The Implications of Hedge Fund Activism on the Target firm’s Existing Bondholders

1. The Implications of Hedge Fund Activism on the Target firm’s Existing Bondholders April Klein* and Emanuel Zur** *Stern School of Business, NYU **Baruch College, CUNY EFMA Symposium: Corporate Governance and Control April 10, 2009

2. An Example:Tennenbaum Capital Partners vs. Jo-Ann Stores Michael Tennenbaum: Senior partner Sells fabrics, crafts, sewing notions

3. Timeline • In April 2006, Tannenbaum Capital Partners filed a SEC13D that it owned over 5% of Jo-Ann Store’s common stock • On January 9, 2007 Jo-Ann Stores entered into a standstill agreement with Tannenbaum Capital Partners • Jo-Ann Stores agreed to: • Opt out of Ohio’s control share acquisition law • Declassify the board of directors beginning 2009

4. Jo-Ann Stores Inc. Rating Decrease To B- & Standstill Agreement 13D Filing Rating Decrease To CCC+

5. What else happened to the firm the following year? • Operating performance dropped: ΔEBITDA/Assets = -0.063 ΔCFO/Assets = -0.092 • Debt-to-assets ratio increased: ΔDebt/Assets = 0.228

6. Our Paper: Is this Typical? • Examines bond price reaction and bond ratings for hedge fund targets for one year following the initial 13D filing • Offers some reasons behind the changes that we see in (1).

7. Brief Summary of Some of the Paper’s Results • Bondholders earn a mean excess bond return of -6.6% around the initial 13D filing • Over the remaining year, bondholders earn an additional -7.8% excess bond return • Over ½ of the target firms’ bonds are downgraded by a U.S. credit agency within one year of the initial 13D filing

8. Why Does This Happen? • Subsequent Decrease in Firm Profitability • Subsequent Decrease in Cash on Hand and Firm Assets (Collateral Effect) • Increase in Debt Ratio • Increase in Equity Risk

9. Firm is merged or acquired within two years • Type of activism: confrontational vs. non-confrontational • Activist gains at least one seat on the board

10. Background: Previous Studies on Hedge Fund Activism Examine Shareholder Effects • Klein and Zur (2009); Brav, Jiang, Partnoy, and Thomas (2008); Greenwood and Schor (2009) • 7-10% abnormal returns to target firm’s shareholders around the Schedule 13D filing date • Changes made in target firm’s corporate governance • Klein and Zur – activist often goes on the board of directors • Brav et al. – turnover of CEO relatively high • Greenwood and Schor – more likely to be a takeover target within 18 months of initial investment

11. Sample Selection and Data Description • What is a hedge fund? • An investment vehicle without most of the regulations and restrictions • Investment Company Act of 1940 • Securities Exchange Act of 1934 • Securities Act of 1933 • An investment vehicle for wealthy individuals and institutions • Accredited Investors or • Qualified Investors

12. Sample • Begin with all hedge fund activism (Schedule 13D filings) between 1994 and 2006. • 635 events • Reduce to the subset of firms that had outstanding rated debt when the Schedule 13D was filed • 253 firms • Reduce to the subset of firms that had debt continually rated for at least one year after the initial filing • 128 firms

13. Summary Statistics on Data: Table 1

14. Initial Bond Ratings

15. Question 1: What is the Bond Market Response to the Hedge Fund Intervention? • Excess Bond Returns • Hedge fund firm’s bond return – Matched firm’s bond return (industry, initial bond rating, market-to-book ratio) • TRACE database – daily bond prices • Window – [-10, +10] days • 85% of the firms have data for this exact window • See paper for further details

16. Excess Bond Returns Around SEC 13D Filing Date

17. Question 2: What Happens to the Bond’s Ratings Over the Year Following the Initial 13D Filing?

18. Question 2: What Happens to the Bond’s Ratings Over the Year Following the Initial 13D Filing? Between 1996 and 2006, S&P downgrades for all bonds varied from 7.32% (2006) to 18.77% (2002)

19. Are the Two Related?

20. Question 3: Are there longer term effects • Klein and Zur (2009): find continuation of positive abnormal shareholder returns through one year after the initial 13D filing • Similar finding for bondholders? Or do the negative excess returns around the 13D filing reverse?

21. Excess Bond Returns for [+10, +365] Window

22. By Subsequent Change in Bond Rating

23. Question 4: What factors are responsible for the negative excess returns and downgrades? • Examine changes in accounting and market ratios • Between activism sample and control sample • Relate them to excess bond returns • Also examine other factors related to hedge fund activism • M&A activity • Confrontational vs. Non-confrontational activism • Activist gains at least one board seat

24. Factors Come From Previous Papers on Determinants of Credit Risk • Total Assets, Leverage Ratios, Subordinated Debt, Unsystematic Equity Risk, Cash, Interest Coverage Ratio and Operating Margin • Kaplan and Urwitz; Standard and Poors’ Rating Direct; Blume, Lim and MacKinlay • M&A and change in asset risk of the firm • Billet, King & Mauer • Spin-offs and loss of collateral (change in assets) • Maxwell and Rao

25. What Happened Afterwards?(One Year Changes) Profitability declines in the year after the 13D filing compared to the control sample

26. Long-term debt-to-assets and Total debt-to-assets increased compared to the control sample

27. Cash on Hand Ratios Cash on Hand Decreases compared to Control Sample

28. Ability to Pay Off Debt Ability to Pay Off Debt declines compared to control firms

29. Other Ratios Assets decline, Risk rises and more Dividends are Paid out

30. [-10, +10] Excess Bond Returns are more negative if: EBDITDA declined Total Assets declined Activist Style Total cash increased Dividends paid increased [+10, +365] Excess Bond Returns are more negative if: EBDITA declined Total Assets declined Activist Style Total Debt Increased Unsystematic risk increased M&A activity Gained seat(s) on target’s board How are these changes related to the two different windows we look at?

31. Question 5: Are there expropriation effects from bondholder to shareholder • Brav et al. (2008) • We examine both excess bond and stock returns around 13D and [+10, +365] windows • Really want to look at $ excess returns for stockholders and bondholders • If negative excess returns (bondholders) equals positive excess returns (stockholders), then there is a “perfect” transfer of wealth between stakeholders • If negative excess returns (bondholders) is less than positive excess returns (stockholders), then there is a “partial” transfer of wealth between stakeholders

32. All hedge fund targets Almost perfect transfer of risk in $ terms

33. All hedge fund targets Partial transfer of wealth

34. But, looks can be deceiving Bond and Stock Abnormal Returns Follow Subsequent Changes in Bond Ratings Around for 13D Filing

35. But, looks can be deceiving Same for later window

36. Initial Conclusions of Study • Hedge fund activism, on average, hurts existing bondholders • Negative excess returns around and up to one year following the initial 13D filing • Over 50% of the targets’ bond credit ratings fall within a year

37. Reasons for decline are related to increases in credit risk • Profitability declines • Collateral Effects (assets and cash decline; dividends increase) • Riskiness increases (debt increases; unsystematic equity risk increases)

38. Activist’s Style and Subsequent Changes in Firm Matter • Confrontational Activism • Activist Gains Board Representation • M&A not good for bondholder • Is there an expropriation effect? • Yes and No