Are Institutional Investors with Multiple Blockholdings Effective Monitors?

Jun-Koo Kang is Canon Professor at the Nanyang Technological University Business School; Jane Luo is Senior Lecturer at the University of Adelaide Business School; and Hyun Seung Na is Associate Professor at Korea University Business School. This post is based on their recent article, forthcoming in Journal of Financial Economics.

Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forum here)

Previous studies show that, unlike small dispersed shareholders, large shareholders have strong incentives to monitor management and take actions that increase firm value (Shleifer and Vishny, 1986; Demsetz and Lehn, 1985). Despite extensive research on the monitoring role of large shareholders, the literature has paid little attention to the fact that institutions frequently serve as large shareholders in many firms at the same time and whether their monitoring incentives and effectiveness vary with the number of stocks they hold as large shareholders. This lack of evidence is surprising given that institutional investors in the US on average hold a significant number of block shares in different firms. According to the data from Thomson Reuters Institutional Holdings (13F) for the period 1993 to 2010, an institutional investor on average serves as a blockholder for five different firms at the same time.

In this article, we examine how multiple large holdings by institutional investors influence their governance incentives and abilities. There are two competing arguments for the impact of multiple blockholdings on institutional monitoring. First, limited attention caused by multiple blockholdings makes institutional investors’ monitoring less effective. Institutional investors with multiple blockholdings face time constraints in monitoring their portfolio firms and are thus less likely to perform effective monitoring functions. Therefore, multiple blockholdings reduce institutional investors’ monitoring effectiveness and adversely affect firm value. The other argument, however, predicts that multiple blockholdings provide institutional investors with enhanced capabilities and incentives to monitor corporate managers because governance-relevant information and monitoring experience obtained from multiple blockholdings reduce monitoring costs and information uncertainties associated with monitoring. For example, institutional investors with activism experience (e.g., Schedule 13D filing) of targeting poorly performing firms would be more capable of disciplining inefficient managers in their portfolio firms. Therefore, multiple blockholdings are expected to improve institutional investors’ monitoring effectiveness and firm value.

To examine the effect of multiple blockholdings on institutional monitoring, we use the number of blockholdings by a firm’s large institutions after controlling for institution size and skewness in the blockholding number. Specifically, using the 13F database on institutional holdings, we count the number of firms in which an institutional investor simultaneously owns at least 5% of their shares (raw blockholding number) and regress ln (1 + raw blockholding number) on fund size managed by the institutional investor. We use the residual from this regression as our blockholding measure to examine the monitoring effectiveness of institutional investors with multiple blockholdings. This residual approach ensures that the large number of stocks held by an institutional investor as a blockholder is not simply due to its large fund size, which reflects the financial resources available.

Using a sample of Standard & Poor’s (S&P) 1500 firms, we first find that forced CEO turnover sensitivity to performance is significantly higher when the firm has institutions with larger residual blockholding numbers as its large institutional shareholders. Moreover, firms with such institutions realize higher abnormal returns around a forced CEO turnover announcement. Next, we investigate stock price reactions around initial Schedule 13D filings by institutional investors targeting the sample firms. The abnormal stock returns are higher when the activist institutions have more residual blockholdings. We also find that changes in residual blockholding numbers are positively and significantly associated with changes in Tobin’s q. Overall, these results support the view that multiple blockholdings increase institutional investors’ monitoring effectiveness and firm value.

We then examine channels through which multiple blockholdings facilitate effective institutional monitoring and increase firm value: industry expertise, past activism experience, and accumulated monitoring experience from long-term large equity investments. Industry knowledge and experience from multiple blockholdings in firms operating in the same industry are expected to be an important channel through which institutional investors gain monitoring effectiveness. In various aspects of firms’ businesses, such as asset characteristics and financial policies, commonality exists among firms in the same industry. This commonality enables institutions with multiple blockholdings in firms in the same industry to accumulate industry-specific knowledge and information relevant to monitoring firms. Institutions’ prior activism and governance experience (e.g., Schedule 13D filing) are also expected to be an important channel for effective monitoring because experience in leadership restructuring and corporate policy intervention in activism campaigns helps institutions reduce subsequent monitoring costs. Finally, institutions’ long-term investment horizons can also be an important channel for effective monitoring. A longer investment horizon can improve an institution’s accessibility to better quality information about firms and thus provide significant information advantages over institutions with short investment horizons. Overall, these arguments suggest that multiple blockholdings lead to better monitoring when institutional investors have multiple large ownerships in firms operating in the same industry, have prior activism experience, or serve as blockholders for their portfolio firms over a long period of time.

Consistent with these predictions, we find that the sensitivity of forced CEO turnovers to performance is higher when institutional investors have multiple blockholdings in the same industry, when they have 13D filing experience, or when they serve as long-term blockholders in their other portfolio firms. The analyses for the announcement effects of forced CEO turnovers and initial Schedule 13D filings show similar results. These findings suggest that information spillover and accumulated monitoring experience are important channels through which multiple blockholdings enhance institutional monitoring.

Our results are robust to using institution fixed effects to remove potential bias arising from time-invariant omitted institution characteristics and to using change regressions to control for the bias associated with time-invariant omitted firm characteristics. To further address the endogeneity bias that can exist in our tests, we perform an instrumental variables approach in which we use the composition and reconstitution of the Russell 1000 and 2000 indexes to construct our instrumental variables (Boone and White, 2015; Fich, Harford, and Tran, 2015; Schmidt and Fahlenbrach, 2017; Appel, Gormley, and Keim, 2016). The results do not change.

Our results provide important insights into the monitoring role of institutional investors by developing a broad new measure of concentrated ownership by institutional investors that captures their monitoring incentives and governance-relevant experiences.

The complete article is available here.

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