Influencing Control: Jawboning in Risk Arbitrage

Transcription

1 Influencing Control: Jawboning in Risk Arbitrage Wei Jiang Tao Li Danqing Mei This draft: March 2015 Abstract We provide the first study on a relatively new phenomenon of activist risk arbitrage, in which activist shareholders attempt to block an announced M&A deal with public campaigns in order to extract better terms. Compared to the conventional (passive) risk arbitrage, we find that activist arbitrageurs are more likely to select deals that are susceptible to managerial conflict of interest, including going-private deals, friendly deals, and deals with lower announcement premiums. Moreover, while it does not significantly change the probability of deal completion, activists action increases its sensitivity to market price signals. Finally, activist risk arbitrage yields significantly higher returns than passive ones, with little incremental deal risk. We thank Artem Katilov, Klimenti Katilov and Ying Zhu for their excellent research assistance. Wei Jiang is the Arthur F. Burns Professor of Free and Competitive Enterprise, Finance and Economics Division, Columbia Business School. She can be reached at wj2006@columbia.edu. Corresponding author. Tao Li is Assistant Professor of Finance, Warwick Business School. He can be reached at tao.li@wbs.ac.uk. Danqing Mei is Ph.D. Candidate in Finance, Columbia Business School. He can be reached at dmei19@gsb.columbia.edu.

2 1 Introduction In early March 2011, 99 Cents Only Stores ( 99 Cents ), a very deep discount retailer, was preparing to be acquired by the Schiffer/Gold family (a 33% owner). The deal was partially financed by Leonard Green, a private equity firm. At the offer price of $19.09 per share, the existing shareholders stood to gain a premium of 14.5% over the pre-announcement price. Then on March 11, FBR Capital Markets, the asset management arm of the investment bank FBR, disclosed a 5.4% stake in 99 Cents in a Schedule 13D filing, 1 asserting that the set price substantially undervalued the company and it would oppose the buyout. After rounds of engagement with the management, and eventually a limited auction, 99 Cents announced on October 11 that it agreed to be acquired by Ares Management, a private equity firm, and the Canadian Pension Plan Investment Board for $22 per share in cash, a 32% premium over the pre-announcement price. The Schiffer/Gold family agreed to tender its shares to the buyers who were not their first choice. The story is reminiscent of an M&A arbitrage or risk arbitrage by speculators, but carries features that are distinct from the conventional risk arbitrage analyzed in the literature. 2 In a conventional, or passive, risk arbitrage, a speculator takes a long position in the target company (it may also take a simultaneous short position in the acquirer in stock deals based on the exchange ratio) right after the announcement of an acquisition when the stock price tends to jump up but will likely remain below the final purchase price due to deal failure risk this was what FRB Capital did. The passive arbitrageur then votes its shares in favor of the merger and hopes to profit from full price convergence at deal consummation. 1 The U.S. Securities Exchange Act mandates an instant (within 10 calendar days) disclosure of 5% or more beneficial ownership by any investor (or any legal group formed by investors) in a publicly listed company, if the investor intends to influence corporate policies or control. Among the required disclosure is the intent of the owner. If the intent is purely for passive investment, the investor only needs to file a less stringent 13G form due within 45 days after the end of the calendar year. 2 The representative work in the area includes theory work by Cornelli and Li (2002) and Gomes (2012), and empirical studies by Baker and Savasoglu (2002), Mitchell, Pulvino, and Stafford (2004) and Hsieh and Walkling (2005). 2

3 During the process the speculator does not voice its opinion other than expressing it by voting its shares. In fact, the passive arbitrageur avoids engaging the management so as not to compromise its freedom to trade under insider trading rules here FRB Capital diverged from the typical route of risk arbitrage. Instead, FRB Capital voiced loudly its opinion that the target deserved a higher bid, and threatened to block the deal via both its own voting rights and, more importantly, its influence on other shareholders. By adopting a passive risk arbitrage strategy, FRB would have earned a return of 14% from its long position (if its stocks were tendered at $19.09) over the pre-announcement price. However, with its activist risk arbitrage strategy, FRB pocketed a much higher return of 32% at the improved price of $22. The incremental costs were those associated with a 13D filing and the time/effort spent in jawboning, and perhaps a higher risk that the deal will completely fall through, after which the price would have to go back to the pre-announcement level. The FRB Capital/99 Cents case was by no means an exception. Such activist arbitrage activities have been on the rise: they were observed in 0.6% of all M&A deals in 2000, but their penetration rose to 13% in However, the academic literature has not formally analyzed the full process, characteristics, as well as the impact of activist risk arbitrage on the market for corporate control. Our study fills the gap. As shareholder activism launched by institutional investors becomes an increasingly more common form of corporate governance, 3 their blend with a popular passive arbitrage strategy is instructive. A signature of institutional investor activism has been that it strives to influence corporate policies and governance, but it does not aim at control (Brav, Jiang, Partnoy, and Thomas, 2008a). The activist arbitrage strategy, by instilling shareholder activism into corporate control events, thus bridges the two by aiming at influencing control. Our study builds on three disjoint subsamples covering all M&A deals between 2000 and 3 Please see Gillan and Starks (2007) for a survey on general shareholder activism, and Brav, Jiang, and Kim (2010) for a survey on hedge fund activism. 3

4 2013. The most important of the three is the event sample: a manually composed sample of 335 activist risk arbitrage events where there was observed jawboning by outside blockholders during the acquisition. Next in importance to the event sample is the conditional control sample, which consists of 2,681 disclosed passive risk arbitrage events. The last is the unconditional control sample, which is the complement set left over from all the 3,464 M&A deals during the period. Both control samples are constructed following the standard procedure used in the M&A and the (passive) risk arbitrage literature. Our analyses reveal similarities as well as dissimilarities between the two forms of risk arbitrage strategies. On the similarity side, both types prefer larger deals and target companies with higher institutional ownership, as well as adopt a similar toehold strategy. On the other hand, the most striking dissimilarity lies in the fact that activist arbitrageurs are more likely to attack going-private deals, in which the acquirers are often the management themselves ( MBOs ) and/or financial acquirers (such as private equity firms). In comparison, non-going private M&A deals are more likely to have other companies as strategic buyers aiming for synergies or better positioning in the market. Second, a best predictor for an arbitrageur to be an activist rather than remaining passive is the relatively low announcement premium. Third, activists are more likely to disturb the otherwise friendly deals. Presumably in those deals, the board and the management, by endorsing the deals with favored acquirers, may not have done their due diligence to challenge the acquirers for better terms or to solicit multiple bids. These results suggest that activist risk arbitrage is potentially an important form of governance in guarding investors interests during corporate control changes which are susceptible to management self-dealing or other forms of managerial conflict of interest. As expected, activist arbitrageurs earn much higher average returns compared to the passive ones, compensating for the extra jawboning work as well as for assuming more risks both legal and deal risks. Baker and Savasoglu (2002) document an annualized return 4

5 of 7-11% for passive risk arbitrageurs, and this number is lowered to 5-6% in our more recent sample. The average return accrued to activist arbitrageurs is 14% from post-deal announcement to resolution. To the extent that any abnormal return in trading has to come from some form of private information, the return spread between the activist and passive strategies is not surprising. In Cornelli and Li s (2002) model, a passive risk arbitrageur creates private information after purchasing shares because he is now privately informed about his own intended vote, which in turn increases the value of the shares by raising the probability of a favorable vote outcome hence deal completion. 4 Applying the same framework to an activist risk arbitrageur, her information advantage becomes greater because she is privately informed about her intention (and some confidence in her ability) to push up the price of the acquisition in addition to a passive arbitrage strategy, hence there is more room for price appreciation. 5 By blocking an announced deal in order to extract a higher price, the activist arbitrageurs potentially assume more deal failure risk than the passive arbitrageurs who vote their shares straight in favor of the deal. It is thus important to assess the risk side. We find no evidence that activists select deals with a higher ex-ante completion probability. However, they increase the sensitivity of deal completion to the ex-ante completion probability. On the other hand, activist arbitrage is associated with only a small and insignificant drop in the overall deal completion rate. Relatedly, a hazard analysis indicates that activists do not noticeably slow down the process toward deal completion. Therefore, activist arbitrageurs are not only sophisticated in picking deals for which the ex-ante deal failure risk is relatively low, but they also increase the completion rate of deals that are welcomed by the market 4 Note that even passive risk arbitrage contains an activist element in that the arbitrageur s action potentially affects the terminal value of the security being arbitraged, as opposed to a pure trading arbitrage strategy where the security value is exogenous and arbitrageurs merely profit from a convergence of price to the value. For a more detailed discussion, please see Bradley, Brav, Goldstein, and Jiang (2010). 5 In Gomes (2012) model, the passive arbitrageurs may also collectively push up the bids in a minority freeze-out because the acquirers set a high preemptive bid to counter the hold-out by the arbitrageurs. In this setting, the higher bid price arises in equilibrium with mutually consistent beliefs, rather than through jawboning as in an activist arbitrage. 5

6 (as reflected in the ex-ante deal completion rates). The two sides constitute a sustainable equilibrium in which activists do well for themselves while doing good for the investor public, echoing the findings of Brav, Jiang, Partnoy, and Thomas (2008b). 2 Data and Sample Selection 2.1 Sample of Mergers and Acquisitions Our sample of mergers and acquisitions ( M&As ), announced between January 1, 2000 and December 31, 2013, is constructed using information from the Securities Data Company ( SDC ) database. We include all attempted acquisitions, regardless of whether they are consummated or not. We apply the following filters commonly used in the prior literature on M&As (Hsieh and Walkling, 2005; Gaspar, Massa and Matos, 2005): (1) The target company must be covered by CRSP before deal announcement. (2) The acquirer owns less than 50% of the target s stock before the acquisition, and a post-acquisition stake of more than 50%. (3) We categorize each deal into a stock, cash or hybrid (part stock and part cash) deal. As SDC s definition of payment form appears to be different from merger agreements for certain deals, especially those labeled by SDC as Unknown and Other, we manually collect each deal s form of payment from merger agreements and 8-Ks filed with the SEC. For stock transactions involving floating-exchange ratios and collars, 6 we gather information about the terms of the transaction and key dates from SEC filings specified above. (4) The transaction is not classified by SDC as divestiture, spin-off or repurchase. Finally, we verify in Factiva all mergers with deal status labeled as Pending. If the deal has since been consummated or withdrawn, we change its status accordingly. We then drop deals with the Pending status as of August These criteria result in a sample of 4,093 deals. Data on 6 A collar agreement can be viewed as a combination of stock and cash offers; it mitigates the impact of uncertainty about the buyer s share price through either a transfer of cash or an adjustment in the exchange ratio. See Fuller (2003) and Officer (2004) for a more detailed description of collar offers. 6

7 deal announcement date, effective date, withdrawal date, deal premium, and characteristics of the target and acquirer are collected from SDC. Institutional holdings data is from the Thomson Financial 13F Database. 2.2 Sample of Activist Risk Arbitrageurs Our initial sample of deals involving publicly observable activist risk arbitrageurs is collected from SharkRepellent, a data provider that specializes in corporate governance. The sample includes 272 merger targets involving activist campaigns (335 deal-activist pairs, as 45 deals involved multiple activists participation) during the period For each target firm, we identify the activist arbitrageurs as the institutional investors who publicly criticized the transaction or solicited proxies against the deal. We then manually collect activist arbitrageurs plans and actions through their press releases (letters to boards/management) and Schedule 13D filings if these investors acquired more than 5% of a publicly traded target company. Such information include ownership stakes, announcement date (press release or Schedule 13D filing date), and withdrawal date if the campaign was unsuccessful. We then take several additional steps to ensure sample completeness. In the first step, we manually collect all Schedule 13D filings between deal announcement and resolution for all mergers announced between 2000 and The filing entity is regarded as an activist arbitrageur if it stated under Item 4 that the purpose of the investments was to influence or act against the proposed acquisition. Given that 13D filings identify only investors holding more than a 5% stake in a company, in our second step we perform extensive news searches in Factiva to gather press releases (letters to boards/management) that expressed concerns about the deal and sought to influence or act against the acquisition. These steps yield an additional 24 target firms involving activist arbitrageurs. We call this combined sample the augmented activist arbitrageur database. An example of activist risk arbitrage is shown in Appendix A. 7

8 A second popular strategy adopted by activist arbitrageurs is to purchase stocks in a merger target before exercising their appraisal rights, which allows dissenting shareholders to seek value they deem fair rather than to accept the merger consideration. Dissenting shareholders must vote against the merger or withhold their shares from tendering, before asking a court to determine the value of their stocks. A majority of the appraisal litigations are filed in the Delaware Court of Chancery. Among the 2,454 Opinions and Orders on appraisals issued by the Delaware Court of Chancery between 2000 and 2013, we collect all appraisal petitions against public companies, including information on dissenters and their holdings in the merger target, as well as the fair tender price granted by a judge. This step yields 23 unique merger targets involving activist arbitrageurs that are not already included in the augmented activist arbitrageur database, because these appraisals did not entail additional public campaigns against the proposed merger. We end up with 210 deals targeted by activist arbitrageurs after merging our M&A database with the sample of activist arbitrageurs. Following the same procedure, we also identify 40 acquirers targeted by activist arbitrageurs during the same sample period. In contrast to passive arbitrageurs who short the acquirer, activist arbitrageurs in these cases long the acquirer and profit from value improvement rather than spread convergence. In Section 6, we thus analyze these deals separately from the merger targets. It is worth reemphasizing that our sample is about negative risk arbitrage in which the arbitrageur campaigns against the deal in its current form. A comprehensive search of Schedule 13D filings and news stories using Factiva would also yield cases for positive risk arbitrage in which investors buy shares in order to vote in favor, and they publicly promote the deal. We exclude such events from our sample. Figure 2 plots the number of merger transactions and activist arbitrageur activity over our sample period. Activist arbitrage activity is generally correlated with M&A volumes, reaching its peak in 2007, 8

9 before dropping significantly during the financial crisis and then resuming in the most recent years. Table 1 lists the top players in our sample that invested in at least four merger transactions. The top four are GAMCO Investors, Inc., Ramius LLC, Carl C. Icahn, and Elliott Associates, LP, and combined they account for 12.4% of all the deals. In Table 2, we report the size of activist arbitrageurs stakes in merger targets, both in dollar value one day before disclosure and as a percentage of outstanding shares. The median initial (maximum) percentage stake that activist arbitrageurs take in the merger target is 7.1% (8.2%), and the median dollar investment is $22.0 ($25.5) million. 7 The level of ownership is comparable to the full sample of hedge fund activism reported in Brav, Jiang, Partnoy, and Thomas (2008). As activist arbitrageurs in general do not hold controlling blocks, they implement changes in a deal under the original proposal via influence on the board or fellow shareholders. The influence based tactics, from public campaigns to proxy solicitation, are thus necessitated by the gap between the typical ownership of activists and the majority vote required. A majority of the 210 mergers (205 deals) require the approval of a majority of shares outstanding (seven such deals require a supermajority (two-thirds) approval of shares outstanding). The remaining five deals require the approval of a majority of shares voted (counting abstention shares). Given that the average (median) approval rate in our sample is 69.1% (72.2%), the votes directly commanded by the activist arbitrageurs are unlikely to be pivotal. Hence jawboning in order to win fellow shareholder support is crucial. Regarding activist arbitrageurs investment horizons, Table 2 shows that the median duration between deal announcement and initial disclosure of activist arbitrageur holdings is 15 trading days, with an interquartile range of 5 to 40 days, indicating that the risk arbitrageurs are swift in establishing toeholds right after announcement. Such quick action 7 The Initial columns show stakes that the activist arbitrageur holds in a merger target when it initially discloses its positions through a Schedule 13D filing or a press release. The Maximum columns report the maximum stakes activist arbitrageurs hold in a merger target, which are retrieved from subsequent new disclosures by other activist arbitrageurs as well as amendments to the initial disclosure. 9

10 is made possible by being part of a massive exchange of shares among a diverse shareholder clientele. Jetley and Ji (2010) find that trading volumes in the target stock subsequent to the merger announcement tend to be 11.2 times higher than normal after Estimates of arbitrage funds ownership of the target s shares subsequent to the merger announcement range from 15% during (Hsieh and Walkling, 2005) to 35% during (Officer 2007). The median duration between initial disclosure of holding and deal resolution is 60 trading days, affording activist arbitrageurs plenty of time to influence completion as well as the terms of the merger. Activist arbitrageurs use a variety of tactics to oppose an announced deal under the stated terms. The most common ones include: (1) A public criticism of the transaction by letters addressed to the target s board and/or shareholders, usually accompanied by press releases (138 cases). The same letter is often attached to a Schedule 13D filing under Item 4 in which activists specify the intent of the newly established share block (151 cases). (2) Proxy solicitation aiming at vetoing the deal (45 cases, 19 of which involve proxy contests). (3) Proposing alternative acquisitions by the activists and their allies (10 cases). (4) Lobbying proxy advisory firms like Institutional Shareholder Services ( ISS ) in order to influence their institutional shareholder clients. For our sample transactions, ISS issued 93 voting recommendations with a support rate of 72.0%. (5) Exercising appraisal rights (22 cases) where arbitrageurs receive court-issued new valuation of the target shares after voting against (but fail to block) the deal. Activist arbitrageurs tactics have proven to be successful overall, often accomplishing their goals before even reaching the final vote. In our sample, they force the acquirer to sweeten their offer in 56 transactions, make the target board to accept a higher bid from a third party in 16 transactions, and contribute to the withdrawal of bids in 26 deals. In fact, only 8 transactions are blocked in the actual voting stage in which the majority of the shareholders vote down the transaction. The remaining 104 deals are approved under the 10

11 original terms. The success rate of 50.5% is on par with that reported in Becht, Franks, Grant and Wagner (2015), who use a recent sample on hedge fund activism. 2.3 Sample of Passive Risk Arbitrageurs Passive risk arbitrageurs are institutions that purchase stocks after acquisition announcements, but do not openly criticize or campaign against the deals or attempt to change major terms of the deals. To identify passive arbitrageurs, we follow the methodology developed by Hsieh and Walkling (2005), and illustrate the process in Figure 1. First, we require that a deal spans at least two quarters. That is, the deal announcement and resolution cannot fall into the same quarter. This step eliminates 629 deals, and our sample is reduced to 3,464 deals. The purpose of this step is to make sure that we can calculate the change in institutional ownership around deal announcement. Second, from the end of Quarter t-1 to the end of Quarter t the deal is announced between these two dates the arbitrageur has a positive change in stock ownership for at least 6 deals and in more than 60% of all deals in which they have holdings during our sample period. Institutional investors meeting these criteria are defined as passive risk arbitrageurs in those deals. As the two numerical cutoffs are arbitrary, we carry out robustness checks with different cutoffs to make sure that varying the cutoff criteria within a reasonable range does not change our main results. The above steps identify 3,714 unique passive risk arbitrageurs between 2000 and We then proceed to identify deals that have participation by passive arbitrageurs. In the next step, we isolate deals that are held by at least one passive arbitrageur but are not held by any of the activist arbitrageurs in our sample. The double criteria yield 2,461 deals. In addition to identifying passive risk arbitrageurs through 13F filings, we supplement the search by processing all schedule 13D filings between announcement and resolution for all deals between 2000 and The filing investor is considered a passive arbitrageur if it did not state under Item 4 that the purpose of its investments was to influence the pending 11

12 merger, and there is not trace in the new archive indicating the opposite. This procedure yields an additional 220 unique passive risk arbitrageurs. After merging our M&A database with the samples of risk arbitrageurs, we end up with 210 deals targeted by activist arbitrageurs, 2,681 deals involving passive arbitrageurs, and 573 deals involving no disclosed arbitrageurs. Of the total of 3,464 mergers, 2,089 are cash offers, 749 are stock deals and the rest are paid in both cash and stock. 3 Characteristics of Deals Involving Activist Arbitrageurs 3.1 Overview We now examine the characteristics of merger targets that are most likely to attract activist arbitrageurs. The first column of Table 3 reports characteristics of merger targets held by activist arbitrageurs. We compare these merger targets with those held by passive arbitrageurs, the traditional risk arbitrageurs documented in the prior literature (e.g., Hsieh and Walkling, 2005; Mitchell, Pulvino and Stafford, 2004), as well as deals involving no disclosed arbitrageurs. Deals held by activist arbitrageurs on average have an announcement premium of 19.1%, relative to a 32.2% premium for deals involving passive arbitrageurs (t-statistic for the difference equals -7.5) and a 39.3% premium for those without disclosed arbitrageurs (t-statistic for the difference equals -7.6). As the announcement premium is a common proxy for how much the offer price is in excess to the merger target s closing stock price one day prior to the announcement, the significant difference indicates that active arbitrageurs are bargain hunters: They tend to target deals with lower announcement premiums, which have more room for a raise in the bid. Activist arbitrageurs also are more likely to invest in going-private deals, many of which are management-led buyouts and cash deals. These financial buyers tend to initiate lower bids than strategic or corporate buyers, whose higher offer prices can 12

13 be justified by potential synergies created in the merger (e.g., Bargeron, Schlingemann, Stulz and Zutter, 2008). Compared to deals involving passive arbitrageurs, deals held by activist arbitrageurs are 16.6 percentage points more likely to involve multiple bidders (t-statistic for the difference equals 5.5), many of which are approached by the target board at the urge of these activists. In fact, out of the 52 multiple-bidder deals held by activist arbitrageurs, 67.3% of them engaged new bidders only after these arbitrageurs initiated their proposals. Deals involving activist arbitrageurs are less likely to have defensive tactics, such as a shareholder rights plan, against takeovers. This makes hostile takeovers more likely to succeed as a last resort, potentially increasing arbitrageurs profits. Activist arbitrageurs tend to target deals with higher institutional holdings, compared to deals involving passive arbitrageurs or those without disclosed arbitrageurs, consistent with a key finding of Bradley, Brav, Goldstein, and Jiang (2010) in analyzing activists endeavor in opening up closed-end funds. Institutional ownership indicates how sophisticated the shareholder base is. As minority stockholders, activist arbitrageurs need the support of other institutional investors in order to achieve their agenda. Deals involving activist arbitrageurs on average have a higher revision return, which is the increase in the acquirer s bid scaled by the share price right before the initial takeover announcement. The boards of merger targets are usually pressured by activists to reject the initial offer or seek an alternative bid, often resulting in a higher offer price, either from the original bidder or a third-party acquirer. 3.2 Determinants of Activist Arbitrageurs Participation In this subsection, we study the determinants of activist risk arbitrage using two methods. First, we use an unordered choice model (multinomial logit model) to analyze why investors engage in activist arbitrage, assuming that they can choose to be an activist arbitrageur, to be a passive arbitrageur or to not participate. In this analysis, the choices to be a passive arbitrageur or activist arbitrageur are mutually exclusive but are not ordered. The passive 13

14 arbitrageur is deemed as a competing risk rather than a control. Second, we use a probit model to study why investors voice concerns about the deal conditional on their decision to engage in risk arbitrage at a given target firm Analysis of Unordered Choice Columns (1) and (2) of Table 4 report results from fitting an unordered choice model. The base outcome is when a merger target does not involve disclosed arbitrageurs. Column (1) examines the relationship between announcement premium and the relative probability of a deal being targeted by activist arbitrageurs compared to that without arbitrageurs, controlling for other deal characteristics, such as deal size, whether the merger is a going-private deal (an offer from a financial buyer), as well as institutional ownership. Consistent with results in Table 3, the announcement premium has a significant impact on the likelihood of ownership by activist arbitrageurs. A one-standard deviation increase in the announcement premium is associated with a decrease in the marginal probability by 5.5%. The coefficient is statistically significant at the 1% level. Relative to the unconditional probability of being held by activist arbitrageurs of 6.1%, the incremental probability is substantial. This indicates that activist arbitrageurs seek to identify deals with low announcement premiums, which have a high potential for increased bids. In fact, the arbitrageurs stated goals in their 13D filings or news releases are consistent with this finding. In their statements they often use key phrases like substantially undervalued and inadequate. As expected, activist arbitrageurs are more likely to invest in going-private deals, usually financed by financial, rather than strategic, sponsors. The marginal probability of a target being held by activist arbitrageurs is 80 percentage points higher when the offer is from a financial buyer, as opposed to a corporate buyer. In a regression framework, this effect is net of that of the offered premium, that is, it already takes into account that financial buyers typically offer lower bids than strategic buyers. Going-private deals are among the most prone 14

15 to conflict of interest, especially when a controlling shareholder is a member of the buyer group because the controlling stockholder s ownership interest gives it the power to control the approval of the transaction (and reject any alternative transaction), while minority or unaffiliated stockholders are susceptible to potential coercion and other manipulative tactics. A similar argument applies, to a lesser degree, to friendly deals (94.8% of all transactions), where the board endorses the proposed transaction. The significant positive coefficient thus exemplifies the corporate governance element in the activist arbitrageur strategy. Deal size and toehold by the acquirer are positively correlated with the probability of being targeted by activist arbitrageurs, and the coefficients are statistically significant at the 1% level. Furthermore, estimates for institutional holdings suggest that the merger target s shareholder clientele has a significant impact on the likelihood of activist arbitrageurs involvement. A one-standard deviation increase in institutional holdings is associated with an increase in the marginal probability by 1.6% (t-statistic = 7.8). Given their minority stakes in merger targets, it is crucial for activists to rely on the support of these institutional investors in order to implement their strategies. Column (2) reports that relative to target firms involving no disclosed arbitrageurs, deals held by passive arbitrageurs are bigger, have a larger institutional investor base and a larger toehold by the acquirer. All these coefficient estimates are statistically significant at the 5% level. Importantly, there does not appear to be any relationship between announcement premium and the relative probability of a deal being targeted by passive arbitrageurs. This suggests that passive arbitrageurs may not consider the announcement premium as an important factor in adopting their arbitrage strategy Conditional Probit Analysis We now perform a probit analysis on what motivates investors to take the activist approach conditional on their decision to engage in a merger arbitrage. Coefficient estimates 15

16 are reported in column (3). Consistent with the multinomial logit results, a one-standard deviation increase in the announcement premium is associated with a 5.5% decrease in the marginal probability of being targeted by activists (t-statistic = -5.3). This again suggests that relative to passive arbitrageurs, activists tend to purchase shares in deals with lower premiums in order to generate higher ex-post returns. Institutional ownership is positively correlated with voice conditional on arbitrage. The estimate, however, is just short of being statistically significant at 10%. 4 Deal Completion Rates and Duration 4.1 Completion Rates and Activist Arbitrageurs After examining what determines activist arbitrageurs involvement in merger deals, we now study how these arbitrageurs campaigns can affect the probability of deal consummation. On one hand, these sophisticated investors can push the target board to maximize shareholder value by rejecting inadequate offers and seeking higher bids; on the other hand, however, activist arbitrageurs involvement could cause delays in the merger process, creating higher costs and uncertainties that might drive potential suitors away. Whether activist arbitrageurs can create value for target shareholders depend on the tradeoff between positive revision returns (as shown in Table 3) and potentially higher risk of deal failure. In column (1) of Table 5, we use a probit model to examine whether activist arbitrageurs involvement can predict deal completion, controlling for important deal characteristics, such as the announcement premium, deal size, whether an offer is from a private acquirer and institutional ownership. Deals targeted by activist arbitrageurs are 3.6 percentage points less likely to be consummated, and the effect is marginally significant (t-statistic = -1.70), and of modest economic magnitude given the average completion rate for merger deals in our sample is about 85.2%. We also confirm that going-private deals have a lower probability 16

17 of completion, possibly due to lower offer prices and greater resistance from shareholders. Consistent with Hsieh and Walkling (2005), friendly deals are more likely to be completed. We also find that tender offers enjoy a higher probability of deal success, while the use of defense tactics are associated with lower consummation rates. On the surface, activist arbitrageurs do not help to ease the closure of merger deals. This is somewhat in contradiction to the general goal of a risk arbitrageur who has the greatest incentive to have deals consummated (Cornelli and Li, 2002). This, however, may reflect both a selection and a substitution effect: as bargain hunters, activist arbitrageurs might buy into deals with lower ex-ante success rates, such as going-private deals, which could generate higher ex-post returns. On the other hand, an arbitrageur has to be willing to shut down some marginal deals in order to extract better terms. To test this hypothesis, we relate the ex-post success rate with a proxy for the ex-ante completion rate which equals to (P +1 P 1 )/(Initial offer price P 1 ), in which P 1 and P +1 denote the target s stock prices one day before and after the deal announcement, respectively. 8 This measure is similar to those used in Brown and Raymond (1986) and Larcker and Lys (1987). This proxy captures the prevailing market wisdom about the deal outcome, and empirically it positively predicts the success of a deal: In our sample, a one-standard deviation increase in the ex-ante completion probability leads to a 3.4% increase in success for an average deal, controlling for major deal characteristics. Moreover, to make sure that activist interventions do not contaminate this ex-ante completion rate, we eliminate 17 deals in which the activist arbitrageurs disclosed their holdings at deal announcement or on day +1. A preliminary comparison shows that the ex-ante completion probability for deals targeted by activists, at 70.9%, is 1.9 percentage points lower than that of the control sample, and the difference is statistically insignificant (t-statistic = -0.79). This suggests that activist arbitrageurs do not appear to work on deals that are perceived by the market as being 8 Alternative measures such as (P +1 P 20 )/(Initial offer price P 20 ) and (P +1 P 10 )/(Initial offer price P 10 ) yield similar results. 17

18 less hopeful of completion. We then examine the relationship between ex-ante and ex-post deal completion rates for those targeted by activist arbitrageurs, controlling for deal characteristics. As reported in column (2) of Table 5, the coefficient on ex-ante completion is positive (t-statistic = 3.7), suggesting that a one-standard deviation increase in the ex-ante completion probability leads to a 10.9% increase in success for deals involving activists. For deals involving no such investors, however, a one-standard deviation increase in the ex-ante completion rate leads only to a 2.3% increase in success. The two-sample t-test for these two coefficient estimates rejects the null hypothesis that they are equal (t-statistic = 2.1). These results imply that the presence of activist arbitrageurs is associated with a higher sensitivity of ex-post completion to ex-ante success probability. In summary, results in Table 5 suggest that although activist arbitrageurs do not appear to invest in merger targets with higher ex-post success rates, they tend to influence the outcome of the offer, making a deal more likely to succeed when it is more welcomed by the market. Luo (2005) shows that the sensitivity of deal completion to market reaction is indicative of corporate insiders learning from the collective wisdom of the market to make better investment decisions. Our results thus support the hypothesis that activists serve as monitors so as to make management more receptive to the cues from the market prices. This, coupled with the ability to generate superior revision returns (shown in Table 3), implies that activist arbitrageurs are capable of creating value for target shareholders. 4.2 Activist Arbitrageurs and Duration to Deal Resolution Although activist arbitrageurs aim to maximize the target s shareholder value, their campaigns could cause delays in the merger process, potentially creating higher costs for shareholders. In this subsection, we analyze how activist arbitrageurs involvement is related to the duration of the merger (from announcement to resolution). In column (1) of Table 6, we regress the logarithm of deal duration on the activist arbitrageur dummy and 18

19 major covariates, such as deal size, whether it is a stock deal and institutional ownership. The duration of a deal involving activist arbitrageurs on average is 7.3% longer than those without. 9 However, the coefficient estimate is not statistically significant at the 10% level. On average, larger deals, stock mergers and deals that involve defense tactics take a longer time to consummate, while friendly bids and tender offers have a shorter duration. In column (2), we use a Cox proportional hazards model to estimate the hazard for being targeted by an activist arbitrageur, which is robust to non-linear specifications. 10 The estimated hazard ratio for the activist arbitrageur dummy is 0.86, implying that the hazard for deals involving activists is 14% lower than that for other deals. In other words, the average duration for deals targeted by activists is longer than that for other deals. The coefficient estimate is marginally significant at the 10% level. The hazard ratios for all other control variables are consistent with the OLS results. For robustness analysis, we repeat the estimation by using a Weibull parametric model in column (3). 11 The Weibull model is more general and flexible than the Cox model and allows for hazard rates that are nonconstant but monotonic. The estimated hazard ratio for the activist dummy is again 0.86 and insignificant. Perhaps contrary to intuition, these results suggest that activist arbitrageurs involvement only marginally prolongs the duration to completion. 5 Stock Returns and Activist Arbitrageurs We now address the fundamental questions on whether and when activist risk arbitrageurs can create value for target shareholders. We begin by examining ex-ante and ex- 9 The percentage difference in durations between deals targeted by activist arbitrageurs and those in the control group is equal to 100(e xj 1)% where x j is the jth covariate. 10 In the Cox model, the hazard ratio is characterized as h i (t) = h 0 (t)e Xi β where t is the duration to completion. 11 In the Weibull model, the hazard ratio is characterized as h i (t) = λ i ρ(λ i t) ρ 1 where λ i = e Xi β, t is the duration to consummation and ρ is a parameter. 19

20 post measures of merger returns for target companies involving activist arbitrageurs, passive arbitrageurs and no disclosed arbitrageurs. The ex-ante returns reflect the selection effect of activist risk arbitrage, while the ex-post returns measure value creation by activist arbitrageurs. In Section 6, we perform a similar exercise for acquiring companies involving activist arbitrageurs. 5.1 Ex-Ante and Ex-Post Returns for Merger Targets We follow Schwert (2000) and Hsieh and Walkling (2005) to estimate ex-ante merger returns. The takeover premium is estimated as the merger target s cumulative abnormal return ( CAR ) from 54 trading days prior to the first bid announcement to deal resolution. For deals involving appraisal petitions by activists, we add the appraisal return, which is calculated as the difference between the appraisal price and the stock price on the last trading day scaled by the price on the last trading day. 12 We also separately estimate runup and markup, which are the CAR for trading days (-54, -1) and the CAR between one day before the first bid and deal resolution, respectively. Daily abnormal returns ( ARs ) are calculated for each stock using the Fama-French four-factor model. CARs are the sum of daily ARs, whereas cumulative average abnormal return ( CAAR ) is the average CAR across stocks Long-Only Returns Panel A of Table 7 presents abnormal returns for investors who long target companies. Given that activist arbitrageurs do not disclose their holdings in acquirers and only 19 of 210 deals targeted by activist arbitrageurs are stock deals, these long-only returns are suitable measures for activist arbitrageurs gains. The average takeover premium for deals 12 Appraisal prices granted by a Delaware State judge are available for 14 appraisal petitions in our database. The average (median) appraisal return is 15.6% (19.6%). The average (median) length between deal completion and the appraisal decision is 1,043.1 (1,106) calendar days. 20

21 involving activist arbitrageurs is about 24.9%, while it is 31.6% for those targeted by passive arbitrageurs (t-statistic of the difference equals -2.05), consistent with our earlier finding that activist arbitrageurs tend to target deals with lower announcement premiums, in which it may be more feasible to generate higher ex-post returns. The takeover premium for deals involving no disclosed arbitrageurs is about 29.7%, slightly lower than that for mergers targeted by passive arbitrageurs. The average markups are 19.7% and 26.4% for activist and passive arbitrageurs, respectively, consistent with results for the takeover premium. Interestingly, for the run-up there does not appear to be any difference between deals involving activist and passive arbitrageurs (5.7% vs. 6.4%; t-statistic of the difference equals -0.35). This suggests that activist arbitrageurs may not possess valuable insider information prior to deal announcement, which is consistent with the fact that activist arbitrageurs typically launch their campaigns after deal announcement. This is contrary to findings in Dai, Massoud, Nandy, and Saunders (2013), who suggest that arbitrageurs trade on private information before the M&A announcement date. Results are similar if we exclude deals in which activist arbitrageurs only seek appraisal petitions without engaging other campaign tactics. We now examine whether activist arbitrageurs are able to generate superior ex-post abnormal returns in target companies, compared to passive arbitrageurs. As the information associated with the first bid usually has already been incorporated in stock prices before the first day after merger announcement, the abnormal return between the second day after deal announcement and resolution reflects activist arbitrageurs ability to bring out extra returns by campaigning against the merger. This is our main ex-post return measure. CAAR (+2, resolution) is 4.8% for deals involving activist arbitrageurs, greater than a 1.6% return for those targeted by passive arbitrageurs and a -1.3% for those involving no disclosed arbitrageurs. In annualized terms, the difference is 14.4% vs. 4.1%, again significant (t-statistic = 2.19). It is worth noting that deal duration plays little role in explaining this difference as the median durations are 86 and 80 trading days for both groups, respectively. The dif- 21

22 ferences in the median abnormal returns are equally stark. The median CAR is 2.4% for deals targeted by activists, while it is just 0.1% for passive arbitrageurs, indicating that about 50% of the deals involving passive ones have negative abnormal returns after day +2. Interestingly, if we exclude deals with appraisal petitions only, CAAR (+2, resolution) is slightly lower as the appraisal values granted by Delaware State judges on average carry a positive premium over the merger prices (see footnote 11). 13 For robustness analysis, we now use an alternative ex-post return measure CAAR (max[+2, Disclosure 10], resolution), in which max[+2, Disclosure 10] stands for the latter of day +2 and 10 days before an activist arbitrageur s disclosure. As the SEC allows 10 days between when an investor reaches 5% of the target company s outstanding shares and when the investor must file a Schedule 13D, this return measure captures the run-up of an activist arbitrageur s disclosure (Brav, Jiang, Partnoy and Thomas, 2008a; Klein and Zur, 2009). 14 For all deals targeted by activist arbitrageurs, CAAR (max[+2, Disclosure 10], resolution) is 5.0%, slightly higher than our main ex-post return measure. Next, we investigate short-term stock returns around activist arbitrageurs disclosure dates. Within a 20-day window around their disclosure dates, the average CAR is about 2.0% for all target firms held by activist arbitrageurs (the annualized CAAR is about 31.5%), suggesting that the market perceives a positive effect of activist risk arbitrage. Excluding deals involving appraisal rights only, the order of magnitude is similar Long-Short Returns As arbitrageurs typically attempt to isolate transaction risk by hedging against changes in the acquiring firm s stock price, in Panel B we present long-short abnormal returns for all merger deals. Few stock deals are targeted by activist arbitrageurs (19 out of 210 deals), 13 Rather than actively oppose a merger deal, dissenting shareholders seeking appraisal petitions typically vote against the merger and ask a court to determine the fair value of their stocks. 14 In our sample, 54 of the 210 disclosures by activist arbitrageurs are not through Schedule 13D filings. 22

23 while more than 20% of deals involving passive arbitrageurs are stock deals. As long-short abnormal returns are typically higher than long-only returns, 15 the ex-post return differential between deals targeted by activist and passive arbitrageurs thus is smaller than that in Panel A. CAARs (+2, resolution) are 4.1% and 2.4% for activist and passive arbitrageurs, respectively. In annualized terms, the figures are 13.3% and 6.0%, respectively (t-statistic of the difference equals 1.70). In Appendix B, we present abnormal returns for cash deals and stock deals separately. The results are broadly consistent with our main results in Panels A and B of Table Returns for Completed and Withdrawn Deals To further identify the sources of ex-post returns generated by activist arbitrageurs, we examine completed and withdrawn deals separately. Panel C presents long-only abnormal returns for completed mergers. Target firms involving activists on average have lower takeover premiums, run-ups and markups than those involving passive or no disclosed arbitrageurs, consistent with findings in Panel A. This suggests that activist arbitrageurs tend to purchase undervalued assets (they target stocks with lower announcement premiums) in the hope of generating higher returns ex post. CAAR (+2, resolution) for deals targeted by activists almost doubles that for deals involving passive arbitrageurs (7.4% vs. 3.2%; t-statistic of the difference equals 1.88). This larger spread, relative to that in Panel A, is a strong indication that activist arbitrageurs are capable of pushing for higher bids for deals that are eventually successful. Other ex-post return measures yield consistent results. For withdrawn deals, the takeover premium, run-up and markup for various arbitrageur groups are significantly lower than those for successful deals. These are shown in Panel D. The takeover premium and markup for deals targeted by activists are again lower than those involving passive arbitrageurs. CAARs (+2, resolution) for deals involving activist and pas- 15 Acquirers stock prices often decrease after deal announcements (Mitchell, Pulvino and Stafford, 2004). 23