Validation Capital

21 Pages Posted: 16 Feb 2021

See all articles by Alon Brav

Alon Brav

Duke University - Fuqua School of Business; European Corporate Governance Institute (ECGI); National Bureau of Economic Research (NBER)

Dorothy S. Lund

University of Southern California Gould School of Law

Edward B. Rock

New York University School of Law; European Corporate Governance Institute

Date Written: February 1, 2021

Abstract

Although it is well understood that activist shareholders challenge management, they can also serve as a shield. This Article describes “validation capital,” which occurs when a bloc holder’s—and generally an activist hedge fund’s—presence protects management from shareholder interference and allows management’s pre-existing strategy to proceed uninterrupted. When a sophisticated bloc holder with a large investment and the ability to threaten management’s control chooses to vouch for management’s strategy after vetting it, this support can send a credible signal to the market that protects management from disruption. By protecting a value-creating management strategy that might otherwise be misjudged, providers of validation capital benefit all shareholders, including themselves. However, validation capital may also have a dark side: in theory, it could be used to entrench under-performing management from outside interference that would benefit the company and its shareholders. In this scenario, the bloc holder acts as a hired “bodyguard” who receives a side payment in exchange for the promise to ward off other investors. We theorize that legal and market forces do much to constrain the corrupt form of validation capital, and our empirical study of hedge fund activism events from 2015 offers evidence in support of our theory. We find that although side payments from corporate management to hedge funds are relatively common, they tend to be small, and not of the magnitude necessary to induce corruption of the sophisticated funds capable of generating a persuasive signal.

Suggested Citation

Brav, Alon and Lund, Dorothy S. and Rock, Edward B., Validation Capital (February 1, 2021). NYU Law and Economics Research Paper Forthcoming, Available at SSRN: https://ssrn.com/abstract=3786161

Alon Brav

Duke University - Fuqua School of Business ( email )

100 Fuqua Drive
Durham, NC 27708-0120
United States
919-660-2908 (Phone)
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European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
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1000 Brussels
Belgium

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
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Dorothy S. Lund

University of Southern California Gould School of Law ( email )

699 Exposition Boulevard
Los Angeles, CA 90089
United States

Edward B. Rock (Contact Author)

New York University School of Law ( email )

40 Washington Square South
New York, NY 10012-1099
United States

European Corporate Governance Institute ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

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