Capital Markets

Moody’s: Activists Hurt Bondholders

A new study says activist shareholders (read: hedge funds) typically hurt the credit quality of their target companies.
Tim ReasonJune 12, 2007

Activist hedge fund managers aren’t just shaking up management. They’re also rattling the bond market.

According to a new study by Moody’s Investors Service, bonds often experience an erosion of credit quality when management cedes ground to short-term shareholder activists.

“Demands by short-term activist investors are generally negative for credit quality, especially when they result in the break-up of the company or the sale of significant assets with the proceeds passing to shareholders,” said Moody’s Mark Watson, a co-author of the report along with Francis Byrd and Drew Hambly, in a press release. “Just as bad for creditworthiness are significant increases in dividends or share purchase programs, a more aggressive growth strategy, or a more leveraged financial strategy.”

The report does not specifically identify hedge funds as the short-term activists. However, the union and pension fund investment pools that have been pushing for change at scores of companies hold themselves up as long-term investors. They generally align themselves with hedge funds that are seeking better shareholder value, but part from them when it comes to calling for draconian cuts in staff.

According to the report, prepared by Moody’s Corporate Governance Specialist Group, activist investors differ from long-term investors in several ways. They have a short-term investment horizon — typically 18-24 months — after which they divest their holdings or a large portion of them. They use governance as a platform for agitating for strategic or financial changes. And, says Moody’s, they commonly use high-pressure tactics, such as media coverage and the threat of proxy fights. They are also willing and able to place director representatives on the boards of the companies they target.

According to Moody’s, short-term shareholder activists typically focus on companies that exhibit certain characteristics, such as strong balance sheets, entrenched or complacent management teams, or companies with relatively low leverage.

The most common demands by short-term shareholder activists are to push for strategic changes — including acquisitions, asset sales, sale of the company, share buy-backs, increased dividends; operational changes; or governance changes such as board representation, or senior management changes.

“These are potentially significant demands, and any one of them has the potential to change the company’s credit profile over the short to medium term,” says Watson in the report. “The activists also distract management from running the business to deal with their demands, eating up corporate resources and wealth.”

Not all activist actions, however, hurt a company’s credit quality. The report also found a minority of cases in which some actions were credit neutral to the company’s long-term position. “This is especially the case when, following activist intervention, a company embarks on a more focused strategy, moves away from expansion into non-core business areas and makes significant improvements to practices, including more disciplined capital allocation,” says Watson.

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