Governance and Comovement Under Common Ownership

The following post comes to us from Alex Edmans, Professor of Finance at London Business School; Doron Levit of the Finance Department at the University of Pennsylvania; and Devin Reilly of the Department of Economics at the University of Pennsylvania.

Most existing theories of blockholder governance consider a single firm. However, in reality, many institutional investors hold blocks in multiple firms. In our paper, Governance and Comovement Under Common Ownership, which was recently made publicly available on SSRN, we study the implications of common ownership for corporate governance and asset pricing. In particular, we address two broad questions. First, does holding multiple blocks weaken governance by spreading a blockholder too thinly, as commonly believed? If not, under what conditions can multi-firm ownership improve governance? Second, can common ownership lead to correlation between stocks with independent fundamentals, and if so, in which direction?

In our model, the blockholder governs through “exit”, disciplining the manager by selling shares if he shirks. Such sales reduce the value of the manager’s equity compensation ex post, thus inducing him to maximize firm value ex ante. We model governance through exit rather than “voice” (intervention) for three reasons. First, McCahery, Sautner, and Starks (2011) report that exit is the main governance mechanism used by institutions. Second, if holding multiple blocks means that the investor holds smaller stakes in each firm, she may lack sufficient control rights to intervene. Third, exit has asset pricing implications, since it involves the blockholder trading the firm’s stock.

As a benchmark against which to assess the effects of common ownership, we start with a model in which the blockholder owns shares in a single firm. The manager can take an action (such as shirking, cash flow diversion, or empire building) that yields a fixed private benefit, but reduces firm value by a random amount privately known to him. The blockholder privately observes the manager’s action, and based on this information, may either sell shares or retain them until firm value is realized. As in Admati and Pfleiderer (2009), her trade is observed by the market maker, but not fully revealing because she may also suffer a liquidity shock that forces her to sell half of her stake (although she may choose to sell more). In equilibrium, the blockholder sells shares, reducing the stock price, if she needs liquidity or the manager shirks.

The core analysis is a model with two independent firms, where the blockholder owns a stake in each firm. She can satisfy her liquidity need by selling either half of her stake in each firm or her entire stake in one firm. Importantly, the decision to sell is made at the portfolio rather than firm level. As we discuss below, this is a key implication of common ownership.

Whether governance is stronger under common ownership than a single-firm benchmark depends on the blockholder’s trading strategy when one manager shirks and the other works. If she pursues balanced exit (sells both firms), governance is weaker because the manager’s effort incentives are lower—even if he works, he will still be sold if the other manager shirks. If she pursues imbalanced exit (sells only one firm), governance is stronger because the blockholder has a choice of which firm to sell if she suffers a liquidity shock. This has two implications. First, if a manager works, he is not necessarily sold if the blockholder requires liquidity—she may sell the other firm. Second, if a manager is the only one sold, this is a strong signal that he has shirked rather than that the blockholder has suffered a liquidity shock, since she could have sold half of her stake in both firms in the latter case. For both reasons, the link between managerial effort and the blockholder’s exit decision is stronger.

We show that the blockholder is more likely to pursue imbalanced exit, and thus governance under common ownership is stronger, when the agency problem is severe (private benefits from shirking are high or the manager’s stock price concerns are low). Thus, our model relates the efficiency of multi-firm governance to the underlying characteristics of the portfolio companies. Intuitively, if agency problems are weak, then balanced exit is more likely to result from a liquidity shock than both managers shirking. The market maker thus sets high prices upon observing balanced exit, encouraging the blockholder to choose it.

Moreover, we show that common ownership leads to correlation between the stock prices of portfolio companies, even with independent fundamentals. On the one hand, liquidity shocks cause the blockholder to sell both firms, driving both prices down. On the other hand, imbalanced exit depresses the price of the sold firm but increases the price of the retained firm. Overall, the correlation is negative if and only if the probability of imbalanced exit is sufficiently high. Hence, the severity of the agency problem affects the direction of correlation, through determining the probability of imbalanced exit.

Finally, we show that common ownership also leads to strategic interactions between firms—greater effort by one manager affects the effort incentives of another manager, thus giving rise to governance externalities.

Overall, the paper has broader implications for governance and comovement. First, we introduce a new determinant of a blockholder’s effectiveness in exerting corporate governance—the number of blocks that she owns—that gives rise to new empirical predictions. Second, allowing a blockholder to own stakes in multiple firms need not weaken governance by spreading the blockholder too thinly, as commonly argued. Third, common ownership between stocks can lead to negative correlation by introducing a “tournament” aspect in the blockholder’s exit decision, rather than only the positive correlation commonly believed. Fourth, comovement between stocks is driven not only by asset pricing variables such as loadings on macroeconomic factors, but also corporate finance variables such as common ownership and the severity of agency problems. Fifth, the price impact of blockholder depends not only on how many shares she sells of the firm in question, but also her trades in otherwise unrelated firms.

The full paper is available for download here.

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