:
There is a widely shared assumption that takeovers leave nonshareholder constituencies, especially employees, significantly worse off. Admittedly, a fair bit of anecdotal evidence supports the claim. The AFL–CIO estimated, for example, that 500,000 jobs were lost as a direct result of takeover activity between 1983 and 1987 alone. Acquiring companies also supposedly use funds taken out of the target company's pension plans to help finance the acquisition. In light of such stories, prominent management author Peter Drucker spoke for many when he observed that "employees, from senior middle managers down to the rank and file in the office or factory floor, are increasingly being demoralized—a thoughtful union leader of my acquaintance calls it 'traumatized'—by the fear of a takeover raid."
Corporate takeovers also affect the communities in which the corporation has plants and other facilities. In the wake of Boone Pickens' raid on Phillips Petroleum, for example, Phillips eliminated 2,700 jobs in its Bartlesville, Oklahoma headquarters. Because Bartlesville's population was only 36,000, this downsizing devastated the local community. Similar tales of woe doubtless could be told of many communities affected by takeover related corporate restructurings.
Highly leveraged takeovers may adversely affect the interests of bondholders and other corporate creditors. As the theory goes, pre takeover creditors assessed the corporation's creditworthiness and set their loan terms based on the corporation's existing assets and debt equity ratios. In a highly leveraged acquisition, the bidder finances the acquisition by borrowing against target corporation assets and/or selling target assets. This significantly lowers the corporation's creditworthiness, yet pre takeover creditors are not compensated for this loss. Bondholders are particularly hard hit by this phenomenon. Bond rating agencies routinely downgrade a corporation's pre takeover bonds to reflect the firm's increased riskiness post takeover, which immediately reduces those bonds' market value.
A number of commentators have advanced theoretical bases for the claim that takeovers are detrimental to nonshareholder corporate constituents. As the basic argument goes, many of the contracts making up the corporation are implicit and therefore judicially unenforceable. Some of these implicit contracts are intended to encourage stakeholders to make firm specific investments. Consider an employee who invests considerable time and effort in learning how to do his job more effectively. Much of this knowledge will be specific to the firm for which he works. In some cases, this will be because other firms do not do comparable work. In others, it will be because the firm has a unique corporate culture. In either case, the longer he works for the firm, the more difficult it becomes for him to obtain a comparable position with some other firm. An employee will invest in such firm specific human capital only if rewarded for doing so. An implicit contract thus comes into existence between employees and shareholders. On the one hand, employees promise to become more productive by investing in firm specific human capital. They bond the performance of that promise by accepting long promotion ladders and compensation schemes that defer much of the return on their investment until the final years of their career. In return, shareholders promise job security. The implicit nature of these contracts, however, leaves stakeholders vulnerable to opportunistic corporate actions.
As the theory goes, this vulnerability comes home to roost in hostile takeovers. In all hostile acquisitions, the shareholders receive a premium for their shares. Where does that premium come from? Recall that the employees' implicit contract involved delaying part of their compensation until the end of their careers. If the bidder fires those workers before the natural end of their careers, replacing them with younger and cheaper workers, or if the bidder obtains wage or other concessions from the existing workers by threatening to displace them or to close the plant, the employees will not receive the full value of the services they provided to the corporation. Accordingly, a substantial part of the takeover premium consists of a wealth transfer from stakeholders to shareholders. Or so the story goes.
There are any number of problems with this thesis, however. For one thing, there is no credible evidence that takeovers transfer wealth from nonshareholder constituencies to shareholders. The theoretical justification for protecting nonshareholders is equally unpersuasive. Many corporate constituencies do not make firm specific investments in human capital (or otherwise). In contrast, the shareholders' investment in the firm always is a transaction specific asset, because the whole of the investment is both at risk and turned over to someone else's control. Consequently, shareholders are more vulnerable to director misconduct than are most nonshareholder constituencies. Relative to many nonshareholder constituencies, moreover, shareholders are poorly positioned to extract contractual protections. Unlike bondholders or unionized employees, for example, whose term limited relationship to the firm is subject to extensive negotiations and detailed contracts, shareholders have an indefinite relationship that is rarely the product of detailed negotiations. In general, nonshareholder constituencies that enter voluntary relationships with the corporation thus can protect themselves by adjusting the contract price to account for negative externalities imposed upon them by the firm. Many nonshareholder constituencies have substantial power to protect themselves through the political process. Public choice theory teaches that well defined interest groups are able to benefit themselves at the expense of larger, loosely defined groups by extracting legal rules from lawmakers that appear to be general welfare laws but in fact redound mainly to the interest group's advantage. Absent a few self appointed spokesmen, most of whom are either gadflies or promoting some service they sell, shareholders—especially individuals—have no meaningful political voice. In contrast, cohesive, politically powerful interest groups represent many nonshareholder constituencies. As a result, the interests of nonshareholder constituencies increasingly are protected by general welfare legislation.