The Role of Institutional Investors in Open-Market Share Repurchase Programs

Thomas J. Chemmanur

Boston College – Carroll School of Management

Yingzhen Li

The Brattle Group

Abstract:

Theoretical papers such as Brennan and Thakor (1990) argue that large investors such as institutions produce information about firms around stock repurchases. In this article, we use a large sample of transaction-level institutional trading data and the data on US firms’ actual repurchases made available by the 2003 revisions to the Exchange Act to test this assumption about open-market repurchase programs (OMRs) for the first time in the literature. We document several results new to the literature. First, institutional trading prior to an OMR announcement has significant predictive power for the magnitude of the abnormal return to the firm’s equity around open-market share repurchase announcements. Second, institutional trading immediately after an OMR announcement has significant predictive power for the firm’s subsequent stock return performance: the larger the net buying by institutions, better the subsequent long-run stock returns. Third, institutions are able to realize significant abnormal profits (net of commissions and trading costs) by trading in the equity of firms undergoing open-market repurchases. Fourth, institutional trading immediately after an open-market share repurchase announcement has significant predictive power for the actual repurchases by the firm: a larger amount of buying of the firm’s equity by institutions is associated with a larger actual repurchase by the firm in the subsequent period. Finally, institutional trading has predictive power for the change in the firm’s information asymmetry from before the OMR announcement to after: a larger amount of net buying by institutions is associated with a larger decrease in the degree of information asymmetry facing the firm in the equity market. Overall, our results are consistent with the notion that institutional investors are able to generate a significant information advantage for themselves about firms undergoing open-market repurchases.

The Role of Institutional Investors in Open-Market Share Repurchase Programs – Introduction

In recent years, the number of firms undertaking stock repurchases has increased dramatically, while the proportion of firms distributing value through cash dividends has declined (see, e.g., Fama and French (2001)). The popularity of share repurchases has not been mitigated even after the passage of the Jobs and Growth Tax Relief Act of 2003 in the U.S. which cut the dividend tax rate to 15%, thus substantially reducing the tax disadvantage of dividend payments to investors (see, e.g., Chetty and Saez (2006)). Open-market repurchases (OMRs) constitute around 90% of the stock repurchases consummated in recent years: see, e.g., Comment and Jarrell (1991) or Grullon and Michaely (2004). An interesting question in this context is regarding the precise economic role played by repurchase programs in general and OMR programs in particular in maximizing shareholder value. The rationale for repurchase programs given by the existing literature is that they serve to signal firm insiders’ private information about the intrinsic value of the firm to outsiders in the equity market: see, e.g., Vermaelen (1981), Ofer and Thakor (1987), and Constantinides and Grundy (1989).1

One interesting question in the above context is the role of institutional investors. The theoretical model of Brennan and Thakor (1990) assumes that large investors such as institutions have the ability to produce information about firms in the context of their choice of payment method between open-market repurchases, dividends, and tender offers.2 If institutional investors do indeed possess the ability to produce information about firms undergoing open-market share repurchase programs, how does this information interact with that of firm insiders? To the best of our knowledge, there has been no paper in the literature that empirically analyzes whether institutions indeed have the ability to produce information about firms announcing OMR programs, and how their information interacts with the private information held by firm insiders (which they may attempt to convey to the equity market through a repurchase program). The objective of this paper is to fill this gap in the literature.

The economic setting we consider to develop our empirical analysis can be described as follows. Consider a situation where the insiders of a firm, having private information about its intrinsic value, are considering whether or not to undertake an open-market repurchase program. Let there be two types of outside investors in the equity market. The first type of investors are institutional investors, who have the ability to produce noisy information about the firm (at a cost). The precision of information produced by institutions is lower than that of the private information held by firm insiders, so that, while information production helps institutions reduce their information disadvantage with respect to firm insiders, it does not eliminate it. The second type of investors are retail investors, who do not have any ability to produce information about the intrinsic value of the firm, and are therefore at a disadvantage with respect to both institutions and insiders. Retail investors are essentially liquidity traders in the equity market in the economic setting we study here, similar to their role in market microstructure models such as Kyle (1985). The price of the firm’s stock in the equity market is set by a market maker who is uninformed to begin with, but who sets the stock price to break even (after observing the aggregate order flow of trades in the firm’s equity), again similar to the price-setting rule in market microstructure models. While the market maker cannot fully separate informed and uninformed trades, the price of the firm’s equity will reflect, to some degree, the information held by institutional investors.

Open-Market Share Repurchase Programs

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