Does Stock Liquidity Affect Incentives to Monitor?

In our paper, Does Stock Liquidity Affect Incentives to Monitor? Evidence from Corporate Takeovers, forthcoming in the Review of Financial Studies, we examine the role of liquidity as a monitoring incentive and its effect on firm value by analyzing the market reaction to takeover announcements. The empirical evidence is consistent with the view that there is a tradeoff between monitoring via institutional intervention and liquidity for takeovers of private targets, but not for takeovers of public targets. This finding may be explained by the increased role of the disciplining effect of the threat of exit in connection to actions that on average destroy shareholder value, such as takeovers of public targets (Admati and Pfleiderer 2009).

Controlling for a large set of control variables and industry and year fixed effects, we find that less liquid acquirers acquire private targets that trigger higher announcement returns and are less likely to experience negative announcement returns. We further find that, when the disciplining effect of threat of exit as a monitoring mechanism is expected to be more effective due to the presence of several blockholders, the effect of liquidity on announcement returns is mitigated. This latter result, coupled with our evidence on higher liquidity being associated with a higher likelihood of choosing a private target over a public target and with previous evidence on the positive influence of liquidity on the effectiveness of monitoring via threat of exit (e.g., Bharath, Jayaraman, and Nager 2012), suggests that liquidity may have a two-sided effect on monitoring. It deters institutional intervention, but increases the power of the exit threat in disciplining managers. Overall our results are mostly consistent with the theoretical predictions of Coffee (1991), Bhide (1993), Edmans (2009), Admati and Pfleiderer (2009), and Edmans and Manso (2011).

Supporting our interpretation, we find that in the subsample of acquisitions of private targets, acquirers with lower stock liquidity are more likely to withdraw takeover bids that trigger more negative announcement returns and experience more frequent involuntary CEO turnover following value-destroying acquisitions. We also find that the effect of liquidity on announcement returns is marginally stronger when agency costs, as measured by low CEO incentives or low product market competition, are potentially higher. These results are broadly consistent with an active role for institutional investors in monitoring management when stock illiquidity impedes easy exit. We report results of several additional tests that reduce concerns regarding biases that might arise from omitted variables. We further show that our results cannot be explained by market anticipation of a change in liquidity after a takeover, and are robust to alternative definitions of stock liquidity.

The full paper is available for download here.