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E-MailOğuzhan Karakaş is Assistant Professor of Finance at Boston College. This post is based on an article authored by Professor Karakaş; Elroy Dimson, Professor of Finance at London Business School; and Xi Li, Assistant Professor of Accounting at Temple University. Related research from the Program on Corporate Governance includes Socially Responsible Firms by Allen Ferrell, Hao Liang, and Luc Renneboog (discussed on the Forum here).
In our paper, Active Ownership, forthcoming in the Review of Financial Studies, we analyze highly intensive engagements on environmental, social, and governance (ESG) issues by a large institutional investor with a major commitment to responsible investment (hereafter “ESG activism” or “active ownership”). Given the relative lack of research on environmentally and socially themed engagements, we emphasize the environmental and social (ES) engagements throughout the paper and use the corporate governance (CG) engagements as a basis for comparison.
Our primary sample consists of 2,152 engagement sequences (1,252 ES-, and 900 CG-based sequences) for 613 U.S. public firms between 1999 and 2009. The success rate for engagements in our sample is 18%, and, on average, it takes a sequence of 2–3 engagements before success can be recorded. The elapsed time from initial engagement to success averages nearly one-and-a-half years; the median time is one year. In comparison to CG themes, the chance of achieving success for ES themes is lower (13% vs. 24%), and the number of engagements per sequence is higher (3.7 vs. 2.2).
Compared to a matched sample of companies, firms are more likely to be engaged if they are large, mature, and performing poorly. The likelihood of being engaged is further increased if the asset manager and other socially conscious institutional investors (such as pension activists and SRI funds) have high shareholdings in the firm. Engagement is also more likely if reputation is important for the target company and if the company has inferior governance. The asset manager’s ownership plays a less important role in relation to ES engagements than to CG engagements. On the other hand, reputational concerns are a more important determinant of engagement with firms on ES themes. These last two results indicate the importance of potential collaborations with other stakeholders and of customer opinion and loyalty, notably in consumer-facing industries, for the active ownership.
Conditional on being engaged, which firms are more likely to implement the asset manager’s proposed changes? We refer to cases in which changes are implemented as successful engagements. Success is more likely if the target firm has reputational concerns, a capacity to implement change, economies of scale, and headroom for improvement. For the ES engagements, we find reputational concerns and a capacity to change play a more important role in achieving success. This may be attributed to the costly nature of improvements in areas related to ES dimensions.
Analyzing the engagement features and tactics, we find that successful prior engagement experience with the same target firm increases the likelihood of subsequent engagements being successful. In addition, we find collaborations among the asset manager and other active investors and/or stakeholders to contribute positively to the success of engagements, particularly for the ES engagements. This suggests that it requires more coordinated effort to convince an engaged company’s management regarding the ES issues, in comparison to CG issues.
How does the market react to ESG activism? We find that ESG engagements generate a cumulative size-adjusted abnormal return of +2.3% over the year following the initial engagement. Cumulative abnormal returns are much higher for successful engagements (+7.1%) and gradually flatten out after a year, when the objective is accomplished for the median firm in our sample. We do not find any market reaction to unsuccessful engagements. The abnormal return patterns and magnitudes are similar for the subsamples of CG and ES engagements. This suggests the existence of a threshold for success to be pursued and achieved for both types of engagements. We then examine the cross-section of abnormal returns and find that the positive market reaction to successful engagements is most pronounced for the themes of corporate governance and climate change. For these themes, the cumulative abnormal return of an additional successful engagement over a year after the initial engagement averages +8.6% and +10.3%, respectively.
To investigate the sources of the positive market reaction to successful engagements, we take a difference-in-differences approach and examine the subsequent changes in target firms’ operating performance, profitability, efficiency, institutional ownership, stock volatility, and governance after successful engagements relative to after unsuccessful engagements. We observe significant improvements in all these measures (i.e., an increase in firm performance, investor base, and governance, and a decrease in stock return volatility) following successful engagements, as compared to the unsuccessful ones. Particularly focusing on the ES and CG subsamples, we first find that the return on assets and the ratio of sales to the number of employees improves significantly one year after successful ES engagements, as compared to the unsuccessful ones; but such improvements are less pronounced for successful CG engagements. These findings support the view that successful ES initiatives enhance customer and employee loyalty. Second, we observe an increase in shareholdings by the asset manager, pension activists, and SRI funds one year after successful ES engagements; but such an increase is not apparent for successful CG engagements. These results support the view that ES initiatives generate a clientele effect among shareholders. Third, we find improvements in the corporate governance structure of targeted firms, as measured by the Bebchuk, Cohen, and Ferrell (2009) entrenchment index, two years after successful engagements on all ESG issues. This suggests that good ESG practices signal improving governance quality.
We conclude that environmental, social, and governance activism of the type that we study improves social welfare to the extent that it increases stakeholder value when engagements are successful and does not destroy firm value even when engagements are unsuccessful. We note that, after successful engagements (particularly on ES issues), firms with inferior governance subsequently improve their governance and performance. Our interpretation is that active ownership attenuates managerial myopia and hence helps to minimize intertemporal losses of profits and negative externalities (see Benabou and Tirole 2010). This approach is differentiated from other styles of shareholder action, particularly hedge fund activism. Responsible investment initiatives are less confrontational, more collaborative, and more sensitive to public perceptions; yet they achieve success.
The full paper is available for download here.
