Portfolio Size and the Incentives for Shareholder Activism

May 2016 (with Jing Zeng).

We take a portfolio approach to analyze the investment strategy of an activist investor and show that portfolio size affects both the incentive for the managers of the firms in the activist's portfolio to exert effort and the incentive for the activist to intervene in the firms' operations. We show that a highly capable activist optimally chooses to invest in more firms, even if her capacity to intervene is constrained. This model builds on the notion that both the act of intervention and the threat of an intervention can generate value for firms. We demonstrate that given a portfolio size, the activist's attempt to manipulate the market price of the firms in her portfolio leads her to intervene excessively (insufficiently) when her ability to conduct a value-enhancing intervention is low (high). We show that an activist with higher ability can mitigate her lack of incentives to intervene by optimally increasing the number of firms in her portfolio. This is because a larger portfolio dilutes the threat of activism imposed on each manager, compelling the activist to intervene more in equilibrium. Finally, we demonstrate that, when facing an activist with low ability, short-term stock-based incentive compensation has a perverse effect of disincentivizing managerial effort.

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