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Research Scholar's Abstracts 2008 - Sridhar Sundaram

Effects of Hedge Fund Investment in Founding Family Controlled Firms
Sridhar Sundaram
2008

In recent times, there has been significant attention around investments made by activist hedge funds in target companies and their motivation for such investments. Some argue that when hedge funds buy shares of a target company and pressure management for changes in business strategy, capital structure, dividend policy, etc., it appears that they are seeking a short-term gain at the expense of the long-term shareholders. Contrary to such argument, two recent studies that comprehensively examine hedge fund investments show that hedge funds efforts to improve companies have benefits for all shareholders. Brav, Jiang, Partnoy and Thomas (2006) examine over 880 instances of hedge fund activism during the period 2001-2005 and find that the abnormal return upon announcement of potential activism is in the range of 5-7% without any reversal in the subsequent year. Klien and Zur (2006) also examine shareholder activism by hedge funds and others (private equity funds, venture capitalists) and find that there are important differences between the hedge funds and others in the companies they target and their strategy. They also report that the average announcement effect is 10.2% surrounding the initial Schedule 13D filing by these hedge funds.

Founding family controlled firms (FFCFs) exhibit organizational structures where significant ownership and control reside in one individual or family. These firms seek to retain control over the firm and tend to avoid debt. They seek to avoid debt since high debt levels may result in financial distress and result in a forced change in control over the firm. The Arthur Anderson/Mass Mutual American Family Business Survey (1997) reports that family businesses tend to avoid debt. They find that a third of the firms report no long-term debt and another third report debt levels of only 1%-25% of equity. Mishra and McConaughy (1999) find that founding family CEOs are more averse to control risk, hence carry lower level of debt in their capital structure. These firms also carry high levels of financial slack (cash and marketable securities) and higher levels of dividend payout compared to non-family controlled firms.

Such financial policies adopted by FFCFs may have the effect of reducing their potential growth opportunities. This in turn will dampen the ROE for the firm and will result in lower valuation of the firm. This presents a conflict of interest between the founding family shareholders and the outside shareholders. Hence, these firms present ideal opportunities for activist hedge funds to invest and effect changes in the management policies with the primary goal of increasing the valuation of the firm. These changes may include restructuring its capital structure, dividend policy and operational policies of the firm. This creates a conflict of interest between the management and the hedge fund, but outside shareholders will welcome the investment by the activist hedge fund and their impact on the policies of the firm.