1. The Implications of Hedge Fund Activism on the Target firm’s Existing Bondholders
April Klein* and Emanuel Zur**
*Stern School of Business, NYU
**Baruch College, CUNY
EFMA Symposium:
Corporate Governance and Control
April 10, 2009

2. An Example: Tennenbaum Capital Partners vs. Jo-Ann Stores
Michael Tennenbaum: Senior partner
Sells fabrics, crafts, sewing notions

3. Timeline
In April 2006, Tannenbaum Capital Partners filed a SEC13D that it owned over 5% of Jo-Ann Store’s common stock
On January 9, Jo-Ann Stores entered into a standstill agreement with Tannenbaum Capital Partners
Jo-Ann Stores agreed to:
Opt out of Ohio’s control share acquisition law
Declassify the board of directors beginning 2009

4. & Standstill Agreement Rating Decrease To CCC+
Jo-Ann Stores Inc.
Rating Decrease To B-
& Standstill Agreement
13D Filing
Rating Decrease To CCC+

5. What else happened to the firm the following year?
Operating performance dropped:
ΔEBITDA/Assets =
ΔCFO/Assets =
Debt-to-assets ratio increased:
ΔDebt/Assets = 0.228

6. Our Paper: Is this Typical?
Examines bond price reaction and bond ratings for hedge fund targets for one year following the initial 13D filing
Offers some reasons behind the changes that we see in (1).

7. Brief Summary of Some of the Paper’s Results
Bondholders earn a mean excess bond return of % around the initial 13D filing
Over the remaining year, bondholders earn an additional -7.8% excess bond return
Over ½ of the target firms’ bonds are downgraded by a U.S. credit agency within one year of the initial 13D filing

8. Why Does This Happen? Subsequent Decrease in Firm Profitability
Subsequent Decrease in Cash on Hand and Firm Assets (Collateral Effect)
Increase in Debt Ratio
Increase in Equity Risk

9. Firm is merged or acquired within two years
Type of activism: confrontational vs. non-confrontational
Activist gains at least one seat on the board

10. Background: Previous Studies on Hedge Fund Activism Examine Shareholder Effects
Klein and Zur (2009); Brav, Jiang, Partnoy, and Thomas (2008); Greenwood and Schor (2009)
7-10% abnormal returns to target firm’s shareholders around the Schedule 13D filing date
Changes made in target firm’s corporate governance
Klein and Zur – activist often goes on the board of directors
Brav et al. – turnover of CEO relatively high
Greenwood and Schor – more likely to be a takeover target within 18 months of initial investment

11. Sample Selection and Data Description
What is a hedge fund?
An investment vehicle without most of the regulations and restrictions
Investment Company Act of 1940
Securities Exchange Act of 1934
Securities Act of 1933
An investment vehicle for wealthy individuals and institutions
Accredited Investors or
Qualified Investors

12. Sample
Begin with all hedge fund activism (Schedule 13D filings) between 1994 and 2006.
635 events
Reduce to the subset of firms that had outstanding rated debt when the Schedule 13D was filed
253 firms
Reduce to the subset of firms that had debt continually rated for at least one year after the initial filing
128 firms

13. Summary Statistics on Data: Table 1

14. Initial Bond Ratings

15. Question 1: What is the Bond Market Response to the Hedge Fund Intervention?
Excess Bond Returns
Hedge fund firm’s bond return – Matched firm’s bond return (industry, initial bond rating, market-to-book ratio)
TRACE database – daily bond prices
Window – [-10, +10] days
85% of the firms have data for this exact window
See paper for further details

16. Excess Bond Returns Around SEC 13D Filing Date

17. Question 2: What Happens to the Bond’s Ratings Over the Year Following the Initial 13D Filing?

18. Question 2: What Happens to the Bond’s Ratings Over the Year Following the Initial 13D Filing?
Between 1996 and 2006, S&P downgrades for all bonds varied from 7.32% (2006) to 18.77% (2002)

19. Are the Two Related?

20. Question 3: Are there longer term effects
Klein and Zur (2009): find continuation of positive abnormal shareholder returns through one year after the initial 13D filing
Similar finding for bondholders? Or do the negative excess returns around the 13D filing reverse?

21. Excess Bond Returns for [+10, +365] Window

22. By Subsequent Change in Bond Rating

23. Question 4: What factors are responsible for the negative excess returns and downgrades?
Examine changes in accounting and market ratios
Between activism sample and control sample
Relate them to excess bond returns
Also examine other factors related to hedge fund activism
M&A activity
Confrontational vs. Non-confrontational activism
Activist gains at least one board seat

24. Factors Come From Previous Papers on Determinants of Credit Risk
Total Assets, Leverage Ratios, Subordinated Debt, Unsystematic Equity Risk, Cash, Interest Coverage Ratio and Operating Margin
Kaplan and Urwitz; Standard and Poors’ Rating Direct; Blume, Lim and MacKinlay
M&A and change in asset risk of the firm
Billet, King & Mauer
Spin-offs and loss of collateral (change in assets)
Maxwell and Rao

25. What Happened Afterwards? (One Year Changes)
Profitability declines in the year after the 13D filing compared to the control sample

26. Long-term debt-to-assets and Total debt-to-assets increased compared to the control sample

27. Cash on Hand Ratios
Cash on Hand Decreases compared to Control Sample

28. Ability to Pay Off Debt declines compared to control firms

29. Assets decline, Risk rises and more Dividends are Paid out
Other Ratios
Assets decline, Risk rises and more Dividends are Paid out

30. How are these changes related to the two different windows we look at?
[-10, +10] Excess Bond Returns are more negative if:
EBDITDA declined
Total Assets declined
Activist Style
Total cash increased
Dividends paid increased
[+10, +365] Excess Bond Returns are more negative if:
EBDITA declined
Total Assets declined
Activist Style
Total Debt Increased
Unsystematic risk increased
M&A activity
Gained seat(s) on target’s board

31. Question 5: Are there expropriation effects from bondholder to shareholder
Brav et al. (2008)
We examine both excess bond and stock returns around 13D and [+10, +365] windows
Really want to look at $ excess returns for stockholders and bondholders
If negative excess returns (bondholders) equals positive excess returns (stockholders), then there is a “perfect” transfer of wealth between stakeholders
If negative excess returns (bondholders) is less than positive excess returns (stockholders), then there is a “partial” transfer of wealth between stakeholders

32. All hedge fund targets
Almost perfect transfer of risk in $ terms

33. All hedge fund targets
Partial transfer of wealth

34. But, looks can be deceiving
Bond and Stock Abnormal Returns Follow Subsequent Changes in Bond Ratings Around for 13D Filing

35. But, looks can be deceiving
Same for later window

36. Initial Conclusions of Study
Hedge fund activism, on average, hurts existing bondholders
Negative excess returns around and up to one year following the initial 13D filing
Over 50% of the targets’ bond credit ratings fall within a year

37. Reasons for decline are related to increases in credit risk
Profitability declines
Collateral Effects (assets and cash decline; dividends increase)
Riskiness increases (debt increases; unsystematic equity risk increases)

38. Activist’s Style and Subsequent Changes in Firm Matter
Confrontational Activism
Activist Gains Board Representation
M&A not good for bondholder
Is there an expropriation effect?
Yes and No