DP9409 Why is hedge fund activism procyclical?

Author(s): Mike Burkart, Amil Dasgupta
Publication Date: March 2013
Keyword(s): Career concerns, Corporate governance, Hedge funds, Shareholder activism
JEL(s): G23, G34
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9409

We provide a theoretical model to explain the procyclicality of hedge fund activism. In our model, hedge funds which compete to retain investor flows excessively increase the net leverage of target firms in order to deliver high short-term payouts and signal their ability. Such excessive leverage leads to debt overhang in economic downturns, thereby destroying incentives for activism and engendering procyclicality. Our model thus provides a theoretical explanation that links the procyclicality of hedge fund activism with 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.