Hedge Fund Activism and Organization Capital

Transcription

1 Hedge Fund Activism and Organization Capital Bill Francis Lally School of Management, Rensselaer Polytechnic Institute Troy, NY Gilna Samuel* Lally School of Management, Rensselaer Polytechnic Institute Troy, NY Yinjie (Victor) Shen Lally School of Management, Rensselaer Polytechnic Institute Troy, NY *Contact author

2 Hedge Fund Activism and Organization Capital Abstract This paper investigates the impact of hedge fund activism on firm-level organization capital. We use Schedule 13D filings to track hedge fund activism events and construct sample of control firms using propensity score matching. We find that hedge funds target firms with higher organization capital. Also, there is a significant increase in organization capital after hedge fund intervention for firms with higher organization capital. These results are verified through various robustness tests. We also show that the impact of hedge fund activism on organization capital is sustained in the long term. Finally, we show after hedge fund intervention there is a positive and significant relationship between target firms performance and their increase in organization capital. Key Words: Hedge fund activism, organization capital, monitoring, firm performance 1

3 1. Introduction The separation of ownership and control creates agency conflict between shareholders and managers (Jensen and Meckling, 1976). One method that has been suggested to reduce agency conflict(s) is the monitoring of managers by large shareholders. Shleifer and Vishny (1986) claim that large shareholders have a greater incentive to monitor management because they hold larger proportions of equity. However, empirical work that examines the impact of large shareholders such as, pension funds and mutual funds, on the impact of agency costs on firm value and their decision making find inconsistent results with this theory (see e.g. Karpoff, 2001 and Parino et al. 2003). Recently, a growing body of research focuses on hedge funds, another type of large shareholders that has become more prevalent over the past couple decades. Studies such as Bratton (2006) and Briggs (2007) contend that hedge fund activists have greater incentives to monitor compared to other large shareholders. Clifford (2008) finds that monitoring by hedge fund activists compared to non-activists significantly increases overall performance of target firms. Brav et al. (2008) show that payout and operating performance of target firms increases after hedge fund intervention. Also, Brav et al. (2008), Clifford (2008) and Klien and Zur (2009) show that target firms experience positive stock price reactions after the announcement that the firm is being targeted by a hedge fund activist. Although the literature asserts that hedge fund activists increase value of target firms, the channels through which hedge fund activism creates value have not been extensively studied. One possible channel of value creation by hedge fund activists is through the improvement of the internal environment of the firm. The internal environment of the firm is comprised of the talent and skills of employees and overall corporate culture of the target firms and these aspects of the 2

4 firm are captured by the level of organization capital within the firm. This paper seeks to bridge this gap by examining the impact of hedge fund activism on firm-level organization capital. Eisfeldt and Papanikolaou (2013) define organization capital as intangible capital that is embodied within the firm s key talent, namely the employees. Prescott and Visscher (1980) point out that organization capital involves the accumulation and use of private knowledge about key talent to improve productivity within the firm. As such, organization capital is unique to a firm and cannot be easily transferred or imitated by other firms. The extant literature provides evidence of a positive association between firm performance and firm-level organization capital (see, e.g., De and Dutta, 2007; Tronconi and Marzetti, 2011). However, Eisfeldt and Papanikolaou (2013) show that a characteristic of this type of capital is that it is significantly risker than physical capital because cash flow rights are shared between key talent and shareholders and investors require a higher risk premia for firms with higher levels of organization capital. Thus, managers may be more reluctant to invest in organization capital leading to a subsequent decrease in firm performance, to the detriment of one of their firms other stakeholders (e.g., shareholders). Nevertheless, the theoretical literature provides contrasting predictions on how hedge fund activism will impact organization capital. On one hand hedge fund activists could encourage firm management to invest in organization capital because of the positive association with performance. Brav et al. (2012) show that hedge funds encourage firms to reallocate resources more efficiently, resulting in a 7.3% increase in labor productivity, three years after hedge fund intervention. Cheng et al. (2012) also show that hedge fund activism improves tax 3

5 efficiency of target firms. Given these arguments, we expect organization capital of target firms to increase after being targeted by a hedge fund. Alternatively, critics of hedge fund activism claim that hedge fund activists are shortsighted and do not improve long-term value (see e.g., Bratton and Wachter, 2010). Because organization capital is a risky investment, myopic-activists may be reluctant to increase the organization capital of the target firm. Also, Brav et al. (2008) show that hedge fund activists increase CEO turnover and pay-performance sensitivity leading to concerns that hedge funds impact key talent negatively. Moreover, shareholder pressure from hedge fund managers could induce target managers to engage in myopic actions (Stein, 1988). As a result, these managers prefer to engage in more routine investments possibly at the expense of riskier more value enhancing projects. Thus, these arguments imply that hedge fund activism will decrease firmlevel organization capital. We empirically examine the relationship between hedge fund activism and organization capital using Schedule 13D filings submitted to the Securities Exchange Commission (SEC). We compare organization capital before and after the filing of Schedule 13D for a sample of target and control firms. To address endogeneity concerns of the targeting decisions of hedge funds, we follow Li and Prabhala (2007) and use propensity score matching to construct a control group. The variables used in the propensity score model follows those used by Brav et al. (2008) and examines the probability of being a hedge fund target in the next year. Next, we examine the impact of hedge fund activism on organization capital for the target firms and find that organization capital increases by 12% two years after hedge fund intervention. We conduct additional robustness tests which are consistent with our main results. Additionally, we find that hedge funds with fewer prior targets have a more significant impact on organization capital after 4

6 activism events. We also examine long term horizons and show that hedge funds increase organization capital over the long term. Finally, we find that after activism events there is a positive and significant relation between target firms long-term performance and their increase in organization capital. This paper contributes to three literature streams. First, we contribute to the literature on the impact of hedge fund activism on target firms, in particular, how activists create value for target firms. The literature shows that hedge fund activism creates value by improving the tax efficiency of the firm (Cheng et al., 2012) and reallocating of corporate assets (Brav et. al., 2012). We show that hedge fund activists also create value by increasing firm-level organization capital, which is an intangible asset positively associated with firm performance. Second, this paper has policy implications for the regulation of hedge funds. Hedge funds are a relatively new type of institutional investor and are not as highly regulated as typical institutional investors such as pension funds and mutual funds. Consequently, there is a significant policy debate for the increased regulation of hedge funds because of the presumed myopic behavior of hedge fund managers. We show that hedge fund activism increases organization capital which in turn increases target firm performance. Thus, hedge fund activists are not as short-term focused as some critics believe and increased regulation may not be necessary. Third, we add to a growing body of research on firm-level organization capital. Many studies have examined the role of organization capital within the firm (e.g. Lev and Radhakrishnan, 2005; Lev, Radhakrishnan, Zhang, 2009) and these studies show that organization capital is a significant resource to the firm. Surprisingly, given the importance of 5

7 organization capital for the competitive advantage and growth of a firm, few studies examine its determinants. Hedge fund activism is a governance mechanism that has been shown to have a significant impact on various corporate decisions. In this paper, we can bridge these two distinct streams of literatures by examining the impact of hedge fund activism on the firm s investment in organization capital. The rest of this paper is organized as follows. Section 2 discusses the related literature and hypothesis development. Section 3 describes our data and variable construction. Section 4 describes the methodology. Section 5 discusses our main results, the effect of activists characteristics and robustness checks. Section 6 investigates the long term impact of hedge fund activism. Section 7 examines the impact of the relationship between hedge fund activism and organization capital on firm value. Section 8 concludes. 2. Related Literature and Hypothesis Development 2.1. Difference between hedge fund activists and other institutional investors A hedge fund usually consists of a few sophisticated investors who pool funds together and unlike mutual funds or pension funds, hedge funds are not available to the general public (BarclayHedge LTD, 2011). The literature shows that like most institutional investors, hedge funds have the incentive to monitor the firm management; however, hedge funds have characteristics that are different from typical institutional investors. First, hedge fund managers have stronger financial incentives because these managers often use their personal funds (Kahan and Rock, 2007). Also, hedge fund managers usually have performance based compensation that incentivizes them to improve target firm value 6

8 (Ackermann, 1999). Second, hedge funds are less regulated because they are not available to the general public (Lemeke et. al 2014). Hedge funds are not subject to federal laws such as Employee Retirement Income Security Act of 1974 (ERISA). Also, hedge funds are not required by law to maintain diversified portfolios and are allowed to hold large amounts of equity in a single target firm unlike other institutional investors (Clifford, 2008). Another differentiating characteristic of hedge funds is that there are fewer conflicts of interest as hedge fund managers usually do not have previous business relationships with the target firms. Other institutional investors such as pension funds and mutual funds sometimes have prior business relationships with the target firms or non-financial motives for investing in a company (Brav et al., 2009). Moreover, some hedge funds have a lock-up period in which the hedge fund investors cannot pull out their investment (Clifford, 2008). As a result, since hedge funds are required to invest in target for firms for a certain period of time they may be more likely to undertake strategies which improve long-term firm performance (Agarwal, 2009). Therefore, the organizational structure and managerial incentives of hedge fund activists make them more likely to monitor the firm, compared to other institutional investors. Also, monitoring by hedge fund activists is more likely to have a greater influence on the management of target firms Review of organization capital The notion of organization capital was first introduced by Prescott and Visscher (1980). They define organization capital as an information asset that includes knowledge on the abilities of employees, the improvement in the matching of employees to teams and the human capital of employees. Organization capital consists of two components, namely key talent (Becker, 1993) and firm-specific characteristics (Atkeson and Kehoe, 2002). As such, organization capital is 7

9 defined by Evenson and Westphal (1995, p. 2237) as the knowledge used to combine human skills and physical capital into systems for producing and delivering want-satisfying products. Importantly, a positive relation between organization capital and firm performance is documented in the literature. For example, Eisfeldt and Papanikolaou, 2013 find that firms with more organization capital have 4.6% higher average returns than firms with less organization capital. Tronconi and Marzetti (2011) and Dutta and De (2007) show that organization capital is a significant determinant of firm performance using a sample of European firms and software firms in India, respectively. Organization capital significantly improves firm performance for a number of reasons. First, firms with high levels of organization capital demonstrate better managerial quality and invest more in information technology (IT) (Eisfeldt and Papanikolaou, 2013). These firms have more highly skilled employees and a collection of unique systems and processes relating to operating, investment and innovation capabilities, compared to firms with less organization capital (Lev, Radhakrishnan, and Zhang, 2009). Second, Calin, Chowdhry and Garmaise (2012) show that higher levels of organization capital are associated with lower employee turnover because incumbents are more knowledgeable than outsiders about the firm s unique business processes and are able to use the existing systems more effectively, thereby increasing productivity. Finally, an important characteristic of organization capital is that it is tacit and not directly observed. As a result, firms are able to gain a competitive advantage via organization capital because it is difficult for their competitors to duplicate this capital (Evenson and Westphal, 1995). However, firms with relatively higher levels of organization capital are also characterized by higher risk premia compared to firms with relatively higher levels of physical capital (Eisfeldt 8

10 and Papanikolaou, 2013). They contend that this is the case because unlike physical capital where shareholders own all the cash flow rights, with organization capital the key talent also shares cash flow rights. They claim that there is a risk that this key talent which is the driver of increased firm performance could exercise their option to seek employment elsewhere. The loss of key talent will occur when the value of these outside options is greater than the option to stay with the firm. As a result, key talent shares of the cash flow rights fluctuate systematically thereby, increasing the volatility of the residual income to shareholders. Thus, Eisfeldt and Papanikolaou (2013) point out that organization capital is characterized by a type of risk that is absent from physical capital and investors demand a higher risk premia for firms that have higher level of organization capital relative to physical capital. Consequently, organization capital is associated with higher firm performance but it is a more risky compared to physical capital. These characteristics will impact whether hedge fund activists encourage or discourage the management of target firms to invest in firm-level organization capital Impact of hedge fund activism on organization capital Two conflicting hypothesis of the potential impact of hedge fund activism on firm-level organization capital exist in the theoretical literature. Bebchuk et al. (2014) contend that hedge fund activism significantly increase firm value up to five years after intervention. Hedge fund activists who intend to increase long-term value and performance are inclined to encourage target firm managers to undertake value-enhancing investments. Moreover, the literature shows that organization capital is a significant predictor on firm value (see e.g. Tronconi and Marzetti, 2011) and Dutta and De, 2007). Therefore, hedge fund activists could encourage target firm 9

11 managers to increase investments in organization capital, resulting in an increase organization capital after hedge fund intervention. The opposing argument claims that hedge fund managers are short-term focused and their actions decrease overall firm value in the long run. Hedge fund managers may pressure target firm managers to avoid projects that are riskier but generate higher returns in the long term (Lipton and Rosenblum, 1991). Although organization capital is associated with higher firm performance, it is a more risky asset compared to physical capital. Thus, hedge funds activists could discourage managers from investing in organization capital because it is risky. In addition, target firm managers who feel threatened by shareholder pressure may act myopically because they fear a takeover and do not want the acquirer to benefit from their investments (Shleifer and Summers, 1988). Hence, these arguments suggest that hedge fund activism could lead to a decrease in organization capital of target firms. In summary, because organization capital is closely related to firm value, hedge fund activists could use organization capital as a mechanism to increase firm value and encourage target firm managers to invest in organization capital. On the other hand, the riskiness associated with organization capital could result in hedge fund managers discouraging target firms from investing in organization capital and focus on less risky investments. Hence, it is an empirical question as to whether there is an increase or decrease in a firm s organizational capital subsequent to hedge fund activism. 10

12 3. Data and Variable Construction We use data from several sources. To construct the hedge fund sample, we use these Schedule 13D filings from the Securities Exchange Commission (SEC) EDGAR database. Our sample includes publicly traded firms within the time period 1994 to 2014 since SEC filings in the EDGAR database were scarce before We also obtain financial and accounting data from Compustat, institutional ownership data from Thomson 13F database and analyst data from I/B/E/S Measuring Main Explanatory Variable: Hedge Fund Activism The 1934 Securities Exchange Act requires investors who acquire more than 5% of a publicly traded company to submit a Schedule 13D with the within 10 days and indicate any interest in influencing management. 1 For each Schedule 13D, we identify the name of the filer, filing date and target firm. Next, we create a list of hedge fund activists using data obtained from Brav et al. (2008) 2 and for activists that are not active before 2006, we follow the same procedure in Brav et al. (2008) to identify their names. We then match the name of the filer from Schedule 13D filings to this list. Finally, we supplement our list of events with data from FactSet s Shark Repellant database to capture campaigns that are not included in 13D filings when the activist does not own 5% or more of the company's stock. We define an activism event as the first Schedule 13D filing by a hedge fund activist for the corresponding 1 Investors who intend to remain passive file a Schedule 13G. However, if these investors decide later to become active then they have to file a Schedule 13D. Hedge funds can face legal action from both the SEC or target firms (see e.g. Ronson Corp. vs. Steel Partners II (2005) and SEC vs. Montgomery Medical Ventures, LP (1996)) for misrepresented filings. 2 We thank Wei Jiang for sharing the data used in Brav et al. (2008) with us. 11

13 target firm. Our final sample includes 4318 activism events, 2414 target firms and 858 hedge fund activists for the time period 1994 to Table 1 summarizes our hedge fund sample. Panel A shows the distribution of hedge fund activism events by year. This table shows that hedge fund activism is increasing over time. Panel B shows the participation frequency of hedge fund activists during our sample period. The majority (44.17%) of hedge fund activist target one firm while 10.61% target more than 10 firms. Panel C shows the frequency of activism event on target firms. Most of the target firms (56.50%) were targeted by a single hedge fund during our sample period. [Insert Table 1 here] 3.1. Measuring Dependent Variable: Organization Capital Our dependent variable is organization capital. To measure organization capital we follow the methods used by Lev and Radhakrishnan (2005) and Eisfeldt and Papanikolaou (2013). They develop firm-specific measurement of organization capital using Selling, General and Administrative (SGA) expenses. SGA expenses are an income statement item which includes most of the expenditures that generate organization capital, such as employee training costs and brand enhancement activities. The items included in the calculation of SGA expenses may vary slightly across firms or industries. Organization capital (OC) is computed using the perpetual inventory method. We adjust for depreciation and recursively measure the stock of organization capital using the following formula, (1) 12

14 where is the depreciation rate of organization capital and is the consumer price index. The initial stock of organization capital is computed as follows, (2) where g is the average real growth rate of firm-level SGA expenses. This initial value is computed for the first year in which SGA expense has a non-missing value in the Compustat database and the subsequent missing values become zero. Our estimation of the average real growth rate of firm-level SG&A expenses is 10%. Following Eisfeldt and Papanikolaou (2013) we use a depreciation rate of 15%. This depreciation rate is also used by the U.S. Bureau of Economic Analysis (BEA) to estimate R&D capital in We compute firm-level organizational capital for each year in our sample period and scale by the book value of total assets of the firm. This scaled value is used as our main dependent variable, and is denoted by OC/Assets for the remainder of this paper. The values of OC/Assets are winsorized at 1% and 99% to adjust for extreme values Control Variables Following the literature, we control for size, age of the firm and tangibility. Size of the firm is defined as the natural logarithm of sales. Age is defined as the natural logarithm of one plus the number of years the firm has been in Compustat. Tangibility is defined as net property plant and equipment divided by assets. We include year fixed effects to control for the impact of time trends and macroeconomic factors on organization capital. Eisfeldt and Papanikolaou (2013) claim that differences in 3 Similarly to Eisfeldt and Papanikolaou (2013), we find that our results are robust to a depreciation rate between 10% and 50%. 13

15 accounting practices across industries impact the components included in SG&A expenses such that it may not reflect the true investment in organization capital, as a result, we control for industry fixed effects where industry is defined by the 3-digit SIC code. 4. Methodology 4.1. Propensity score matching Brav et al. (2008) show that hedge fund activists select target firms based on specific characteristics. Thus, our findings may be biased if the characteristics that are unique to target firms also influence the managerial decisions relating to investments in firm-level organization capital. To control for selection bias we use propensity score matching to construct a sample of control firms. Propensity score matching is a widely used method used to mitigate selection bias. This method uses various covariates to estimate the probability of treatment or propensity score (see e.g. Rosenbaum and Rubin, 1983; Li and Prabhala, 2007). In our analysis, the propensity score is the predicted probability of a firm becoming a hedge fund target in the next year and is estimated from the following logistic regression, where, is one if a firm will be targeted by a hedge fund activist in the following year. The variables on the right-hand size are all lagged by one year and are defined in Appendix II. 14

16 We estimate the above logistic regression for all firms in the Compustat database with the required data for the sample period 1994 to 2012 and use the estimated coefficients to calculate the propensity score. 4 The control group is the non-target firms with the closest propensity score to the target firms. The results of the logistic regression are reported in Column (1) of Table 2. The results show that these firm characteristics are statistically significant predictors of the probability of being targeted in the following year. [Insert Table 2 here] We also examine the impact of organization capital on the probability of being targeted and add organization capital to the logistic regression in equation (3). Column (2) of Table 2 reports these results. The estimated coefficient of the organization capital variable has a positive and statistically significant value of 0.350, indicating that firms with higher levels of organization capital are 35% more likely to be targeted by hedge fund activist, on average. Table 3 summarizes and compares the characteristics of the target and matched-control firms one year before hedge fund activism events. Columns (1), (2) and (3) report the mean, median and standard deviation of the target firms, respectively. Columns (4), (5) and (6) report the mean, median and standard deviation for the matched-control firms. Column (7) reports the t- statistic of the mean difference between target and matched-control firms for each firm characteristic and the results indicate that the difference is not significant. Column (8) reports the Wilcoxon signed rank statistic of the median difference between target and matched-control firms for each firm characteristic. These results indicate that there is little difference between 4 We provide an assessment of our propensity score matching in Appendix I. 15

17 targets and matched-control group, based on these firm characteristics. For our analysis, we use a pooled sample of matched-control and target firms. [Insert Table 3 here] 4.2 Regression analysis Following Chen et al. (2012) and Bebchuk et al. (2014) that examine the impact of hedge fund activism on firm performance, we investigate the impact of hedge fund activism on organization capital within a regression framework. This analysis enables us to control for other factors that are associated with changes in organization capital and to determine the statistical significance of our results. We use explanatory indicator variables to examine the change in organization capital from two years before to two years after hedge fund activism events using the following model, 5 where i indexes firms, j indexes industry and t indexes the year. OC/Assets is firm-level organization capital scaled by the book value of assets., and are indicator variables which (4) account for industry and year fixed effects, respectively. is equal to one if year t is the year of the activist intervention i.e., the year of the first Schedule 13D filing by a hedge fund for the corresponding target firm. and are equal to one if the current year is one or two years before the intervention and 0 otherwise. and are equal to one if it is one or two years after the intervention and 0 otherwise. X is a vector of control variables, namely, 5 Our results are robust to various event windows. 16

18 age, size and tangibility which are defined in the previous section. All continuous variables are winsorized at the 1% and 99% levels to avoid the influence of extreme values. This regression framework allows us to examine the change in organization capital for the target firms relative to the matched-control firms. Specifically, each indicator variable represents the difference in year-and-industry-adjusted organization capital of target firms for either two years before to two years after and that of matched-control firms while holding age, size and tangibility constant. represents the difference in organization capital during the year of the activism event. The after-event indicator variables, and represent the difference in organization capital of target firms one or two years after hedge fund intervention. The pre-event indicator variable, and represent the difference in organization capital two years before hedge fund intervention. 5. Results In this section, we report and discuss the empirical results of our model. Section 5.1 uses descriptive and univariate analysis to examine patterns within organization capital of target firms surrounding the hedge fund activism events. Section 5.2 describes the results of the baseline regression. In Section 5.4 we examine the impact of fund experience and activism type on the change in organization capital after the hedge fund intervention. Finally, in Section 5.5 we conduct robustness checks using industry-median adjusted organization capital. 17

19 5.1. Descriptive Statistics and Univariate Analysis In Figure 1 we compare the distribution of organization capital for target firms and their corresponding matched-control firms by relative year within the event window [-2, +2]. For target firms with multiple activism events within this event window, we use the first activism event. Year 0 is defined as is the year of the first Schedule 13D filing by a hedge fund for the corresponding target firm. We define a pseudo event year for the matched-control firms based on the year they were matched to a target firm. This figure shows that target firms have higher levels of organization capital compared to matched-control firms. Also, the line plot for target firms becomes steeper after intervention, suggesting that the difference in organization capital increases at a faster rate after hedge fund intervention. Consequently, this plot suggests that hedge fund activism further increases organization capital of target firms. Table 4 compares average organization capital around hedge fund activism events. Event Year 0 is the year of the first Schedule 13D filing by a hedge fund for the corresponding target firm. Event Year 0 is also the pseudo event year for the matched-control firms based on the corresponding target firm. In Panel A, we report the mean organization capital of target and matched-control firms and their differences for Event Year -2 to Event Year +2. The mean organization capital for target firms is higher than the matched-control firm, on average. Moreover, the difference between the target and matched-control becomes larger after Event Year 0. These differences are also statistically significant and indicate that target firms have higher levels of organization capital before hedge fund intervention and this difference increases after hedge fund intervention. 18

20 In Panel B we compare the changes in the difference in organization capital around hedge fund activism events for target firms and matched-control firms. The changes in the differences of organization capital around event year for target firms are larger, relative to the matched control firms. These changes get larger after the event year. We also examine the difference in the changes around the event year for the target and matched-control firms. These differences are statistically significant and suggest that hedge fund intervention increases organization capital of target firms which amplifies the difference in organization capital of between target firms and matched-control firms. [Insert Table 4 here] Accordingly, the descriptive statistics and univariate analysis suggest that hedge fund activism increases organization capital of target firms. These results are consistent with the hypothesis that hedge fund activists use organization capital as an avenue to create value for target firms. However, these univariate test are not conclusive and do not allow us to control for other factors. Thus, we empirically investigate the impact of hedge fund activism on organization capital using regression analysis, which allows us to control for other variables in the next section Multivariate Analysis In this section, we estimate Equation (4) using Ordinary Least Squares (OLS) and report the results in Table 5. The variables of interest are the event dummy and after-event dummies:. In Column (1), we control for year fixed effects and in Column (2) we control for year and industry fixed effects. The estimated coefficients of the variables of interest are positive and statistically significant for both columns. The results 19

21 suggest that, on average, year-and-industry-adjusted organization capital of target firms increases by 6% during the event year and one year after, relative to matched-control firms. This increase doubles two years after hedge fund intervention. The estimated coefficients for the pre-event dummies, and, are not statisitically significant, indicating that the increases organization capital of target firms, relative to matched control firms, before hedge fund intervention are negligible. These results support the patterns which indicate that organization capital increased after hedge fund activism in Figure 1 and univariate tests reported in Table 4. The literature suggests that survivorship bias of target firms may exist. A firm is removed from the Compustat database if it is acquired by another company (public or private) or delisted (i.e., the firm goes private). Brav et al. (2013) claim that target firms have attrition rates that are double that of the average Compustat firm. Brav et al. (2010) show that there is a negative survivorship bias due to delisting from the Compustat database. Consequently, as a robustness test we limit our sample to firms that contain observations with non-missing data for the event window [-2, 2] and re-estimate our regression model. The estimation using the restricted model is reported in Column (3) and (4) of Table 5. We find that hedge fund activism increases organization capital by 7% during the event year, 9% one year after intervention and 14% two years after intervention, on average. The pre-event indicator variables are not statistically significant. Thus, the results from the restricted sample are consistent with the baseline results. [Insert Table 5 here] Our results are consistent with the view that monitoring of firm management by large shareholders encourages firm management to undertake value-enhancing activities. In particular, 20

22 hedge fund managers have stronger incentives to monitor the firms compared to other large shareholders. The literature shows that hedge funds create value for firms through the improvement of tax efficiency (Cheng et al., 2012) and the reallocation of assets (Brav, 2013). We examine another possible value creation mechanism of hedge fund activists, that is, organization capital. Our overall findings show that hedge fund activism increases firm-level organization capital of target firms. Finally, the control variables in our model have the expected signs based on the literature. The age coefficient is signifcant and positive indicating that older firms have more organization capital. The coefficient of the size variable is significant and negative implying that larger firms have less organization capital. The coeffcient of tangibility is postive and statitically significant, suggesting that firms with more physical capital also have higher levels of organization capital Impact of Hedge Fund Activists Experience Our previous results show that hedge fund activists increase organization capital of target firms. In this section we investigate the impact of activist experience on the change in organization capital after activism events. Based on Panel B of Table 1, most hedge funds in our sample have only one target firm throughout our sample period; however, some funds have more than ten targets. We define fund experience (FundExp) as the number of previous activism events a hedge fund activist has initiated by year t, including activism events initiated during year t. We divide fund experience into quartiles, and report the quartile distribution of hedge fund experience in Panel A of Table 6. Hedge funds in the first quartile have three or fewer targets by year t, funds in the second quartile have between 4 and 9 prior targets by year t, funds in the third quartile have 10 to 24 prior targets at year t and funds in the fourth quartile have more than 24 prior targets at year t. 21

23 For each quartile, we examine the impact of fund experience on organization capital after hedge fund intervention (i.e., the event window [0, +2]). These results are reported in Table 6. The results show that hedge funds in the first two quartiles positively impact organization capital during the event year and one or two years after the activism event. The estimated coefficients are also statistically significant. However, for funds in Quartile 3 and 4 the estimated coefficients are not statistically significant. Overall, our findings indicate that on average, hedge funds with fewer prior targets have a greater impact on the increase in organization capital of target firms relative to matched-control firms, after intervention. We also examine the impact of fund experience using the restricted sample and find consistent results. A possible explanation for these findings is that because of large number of target firms, funds in the bottom two quartiles may prefer to undertake more routine or myopic actions while funds with fewer prior targets prefer activities that increase long-term value of the target firm. [Insert Table 6 here] 5.4 Hostile vs. Non Hostile In this section, we use a subsample of our data with available data for activism type to examine the impact of activism type on organization capital. We define a hostile takeover as proxy fight and divide our sample into hostile and non-hostile activism events. Then, we reestimate our baseline regression model for each activism category. These results are reported in Table 7. Column (1) reports the estimation for non-hostile activism events. The estimated coefficients are positive statistically significant for the indicator variables representing the event year and the after event dummies, similar to the baseline regression. Column (2) reports the estimated model for hostile activism event. The estimated coefficients for each indicator variable 22

24 are not statistically significant. These results suggest that hostile activists do not increase organization capital of target firms, on average. [Insert Table 7 here] A possible explanation for these findings is that firm management probably did not endorse the acquiring of ownership by hedge fund activists and may even fear a hostile takeover. Shleifer and Summers (1988) claim that incumbent managers of the target firm do not want acquiring firms to benefit from their investments and are less likely to respond favorably to shareholder pressure. These managers prefer to engage in less risky projects and prefer more routine investments (Stein 1988). Consequently, managers have fewer incentives to invest in organization capital; as a result, hostile hedge fund activism events do not have a significant impact on organization capital Alternative measures of organization capital We explore other measures of organization capital. Eisfeldt and Papanikolaou, (2013) note that SGA expenses may not capture the all the investments in organization capital. Accounting practices varies across firms; as a result the composition of SGA expenses is not the same for all firms. To mitigate this inconsistency, we follow Li, Qui and Shen (2014) and use industry-median adjusted organization capital. The results are reported in Table 8. The event dummy and after-event dummies are all positive and statistically significant while the pre-event dummies are not statistically significant. These results are similar to our baseline regression. [Insert Table 8 here] 23

25 6. Long Term Impact Critics also suggest that hedge fund activists have myopic goals and are only interested in increasing short-term firm value. If this is true, then the increase in organization capital may not be sustained for longer horizons after hedge fund intervention. To investigate the long-term impact of hedge fund activism on organization capital, we extend our baseline model to include the five year horizon after hedge fund intervention as follows, +. (5) The event year indicators variables are defined similarly to our baseline regression and the same control varaibles and fixed effects are included. Additionally, to investigate the overall impact on organization capital after hedge fund activism, we estimate the following regression,. (6) where is a dummy variable equal to one if a hedge fund has targeted firm i by year t. The control variables and fixed effects are the same as our baseline regression. The estimation of these models are reported in Table 9. We estimate these models for the full sample in Columns (1) and (2). The variables of interest are the after-event dummies: and in Column (1) and in Column (2). The estimated coefficients for these variables are all 24

26 positive and statistically significant, suggesting that hedge fund activists increase long-term organization capital of target firms. We further restrict our sample to firms with observations that contain data for at least five years after hedge fund intervention to mitigate survivorship bias and re-estimate equation (5) and (6). These results are reported in Column (3) and (4). Our results are consistent with the full sample. Also, in Panel B, we use the estimated coefficients from the restricted sample, to examine the joint significance of all five after-event indicators variables. The results indicate that the increase in organization capital is jointly significant over the five year period after intervention. We also investigate the joint significance of and intervention is jointly significant. and the increase in organization capital three to five years after hedge fund [Insert Table 9 here] 7. Impact on Firm Value In this paper, we claim that the hedge fund activists increase firm level organization capital, on average. Studies such as Tronconi and Marzetti (2011) and Dutta and De (2007) show that organization capital is a significant predictor of firm performance. These studies imply that high levels of organization capital are beneficial for firm growth and increase firm value. Also, Brav et al. (2008) show that hedge fund activism increases the operating performance of the firms. Thus, hedge fund activists use organization capital as one source of value creation. To further test the economic significance of this increase in organization capital, we investigate the relationship between firm value and the change in organization capital after hedge fund 25

27 intervention. We use these performance measures to investigate the impact of the increase in organization capital after hedge fund activism using the following regression,, (7) Where, is measured as either ratio of EBITDA to sales or the ratio of EBITDA to assets of firm i at time t, following Brav et al. (2008). The control varaibles and fixed effects are the same as our baseline regression. We estimate the above regression using OLS and report the results in Table 10. The estimated coefficient of the OC/Assets is positive and statistically significant for both measures of performance indicating that organization capital has a positive impact on firm value. In addition, the interaction of the event dummies and OC/Assets are positive and statistically significant, indicating that the increase in organization capital is positively associated with firm value. Therefore, our findings suggest that hedge fund activists use investments in organization capital as a source of value creation after hedge fund intervention. [Insert Table 10 here] 8. Conclusion In this paper, we investigate the impact of hedge fund activism on firm-level organization capital. The literature shows that organization capital is a risky but high return investment which increases firm performance. Shareholders favor investments in organization capital because it value-enhancing; however, managers may be more reluctant to invest in organization capital 26

28 because of the associated risk. We argue that shareholder pressure from hedge fund activists impacts managerial decisions relating to firm-level organization capital. Previous research shows that hedge funds improve firms value by influencing managerial decisions relating to tax efficiency (Cheng et al. 2012) and the reallocation of assets (Brav et al. 2013). Our overall findings show that relative to a sample of matched-control firms, organization capital of target firms increases after hedge fund intervention, on average. This effect of hedge fund activism on organization capital describes another channel through which activists create value for target firms. Additionally, we examine impact of fund experience on the increase in organization capital and find that funds with fewer prior targets are more likely to increase organization capital of target firms. We compare the impact on organization capital for hostile and non-hostile activism events and find that hostile activism events do not increase firm-level organization capital. Next, we conduct robustness tests using industry-median adjusted organization capital and the results are consistent with our main results. Then, we extend our model and examine the long term impact of activism on organization capital and find that the increase in organization capital is sustained in the long-run. Finally, we show that a decrease in organization capital has an economically significant impact on firm value. We examine the relationship between organization capital and firm value measures. Specifically, we use two measures of operating performance, EBITDA/sales and EBITDA/assets, and find that organization capital is positively associated with these firm performance measures. This suggests that the increase in organization capital after hedge fund 27

29 intervention is one of the mechanisms through which hedge fund activism the increases firm value. This paper contributes to the growing body of literature on organization capital. Also, it adds to the literature on monitoring of larger shareholders, in particular, hedge fund activists. Our findings improve the understanding of the value creation mechanisms employed by hedge funds to create value for target firms. However, further study is needed to determine other valuecreation investments and their interaction with organization capital. 28

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