Activist Funds, Leverage, and Procyclicality

We provide a theoretical framework to study blockholder activism by funds who com- pete for investor ?ow. In our model, activists are intrinsically able to raise the value of target ?rms through monitoring. Competition for investor ?ow induces them to enhance the returns generated by monitoring by raising external funding at the level of the target ?rm. We adopt a microfounded approach to account for the lack of macro-state con- tingency in such ?nancing contracts and show that debt is optimal for raising external funding. When good funds are su¢ ciently better than bad funds, competition for ?ow can generate excessive leverage which fosters debt overhang in low macroeconomic states and shuts down activist e¤ort. As a result, investing in activist hedge funds is more desirable when macroeconomic prospects are good. Our model thus links the observed procycli- cality of activism with documented increases in the leverage or payouts ratios of target ?rms. In addition, the model generates several new testable implications and reconciles seemingly contradictory evidence on the wealth e¤ects of activism for shareholders and bondholders.