Print
E-MailJoseph Mc Cahery is Professor in the Department of Business Law at Tilburg University. This post is based on an article authored by Prof. McCahery; Zacharias Sautner of Frankfurt School of Finance & Management; and Laura T. Starks of McCombs School of Business, University of Texas at Austin.
We currently have little direct knowledge regarding how institutional investors engage with portfolio companies. The reason is that many interactions occur behind the scenes. That is, unless institutional investors publicly express their approval or disapproval of a firm’s activities or management, little is known about their preferences and private engagements with portfolio firms. In our paper, Behind the Scenes: The Corporate Governance Preferences of Institutional Investors, forthcoming in the Journal of Finance, we try to rectify this knowledge gap by conducting a survey among 143 institutional investors.
Institutional investors have two active choices when they become unhappy with a portfolio firm: (i) they can engage with management to try to institute change (“voice” or direct intervention); or (ii) they can leave the firm by selling shares (“exit” or “voting with their feet”). Theoretical models have documented the governance benefits of corrective actions through voice. These theories have recently been complemented by models showing that the threat of exit can also discipline management (e.g., Admati and Pfleiderer (2009), Edmans (2009), and Edmans and Manso (2011)). This raises the question of whether institutional investors, in response to dissatisfaction with portfolio firms, take actions that support the validity of these theories.
The respondents to our survey, mostly very large institutional investors with a long-term focus, indicate that voice, especially when conducted behind the scenes, is highly important. For example, 63% of the respondents state that, in the past five years, they have engaged in direct discussions with management, and 45% have had private discussions with a company’s board outside of management’s presence.
In addition, we find evidence that the investor’s horizon makes a difference. First, long-term investors intervene more intensively than short-term investors. Second, investors who choose engagement do so more often because of concerns over a firm’s corporate governance or strategy than over short-term issues. Nevertheless, the institutional investors also indicate that they face impediments to their activism, with the most important hurdles being free rider problems and legal concerns over “acting in concert” rules. Our results also show that investors who are more concerned about liquidity (and hence probably hold more liquid stocks) use voice less intensively.
A central challenge arises in analyzing whether institutional investors use the threat of exit and whether it is effective in bringing about changes in management behavior. The challenge is that the threat of exit is, by definition, unobservable. In fact, if the threat is credible, exit itself does not take place. Our survey sheds light on the exit mechanism because we can ask institutions (i) whether they use exit as a governance device; and (ii) whether they believe that the exit threat is an effective disciplinary device.
The investors in our survey view exit as a viable strategy with 49% (39%) stating that they had exited because of dissatisfaction with performance (governance) in the past five years. Based on their experience with portfolio firms, 42% of the investors believe that the exit threat is effective in disciplining management. As our respondents tend to be dedicated, long-term investors who engage privately, it is plausible that their potential exit truly is a threat. The investors further believe that exit is a complement to a voice strategy rather than a substitute, and intervention typically occurs prior to a potential exit. The survey results further suggest that the effectiveness of the exit threat depends on investors’ equity stake size, whether other investors also exit for the same reason, managerial equity ownership, and whether other large shareholders are also present.
Finally, we consider an increasingly controversial role in corporate governance: the role of proxy advisors. 60% of our respondents use proxy advisors, and about half of these respondents actually use the services of more than one advisor. Although the respondents raise some concerns over conflicts of interest in proxy advisory firms, arising from the offering of consulting services, they find their advice to be of value. The investors report that proxy advisors help them make better voting decisions, but that they remain their own decision makers. Further, investors that use proxy advisors engage their portfolio companies more intensively through voice, rather than substituting the proxy advice for their own voice. Contrary to some regulatory and media beliefs, this suggests that the use of proxy advisors does not necessarily imply that investors take a passive governance role.
The full paper is available for download here.
