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Activist funds, leverage, and procyclicality

Burkart, Mike ORCID: 0000-0002-0954-4499 and Dasgupta, Amil ORCID: 0000-0001-8474-9470 (2014) Activist funds, leverage, and procyclicality. Financial Markets Group Discussion Papers (733). Financial Markets Group, The London School of Economics and Political Science, London, UK.

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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.

Item Type: Monograph (Discussion Paper)
Official URL: https://www.fmg.ac.uk/
Additional Information: © 2014 The Authors
Divisions: Finance
Subjects: H Social Sciences > HC Economic History and Conditions
H Social Sciences > HG Finance
JEL classification: G - Financial Economics > G2 - Financial Institutions and Services > G23 - Pension Funds; Other Private Financial Institutions
G - Financial Economics > G3 - Corporate Finance and Governance > G34 - Mergers; Acquisitions; Restructuring; Corporate Governance
Date Deposited: 05 Jul 2023 09:54
Last Modified: 16 Sep 2023 00:01
URI: http://eprints.lse.ac.uk/id/eprint/119029

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