Activist investor interventions with small, newly public companies can improve their stock performance, a Financial Analysts Journal study finds. In “Shareholder Activism in Small-Cap Newly Public Firms,” Emmanuel R. Pezier and Paolo F. Volpin analyze a private dataset of a UK fund’s engagements with small-cap newly public firms and demonstrate that “behind-the-scenes” engagements resulted in 8% to 10% in cumulative abnormal returns. They attribute these returns to engagements, not stock picking.
I spoke with Pezier, an associate scholar at Saïd Business School, University of Oxford, for CFA Institute Research and Policy Center for insights on the authors’ findings and to produce an In Practice summary of the study. Below is a lightly edited and condensed transcript of our conversation.
CFA Institute Research and Policy Center: What is new or novel about this research?
Emmanuel R. Pezier: I suppose there are two novel elements. First, we study small-cap recently IPOed companies. So, the question is, Does the activism “magic” work in small companies, as we already know it does in large-cap firms? And we are bringing entirely new and previously private data into the literature to test that question. Why are small-cap IPOs interesting? Well, they are very important to the functioning of the wider economy, so studying them, their agency and liquidity problems, and how these problems might be resolved by shareholder activism seems worthwhile.
Second, the activist we study is highly unusual in the way it raises its funds. A traditional activist fund, or regular fund, for that matter, raises cash from investors on day one, then uses that cash over time to invest in firms that it chooses, using its stock-picking and activist engagement skills to generate returns. But then the natural question is, How much of their returns has to do with their stock-picking ability and how much of it has to do with their activist interventions? By contrast, the fund we study receives unwanted stock holdings — for example, payments in kind, rather than cash — from investors on day one. And, importantly, it has no say in which stocks it receives. Hence, the returns are unlikely to be due to stock picking, as there is none, and more likely to be due to activism. So, we get a slightly cleaner shot at measuring “how much” the activism magic works.
What motivated you to conduct the study?
We wondered if the kind of activism techniques that are used by high-profile hedge funds in large-cap companies happen in small-cap companies and if they are effective in generating returns. And we answer those questions. The answer is yes, they are, and yes, they are effective.
What are your study’s key findings?
There are good returns to be had by engaging with the management of companies that have recently gone public and that are small. And the returns attributable to interventions in these small-cap companies are large.
We can’t really generalize and say this type of activism happens on a widespread basis. All we can say is that the fund that we study is intervening behind the scenes and achieving good results, which suggests that activism works in small-cap stocks, like we already know it does in large-cap stocks.
Who should be interested in your study’s findings, and why?
I think anyone who has invested in small-cap IPOs could be interested in this paper. Large institutions are being asked to buy more and more of these, oftentimes “premature,” small-cap IPOs because of changes in stock market regulations aimed at encouraging capital formation in young, high-growth entrepreneurial companies. This isn’t going away if you’re an institutional investor — if anything, you are likely to be facing more and more of these IPOs in the years to come.
In what ways can the industry use the research findings?
The research delivers insights into how to engage with small firms that have high levels of insider ownership — meaning the scope for agency conflicts is high. These insights should be of value to institutional investors that routinely invest in small-cap IPOs but might lack experience in shareholder activism.
What follow-on research does your study encourage or suggest?
Future researchers may wish to examine activist engagements that exploit potential “fault lines,” such as gender, ethnicity, or nationality, which may exist within the board or senior management. In our study, we find that fault lines may exist between the chair and CEO when one of the two is the founder of the firm and there is a large age gap between the two individuals. We believe these fault lines help explain why certain engagements become confrontational and why confrontational engagements unlock the largest returns.
For more on this subject, check out the full article, “Shareholder Activism in Small-Cap Newly Public Firms,” from the Financial Analysts Journal.
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