Editor’s Note: This post comes to us from
Itay Goldstein of the Wharton School at the University of Pennsylvania
In Activist Arbitrage: A Study of Open-Ending Attempts of Closed-End Funds, which was co-written with Michael Bradley, Alon Brav, and Wei Jiang, and which was recently accepted for publication in the Journal of Financial Economics, we conduct a comprehensive empirical study of the attempts of activist arbitrageurs to open-end closed-end funds in the U.S. Unlike the traditional pure-trading arbitrage, activist arbitrageurs do not simply wait for convergence, but rather take actions to open-end the target fund, knowing that upon open-ending the price of the fund’s shares will be forced to converge to the NAV.
Our analysis is based on a unique hand-collected dataset consisting of all activist arbitrageurs’ activities in U.S. based CEFs between 1988 and 2003. Activist arbitrage in closed end funds was quite rare until the early 1990s. However since the mid-1990s—shortly after the SEC significantly relaxed constraints on communication among shareholders of public corporations—this type of arbitrage has become very common. Several arbitrageurs—hedge funds, endowment funds, banks, and financial arms of corporations—have become quite active in initiating proxy contests and proposals targeted at open-ending discounted CEFs. In the peak years of 1999 and 2002, about 30% of the funds in our sample were targets of such attacks.
We find that activist arbitrage has substantial impact on CEF discounts. While most of the open-ending attempts in our sample were met with resistance from the funds’ managements, quite a few led to successful open-endings despite such resistance. In addition, activists’ activities were sufficiently credible in many instances to induce fund managers to take actions themselves to reduce the size of the discount. We find that a key variable that guides activist arbitrageurs in choosing which fund to target is the fund’s discount from its NAV. Using an instrumental-variables approach and an econometric technique that allows us to estimate a simultaneous system of an endogenous dummy variable and an endogenous continuous variable, we are able to show that a one percentage point increase in the discount leads to a 1.07 percentage point increase in the probability of an open ending attempt in a given year.
To investigate the role of communication, we conduct tests using cross-sectional measures of the costs of communication in different funds. The three proxies we employ are turnover, which measures the frequency at which the shares of the CEF change hands, the average size of trade in the fund’s shares, and the percentage of institutional ownership in the fund. Overall, we find that costs of communication enhance activist arbitrage. Interestingly, the effects of the above proxies are present only after the legal reform of 1992. Our results suggest that before the 1992 Reform, communication among shareholders was so severely restricted by the SEC that cross-sectional differences in the shareholder base did not matter much for activist arbitrageurs.
Lastly, we find the governance of funds also plays an important role in determining the probability of an open-ending attempt. Funds that have pro-manager governance structures (i.e., have staggered board, supermajority voting, and ability of the board to call a special meeting) are more likely to be targets for activism after the legal reform of 1992, but not before. This is likely because communication among shareholders is particularly important when managers have more power. While managerial entrenchment attracts more attacks after 1992, we find that it lengthens the time needed to implement a successful open-ending.
The full paper is available for download here.
