Governance and Comovement Under Common Ownership
Alex Edmans
London Business School – Institute of Finance and Accounting; University of Pennsylvania – The Wharton School; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI); Centre for Economic Policy Research (CEPR)
Doron Levit
University of Pennsylvania – Finance Department
Devin Reilly
University of Pennsylvania – Department of Economics
European Corporate Governance Institute (ECGI) – Finance Working Paper No. 437/2014
Abstract:
This paper studies the corporate governance and asset pricing implications of investors owning blocks in multiple firms. Common wisdom is that multi-firm ownership weakens governance because the blockholder is spread too thinly. We show that this need not be the case. In a single-firm benchmark, the blockholder governs through exit, selling her stake if the firm underperforms. With multiple firms, the blockholder may sell even a value-maximizing firm, to disguise her exit from another underperforming firm as being motivated by a portfolio-wide liquidity shock. This reduces the manager’s effort incentives and weakens governance. On the other hand, governance can be stronger, because selling one firm and not the other is a powerful signal of underperformance. Common ownership leads to firms’ stock prices being correlated, even if their fundamentals are uncorrelated. We derive empirical predictions for the direction of correlation and for whether governance is stronger or weaker with multiple firms.
Most existing theories of blockholder governance consider a single rm. However, in reality, many institutional investors hold blocks in multiple rms.1 This paper studies the implications of common ownership for corporate governance and asset pricing. In particular, we address two broad questions. First, does holding multiple blocks weaken governance by spreading a blockholder too thinly, as commonly believed? If not, under what conditions can multi-rm ownership improve governance? Second, can common ownership lead to correlation between stocks with independent fundamentals, and if so, in which direction?
In our model, the blockholder governs through exit”, disciplining the manager by selling shares if he shirks. Such sales reduce the value of the manager’s equity compensation ex post, thus inducing him to maximize rm value ex ante. We model governance through exit rather than voice” (intervention) for three reasons. First, McCahery, Sautner, and Starks (2011) report that exit is the main governance mechanism used by institutions.2 Second, if holding multiple blocks means that the investor holds smaller stakes in each rm, she may lack sucient control rights to intervene. Third, exit has asset pricing implications, since it involves the blockholder trading the rm’s stock.
As a benchmark against which to assess the eects of common ownership, we start with a model in which the blockholder owns shares in a single rm. The manager can take an action (such as shirking, cash ow diversion, or empire building) that yields a xed private benet, but reduces rm value by a random amount privately known to him. In equilibrium, the manager shirks if and only if the value loss is below a threshold; a lower threshold corresponds to greater eciency and thus superior governance. The blockholder privately observes the manager’s action, and based on this information, may either sell shares or retain them until rm value is realized. As in Admati and Peiderer (2009), her trade is observed by the market maker, but not fully revealing because she may also suer a liquidity shock that forces her to sell half of her stake (although she may choose to sell more). In equilibrium, the blockholder sells shares, reducing the stock price, if she needs liquidity or the manager shirks. The threat of selling disciplines the manager and lowers the threshold below which he shirks.
The core analysis is a model with two independent rms, where the blockholder owns a stake in each rm. She can satisfy her liquidity need by selling either half of her stake in each rm or her entire stake in one rm. Importantly, the decision to sell is made at the portfolio rather than rm level. As we discuss below, this is a key implication of common ownership.
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