Hedge Fund Activism and Bank Loan Contracting

Abstract

Using a large sample of loans initiated by firms targeted by hedge fund activists during 1994-2008, we show that hedge fund activism has significant impacts on firms’ bank loan contracts. After the targeting announcement, and relative to firms that are not targeted, the targeted firms pay significantly higher spreads, are more likely to be required to secure their loans, face more covenant restrictions on their financial and investment policies, and have shorter loan maturities. These results are consistent with the hypothesis that hedge fund activism increases credit risk by exacerbating shareholder expropriation of bondholder wealth (the “expropriation effect”). Cross-sectional evidence indicates that the increase in the cost of debt after the activism is greater when the activism targets firms’ capital structure. There is also evidence that activism targeting firms’ corporate governance reduces the cost of debt. Our results imply that firms could face higher costs of debt and greater restrictions on financial flexibility when firms are targeted by activist shareholders.

Keywords: Loan contracting, Credit risk;, Hedge fund activism

JEL Classification: G21, G32