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E-MailPeter Iliev is Associate Professor of Finance at Pennsylvania State University Smeal College of Business; Jonathan Kalodimos is Assistant Professor of Finance at the Oregon State University College of Business; and Michelle Lowry is TD Bank Endowed Professor at Drexel University LeBow College of Business. This post is based on their recent paper, forthcoming in the Review of Financial Studies. Related research from the Program on Corporate Governance includes What Matters in Corporate Governance? by Lucian Bebchuk, Alma Cohen, and Allen Ferrell.
Investors will have strong incentives to pay attention to the corporate governance structures of their portfolio companies if this attention contributes to better portfolio performance. However, because monitoring firms’ governance is costly, it is possible that investors will find it optimal to limit or even fully delegate such oversight to others. Broadly, the objective of this paper is to examine the extent to which mutual fund investors pay attention to the governance structures of companies in their portfolios, and the ways in which this oversight (or lack thereof) affects the underlying companies.
We focus on three specific questions. First, do investors research the governance structures of companies in their portfolios? This would include, for example, research related to the composition of the board of directors, compensation plans, and generally to the balance of power between management and external shareholders. Second, how does investors’ research affect their monitoring behavior, for example via shareholder voting or divestments? Third, does investors’ attention to corporate governance discipline the management at the underlying companies?
We begin with our first question: do mutual fund investors research the governance structures of companies in their portfolios? In the U.S., public companies are required to disclose a rich set of information related to governance, for example on boards of directors, compensation plans, and ownership structure, to name a few. We develop a quantitative measure that captures an investor’s attention to this information. Specifically, we measure investors’ views of proxy filings in the SEC’s EDGAR system. Across 87 different mutual fund families, we track each instance in which the mutual fund family accessed a proxy statement of one of its portfolio companies. Our measure isolates attention that is specific to governance. We find that governance research is different from other types of research: 15% of the variation in mutual funds’ governance-related research is explained by the contentiousness of the items up for vote. We also find that investors concentrate their governance research among their larger portfolio holdings, and more generally among larger companies. Finally, incremental to these factors, the timing of a company’s annual meeting also significantly affects investors’ research: companies with meetings in the busy spring proxy season receive approximately 22% less attention than do other companies that have their meetings during less busy periods. In aggregate, these factors cause attention to be concentrated within a subset of companies.
Interactions between investors contribute to a further concentration of governance research. Specifically, an investor’s governance research is positively related to expected research by other investors. This relation is consistent with research being primarily motivated by voting, and with the impact of a vote being greater if others vote in a similar manner. In sum, investors’ incentives cause some companies to receive substantial attention, while other companies are relatively ignored.
Next, we turn to our second question: how does investors’ research affect their monitoring behavior, for example via shareholder voting or divestments? Our results suggest that more in-depth research has a causal impact on investors’ monitoring behavior. Greater corporate governance research leads investors to update their beliefs about the company and thus take a more active monitoring role. For example, we find that more in-depth research causes an investor to engage in more informed voting in the portfolio company, as opposed to indiscriminately following the recommendations of ISS. Moreover, we also find that more in-depth research increases the probability that an investor uncovers problems in the company: the investor is more likely to vote against management, more likely to decrease ownership in the company (relative to other portfolio holdings), and more likely to entirely divest its position.
The third part of the paper focuses on our last question: does investors’ attention to corporate governance discipline the management at the underlying companies? Results from the first two parts of the paper suggest that concerns regarding the current structure of the company motivate investors to conduct more governance research, and the increased information obtained by investors causes them to pressure companies via both voice and exit. This generates the prediction that investor attention to a company will compel the company to make value-increasing changes. Our findings support this prediction. Consistent with empire-building representing a form of agency conflict that a company’s investors strive to curtail, we find strong evidence that increased attention to the company’s governance has both a negative causal effect on investment and a positive causal effect on payouts.
In sum, our results show that governance research has a causal effect on both investors’ monitoring behavior and on companies’ operations. Our approach toward isolating causality represents an additional contribution of the paper. We take advantage of the fact that incremental to other determinants of governance research, companies whose meetings fall in the busy spring proxy season receive significantly less attention. We use the ‘busy’ indicator as an instrument that captures exogenous shocks to attention to individual portfolio companies.
While our results highlight the benefits of investor attention for the underlying companies, the concentration of research amongst certain types of companies, combined with coordination among investors, means that a significant portion of companies will tend to be relatively ignored. Our final set of results indicates that the tendency to be ignored is persistent over time. A company that resides in the bottom decile of investors’ governance research has a 63% probability of being in one of the bottom-two deciles of investors’ governance research in the subsequent year. This highlights the impact of our findings. Management of a less-researched company tends to be less stringently monitored both this year and into the future.
The full paper can be found here.
