Are financial constraints of corporate activist investors perceived negatively?

Abstract

This paper shows that financial constraints of corporate activist investors are negatively perceived by the market. By conducting an event study on a sample of 561 Schedule 13(D) filings disclosed by US corporations in the years 1996–2016, abnormal share price reactions in the [−10, $+$3] event window are about 10.8% lower for targets of financially constrained corporate investors. The average abnormal return for all targets is equal to 13.4%. This positive market response suggests that activism results in actual value improvement for the target. Yet, our analyses show that value improvements crucially depend on the investor’s access to external financing.

Appendices

Appendices

Measures of financial constraints

1.1 Whited–Wu Index

Following Farre-Mensa and Ljungqvist (2016), the Whited–Wu Index (Whited and Wu 2006) is calculated as:

$$\begin{aligned} WW=-0.091X_{1}-0.062X_{2}+0.021X_{3}-0.044X_{4}+0.102X_{5}-0.035X_{6}, \end{aligned}$$

where

• $X_{1}$ is the ratio of cash flow to assets defined as the sum of income before extraordinary items and depreciation and amortization divided by total assets $\frac{ib+dp}{at}$,

• $X_{2}$ is an indicator set to one if the firm pays a dividend, likewise if the sum of common and preferred dividends paid is positive, zero otherwise $dvp+dvc>0$,

• $X_{3}$ is the ratio of long-term debt to total assets $\frac{dltt}{at}$,

• $X_{4}$ is the size of the investor defined as the natural logarithm of total assets log(at),

• $X_{5}$ is the average industry sales growth, estimated for each three digit SIC industry and each year separately $\frac{{ SALE}_{t}}{{ SALE}_{t-1}}$,

• $X_{6}$ is the investor’s sales growth $\frac{{ SALE}}{{ SALE}_{t-1}}$,

and all variables in italics are Compustat data items. Following convention, the index is calculated for all firms on Compustat and firms are then sorted into tertiles based on their index value. Firms in the top tertile are coded as constrained, and those in the bottom tertile are coded as unconstrained (Farre-Mensa and Ljungqvist 2016).

1.2 Dividend payout ratio

Following Khatami et al. (2015) and Almeida et al. (2004), the investor’s dividend payout ratio is defined as the 2-year average of the dividend payout ratio from the two preceding annual reports at each point in time.

The yearly dividend payout ratio is defined as the sum of dividends ($dvp+dvc$) plus stock repurchases (total expenditure on the purchase of common and preferred stocks prstkc) minus any reduction in the value of net number of preferred stocks outstanding (redemption value pstkrv) divided by operating income ($\frac{ib}{at}$) as in Jagannathan et al. (2000). Further, following Khatami et al. (2015) and Hadlock and Pierce (2010) dividend payout ratios are set equal to 1 if they are above 1 and if a firm has negative operating income and positive dividends. After computing the 2-year average payout ratio for all firms on Compustat, firms are sorted into tertiles based on their annual payout distribution. Firms in the bottom (top) tertile are coded constrained (unconstrained).

1.3 Hadlock–Pierce Index

Following Hadlock and Pierce (2010) and Khatami et al. (2015) the index is calculated as: $HP=-0.737*Size+0.043*Size^{2}-0.040*Age$ where size is the log of inflation adjusted (to 2004) book assets and age is the number of years the firm has been on Compustat with a non-missing stock price. In calculating the index, size is replaced with log($4.5 billion) and age with 37 years if the actual values exceed these thresholds (Hadlock and Pierce 2010). After computing the HP index for all companies on Compustat, the firms are sorted into tertiles based on their annual index values. Firms in the top tertile are coded as constrained and those in the bottom tertile are coded as unconstrained (Farre-Mensa and Ljungqvist 2016).

1.4 Credit rating

Following Heller (2015), Almeida et al. (2004), and Farre-Mensa and Ljungqvist (2016) firms that have a S&P domestic long-term issuer credit rating at least 3 months prior to the Schedule 13(D) filing date are considered to be financially unconstrained. In contrary, firms missing such a credit rating are considered to be financially constrained. The data are obtained from Compustat (variable splticrm)

Categorization: purpose of transaction

The following definitions are explanatory excerpts of Schedule 13(D) filings from the sample. Based on these descriptions, the filing’s transaction purpose was identified. Following, the Reporting Person is the investor disclosing the Schedule 13(D), whereas the Issuer is the company subject to the filing.

• 1. Merger: “the Company entered into the Merger Agreement with the Reporting Person and Merger Sub, pursuant to which the Reporting Person will acquire all of the outstanding equity interests of the Company.”

• 2. Tender Offer: “The Reporting Person announced its intention to commence a partial cash tender offer for up to number of shares of Common Stock at a price of $ price net per share”

• 3. Hostile Takeover: “The Shares have been acquired by the Reporting Person with a view to ultimately acquiring control of the Issuer pursuant to a merger with, or acquisition of additional stock by the Reporting Person or one of its subsidiaries. [...] The Reporting Person has contacted the Chairman of the Board of the Issuer and expressed an interest in acquiring the Company and expects to have further discussions with management of the Issuer.”

• 4. Investment Opportunity while Actively Monitoring the Target: “The primary purpose of the Reporting Person’s acquisition of the Common Stock is for investment. The Reporting Person believes that at this time, the Common Stock represents an attractive investment opportunity. Although it has no current intention to do so, at some time in the future the Reporting Person may decide that it is desirable to seek to acquire the Issuer or seek to control or otherwise influence the management and policies of the Issuer.”

• 5. Alliance Agreement: “The purpose of the transaction is for investment and to establish a long-term distribution alliance between the Reporting Person and the Issuer.”

• 6. License Agreement: “As set forth, the Shares were purchased on in connection with the Development and License Agreement between the Issuer and the Reporting Person.”

• 7. Joint Venture: “The Reporting Person acquired shared voting and investment power over the Contributed Shares in connection with the formation of the joint venture with the Issuer.”

• 8. Engaging into a Proxy Fight: [...] nominating Person and Person to be elected by holders of the Shares to the Board of Directors of the Issuer (the “Board”) at the annual meeting of stockholders of the Issuer, or any other meeting of stockholders held in lieu thereof, and any adjournments, postponements, reschedulings or continuations thereof (the “Annual Meeting”). The Reporting Persons reserve the right to take all action they deem appropriate to obtain Board representation.

• 9. Investor is Subject to Merger: “At the effective time of the Merger (the “Effective Time”), the separate existence of Merger Sub will cease and the Reporting Person will continue as the Surviving corporation and as a wholly owned subsidiary of the Issuer. Each holder of outstanding common stock of the Reporting Person, par value $ per share will receive, in exchange for each share of the Reporting Person’s Common Stock held by such holder, amount of a share of the Issuer Common Stock (the “Exchange Ratio”).

• 10. Issuer Financing: “The purpose of the purchase of the Stock was to provide the Issuer with immediately available funds to address its urgent liquidity needs in exchange for an equity interest in the Issuer.”

Definition of control variables

Control variables
Return on assets (ROA)	ebitda/at
Cash flow (CF ratio)	oancf/at
Tobin’s Q (Khatami et al. 2015)	(at-ceq-txdb+csho*prcc_c)/at
Cash to total assets (cash)	che/at
Book leverage (MacKay and Phillips 2005)	(dltt+dlc)/at
Market value of equity [MV (equity)]	$\hbox {prcc}\_\hbox {f} \times \hbox {csho}$
Size	log(at)
Relative size (Khatami et al. 2015)	$at_{target}/at_{investor}$