Hedge Funds at the Exits

For much of the past several decades, a debate has churned in the investment world over the effects of liquidity on corporate governance. One camp claims it weakens corporate governance by making it far too easy for investors to simply dump their shares instead of intervening when a company underperforms. The other maintains that the potential for quick share-dumping actually functions as a form of governance--when a firm's stock tanks, its managers are forced to take measures to shore up the company's fundamentals. The argument is particularly fierce when it comes to hedge funds, which are often accused of favoring short-term profits over long-term company health.

Assistant Professor Vivian Fang has waded into the middle of that debate by examining a large body of data. Her key finding: Greater liquidity increases the odds that a hedge fund will buy a block (i.e., at least a 5 percent share) and file a 13G Schedule with the Securities and Exchange Commission. "A 13G filing indicates passive intent," says Fang. "It says the hedge fund is not going to try to exert control or engage in proxy fights."

As such, a 13G filing appears to hint that the hedge fund is keeping one foot out the door--and that the stock will inevitably suffer when it bolts. However, she concluded from her analysis that 13G filings consistently led to positive market reactions and improvements in company performance. Why? The mere threat of a major blockholder exit offers a powerful incentive for the firm's managers to maximize performance.

"Our data show that the 13G has an unconditionally positive effect," Fang notes. "In other words, a 13G filing acts as a governance mechanism per se."

"The Effect of Liquidity on Governance"
Edmans A., Fang, V., et al, Review of Financial Studies, (in press)