Leader-Follower Dynamics in Shareholder Activism

Activist shareholders play a central role in moderns corporations. Such blockholders range from investors who actively jawbone or break up firms, to index funds that are largely passive in that they limit themselves to voting. Crucially, in between is a group of hedge funds that have embraced activism as a business strategy in the last decades. Campaigns involving these highly strategic and trading-intensive blockholders have become ubiquitous, often featuring a “lead investor” supported by group of “follower funds”, all with stakes that, individually, are not enough to control targets. This phenomenon—termed “wolf pack activism”—has received considerable attention by practitioners, policymakers and academics, both due to its importance and its rather secretive nature. In fact, while the current regulation in the U.S. permits some degree of communication among blockholders, there are substantial costs for activists who are perceived as acting as a formal group. A fundamental question then arises, one that goes beyond hedge funds: how do leader blockholders gear up to intervene in firms in settings when (i) other investors think alike and can be influenced, but (ii) explicit agreements are not possible?

In a recent paper, we show that sophisticated investors—such as those who actively trade and are sensitive to mispricing opportunities—can use market signals to communicate with other like-minded ones. Since this necessitates some blockholder to act in financial markets first, the leader-follower structure observed in wolf-pack activism has the potential to emerge. Three natural questions arise. First, if a leader fund builds stakes first, how does she distort her behavior to try to bring other investors along? Second, is it in the best interest of these investors to join forces despite everyone anticipating the leader’s self-interested motivations? Third, what are the implications for the governance of firms?

The starting point is that cost management is of utmost importance for activists. First, leader funds typically purchase 1% of shares outstanding when they finalize their blocks and key disclosure thresholds are crossed. Second, subsequent activist campaigns can cost millions of dollars. Importantly, these costs reinforce each other: only those with larger stakes will be willing to bear more activism costs, because any extra value is applied to more shares. From this perspective, by trading first—and fast—leader funds not only avoid undesirable competition that would make block acquisition costly, but they can also use their own trades to try to create profitable mispricing opportunities that other funds can find attractive to exploit. As such followers buy more shares, they will naturally develop more “skin in the game” in that their willingness to spend resources to improve firms will grow. This, in turn, can be used by leader funds to better control their own costs.

As natural as it may seem, this influence channel is a non-trivial one, and understanding its determinants is one of the contributions of our work. To appreciate its subtlety, consider the inferences made after a hypothetical leader’s move. After an abnormally large trade, the market expects this activist to add more value—the firm’s share then trades at a higher price, which discourages any follower from purchasing shares. Conversely, a small trade means a smaller block by the leader: this weakens any follower’s incentive to build their own block, as there is skepticism regarding the value addition of a leader with a small ownership stake. How can the influence mechanism operate then?

Similar investors are like-minded not only because they employ similar strategies, but because the latter generate overlap in research and expertise about firms. In a nutshell, not only can they know more about ways to fix certain firms, but they also know more about what their similar peers know about those same firms: that is, their willingness/ability to intervene in firms can have an element of interdependence, which is key for the influence channel to operate. To see why, consider a leader fund trading aggressively. By virtue of knowing her own willingness to intervene, the follower only makes a positive inference about the leader’s contribution. The market, however, is uncertain about both contributions. With positive interdependence, the market will expect a commensurate addition from the follower: the stock price is inherently more responsive, so large trades reduce the mispricing that the follower can exploit. Conversely, with negative interdependence, a larger addition by the leader is accompanied by a perception of a smaller contribution by the follower, resulting in a weaker price response: the leader can confidently buy to make the follower more optimistic.

What this means in that the leader’s block acquisition changes compared to situations in which influencing others is not possible. With positive interdependence, the leader has another motive to limit her trade in addition to price impact: her more restrained block acquisition can still lead to more value, but less than if acting simultaneously with her follower for instance.  In this case, the leader effectively offloads activism costs on the follower who, in turn, is willing to bear them because the mispricing created makes it profitable to do so. With negative interdependence, the leader must instead act more aggressively to influence the follower, ultimately bearing more activism costs herself, which maps into more value. Consequently, the way in which the usual “collective action” problem plays out depends on the degree of similarity of the activists involved: the more similar they are, the more could have been unlocked had the influence channel been shut down; conversely, if more asymmetric (say, larger leader funds are indicative of smaller followers), the more value-enhancing activism can be.

With enough similarity, however, why would activists “agree” to this arrangement if it lowers firm value? Because it can be mutually beneficial. While the leader sacrifices share value and, crucially, trading gains by moving first, offloading activism costs on others means better cost management. On the other hand, the follower can benefit too because she can control block-acquisition costs: due to an increased price impact, these costs would be higher when competing to build stakes simultaneously with the leader. The bottom line is, in this situation explicit agreements can be replaced by tacit ones: the expectation that an investor will generate  abnormal market signals that only like-minded ones can exploit will induce these to wait; in turn, the anticipation that like-minded investors will react to such signals can prompt leader funds to try to influence them, with the implications just described.

The views expressed here are only the authors’ and they do not represent those of the Federal Reserve Bank of New York or the Federal Reserve System.