DELEVERAGING RISK AND HEDGE FUND ACTIVISM

Abstract

In this thesis, we show that the probability that short sellers will be forced to cover their positions (i.e. deleveraging risk), is positively associated with block formation by hedge funds. We provide evidence that part of the target firms’ outperformance associated with hedge funds’ block formation can be driven by wealth transfers and market timing effects, in addition to the governance mechanism argued by prevailing voice and exit theories of hedge fund activism. We coin this alternative mechanism as opportunism. We found that a one standard-deviation increase in deleveraging risk increases the probability of block acquisition by 0.184%, which is economically significant compared with the unconditional probability of a hedge fund block acquisition of 0.4% in any firm-month. We also show that target firms’ deleveraging risk increases before the block acquisition, peaks during acquisition period, and decreases post-acquisition. We further show that target firms that undergo greater deleveraging during hedge funds’ block formation, experience stronger announcement returns. We use Regulation SHO as an experiment to identify causal effects.