Activist funds, leverage, and procyclicality

We develop a dual-layered agency model to study blockholder monitoring by activist funds that compete for investor flow. Competition for flow affects the manner in which activist hedge funds govern as blockholders. In particular, funds inflate short-term performance by increasing payouts financed by (net) leverage, which discourages value-creating interventions in economic downturns due to debt overhang. Our theory links together the observed procyclicality of activist block formation with the documented effect of such funds on the leverage of their target companies. The model also generates new testable implications and reconciles seemingly contradictory empirical evidence regarding hedge fund activism.