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Activist Investors Do A Lot Of Hurry-Up-And-Wait

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A subject dear to my heart for no particularly good reason is the controversy over whether activist hedge funds should have to disclose their positions early and often (so that management can react and everyone else can piggyback on their trade), or should instead be allowed to keep secretly buying stock so they can surprise everybody with a big stake. The current 1960s-era U.S. law is that once you buy 5% of a stock you get 10 days to disclose, and the controversy is mostly between people who think that's just fine and people who think that that should be shortened to, like, one or two days. The SEC is considering, and Canada is more strongly considering, doing just that.

One side of this controversy is often represented by Harvard Law professor Lucian Bebchuk and his buddies, who basically think that activist hedge funds should be able to profit from their secret knowledge that they've been buying some shares because otherwise why would they do all their good activist deeds, while the other side is mostly represented by poison pill inventor Marty Lipton and his law firm, Wachtell Lipton, who basically think that activist hedge funds should be wiped from the face of the earth. Wachtell's view on this is emotional enough that they think the SEC should make new rules without any empirical examination of what their effects would be, and so Bebchuk & buddies have a new paper out that (1) makes fun of them for that1 and (2) does the empirical analysis.

Specifically they look at 2,000 cases of activist hedge funds filing 13Ds between 1994 and 2007 and find that:

  • Yes, hedge funds mostly do wait until 7-10 days after acquiring 5% of a company before filing their 13D,
  • No, they mostly don't buy shares during that whole time - "their purchases seem to be disproportionately concentrated on the day they cross the threshold and the following day,"
  • No, the ones who file later mostly don't disclose bigger positions than the ones who file sooner, and
  • No, none of that has changed over time (at least, over 1994-2007), refuting Wachtell's claim that "[t]he advent of computerized trading has upended traditional timelines for the acquisition of shares, allowing massive volumes of shares to trade in a matter of seconds."2

Here's how long hedge funds usually wait to file a 13D after they've crossed over 5%:

So the median time between when a hedge fund acquires 5% of an issuer's stock and when it files a 13D is call it 8 days, a bit inside of the 10-day legal limit.3 Here, meanwhile, are trading volumes around the time of crossing the 5% threshold:

This is not necessarily the hedge fund's own trades, but the spike in volume suggests that the bulk of their buying does occur right around the time the hedge fund gets to 5%: "the evidence suggests that, to the extent that blockholders do purchase stakes beyond 5%, these purchases are likely disproportionately concentrated on the day on which the investor crosses the 5% threshold and, to a lesser extent, the immediately following day."

So the typical case is something like:

  • You buy a whole lot of stock in quick flurry over a couple of days, culminating in you owning around 6% of the company.
  • You stop buying and spend around 8 days polishing the prose in your 13D.
  • You file your 13D and let the world know you're about to bring a message of hope and change to the company.
  • Stock goes up, you get rich, etc.

The authors' conclusion is that this shows there's no need to change the rules and shorten the time for reporting, since hedge funds don't particularly take advantage of them now. I guess? I suppose it also shows that there wouldn't be any particularly negative consequences to shortening the time - other than slightly less polished prose in 13Ds - since most activists don't take advantage of the 10-day window to buy more stock anyway.

Which is a little strange? Why not take advantage of the extra 10 days to go from 5% to, like, 25%? Putting it like that makes the answer obvious: having more than 5% of a stock creates some mild annoyances (you have to tell everyone that you own it), but also has some perks. Putting a big concentrated chunk of money to work in a company where you plan to create change, for one thing, but also being taken seriously as a shareholder and an annoyance. "We own 6% of your stock," you can say to management, "it's right there in our 13D."

But having more than 10% of a stock, as an activist, makes your life nearly impossible; consider, for instance, that Carl Icahn has around $100mm in Herbalife paper profits that he's unable to realize because he's not allowed to sell any shares for six months, just because he's a 10%+ holder.4 Also poison pills. Also, of course, having a big concentrated chunk of money at work in a company is nice but no need to go overboard; you don't want to put all your eggs in one Herbalife.

Basically there's a sweet spot for activism and it's considerably below 10% of the stock5 and the typical pattern seems to be that you get to it and stop.

Still why is the buying so bunched up around the time of crossing the 5% threshold? Well here's another chart from the paper; it's the average abnormal returns of the stocks in the study, measured from 20 days before to 20 days after the activist crosses the 5% threshold:

Note a bit of a steepening of the curve around day 7/8: when the (median) 13D is filed, the stock tends to jump on average ~2% over the next couple of days. But note the much greater steepening of the curve around day -1/0: when the activist is buying, the stock tends to jump on average ~4% over the next seven days, before the 13D is (typically) filed. In other words statistically most of the near-term price increase caused by activist hedge funds seems to occur before they disclose their position.6

The whole point of this controversy is more or less: some people (Bebchuk, me, activists) think that activists should be able to buy stock secretly at the unaffected-by-activists price, so they can capture the full upside of their activism. That incentivizes them to do their thing, which presumably brings benefits to other shareholders who are along for the ride. Other people (Wachtell, CEOs) think that activists should have to share their upside with everyone else, and if that means they can't make any profits off of activism, well, so much for activism. And this debate gets played out over when they should have to publicly disclose their stakes in SEC filings.

But the data suggest that the SEC filings are overrated. By the time you file your 13D, statistically, your secret is about 2/3 out: somebody has figured out something (not that hard to do given the average 400% increase in volume in one day) and bid up the price 2/3 of the way to where it'll be when you disclose. So if you keep buying, you'll be sharing your upside with whoever's front-running you. So ... I guess you might as well disclose to everyone else?

Lucian A. Bebchuk, Alon P. Brav, Robert J. Jackson Jr., and Wei Jiang: Pre-Disclosure Accumulations by Activist Investors: Evidence and Policy [SSRN]
Study: Activist Investors Don’t Take Advantage of 10-Day Filing Window [WSJ]

1.From the paper:

[F]our senior partners of [Wachtell] dismissed our claim that an examination of the evidence beyond the anecdotes described in the Petition [that Wachtell submitted to the SEC asking them to shorten the time period for filing] is necessary. The authors expressed concern that such an examination would be difficult and time-consuming and likely delay the “modernization” of Section 13(d) that they view as desirable. Similarly, in a public debate at the conference board with one of us, Martin Lipton, the senior partner of the firm that authored the Petition, rejected the need for an empirical examination of these questions.

Lawyers amirite?

2.Though this elides an important point in Wachtell's petition, the "many ways in which modern investors may acquire economic exposure to a security, including through the purchase of non-traditional or cash-settled derivatives." Presumably that's gone up over time; did they even have cash-settled swaps in 1994? In any case the authors don't look at derivative ownership.

3.Though about 10% of filings are more than 10 days after crossing 5%, which is ... illegal? The authors are a little flummoxed:

As indicated in Table 2 above, 193 of the disclosures in the sample were filed more than ten days after the investor crossed the 5% threshold. These disclosures represent more than 10% of our sample, indicating that about one in ten activist hedge fund filings under Section 13(d), by their terms, do not comply with existing law. Of course, we do not suggest that these investors deliberately flout their obligations under federal securities law. Some of these filings may result from an inadvertent failure to comply with, or a misinterpretation of, the SEC’s existing Section 13(d) rules. But the fact that more than 10% of the disclosures in our sample are filed more than ten days after the investor crosses the threshold—and more than 7% are filed more than fifteen days after the
threshold is crossed—deserves further examination.

4.Also other sundry annoyances. One day when I'm more bored than you can imagine I will tell you the tale of how Carl Icahn should probably have to disgorge, like, three thousand dollars to some plaintiffs' lawyers because of how he structured his Herbalife purchases. Or, plaintiffs' laywers, just contact me directly, that works too.

5.Ooh in part because a fun way to mess with an activist with a 9.9% stake is to buy back some stock and push him over 10%.

6.That's not particularly rigorous! Since a lot of 13Ds are filed earlier it stands to reason that a lot of that average stock run-up would just be caused by those earlier disclosures. Though not, the, like 1% run-up that occurs before they cross the 5% threshold.