Hedge Fund Activism and Internal Capital Markets∗

This paper studies the effects of hedge fund activism on the activity and efficiency of target companies’ internal capital markets. I find that firms targeted by activist hedge funds significantly increase investment cross-subsidies between divisions, predominantly by enhancing the efficiency of their internal resource allocations. Following Schedule 13D filings by activist hedge funds, segment investments of targeted companies become more sensitive to cash flow generated elsewhere in the firm, and this increase in cross-subsidization is primarily driven by the redirection of firm cash flows toward segments with high Tobin’s Q. The increases in the activity and efficiency of internal capital markets due to hedge fund activism are unlikely to be driven by measurement errors in Tobin’s Q or changes in unobserved correlations across segments. ∗I am grateful to René Stulz (Chair), Kewei Hou, and Berk Sensoy for their invaluable advice and guidance. I would also like to thank Alon Brav for providing data on Schedule 13D filings. †Finance PhD Candidate. 810 Fisher Hall, 2100 Neil Avenue, Columbus OH 43210. E-mail: [email protected] ‡Preliminary. Please do not circulate or quote without permission from the author.