The Corporate Governance Preferences Of Institutional Investors

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Behind The Scenes: The Corporate Governance Preferences Of Institutional Investors

Joseph A. McCahery

Tilburg University – School of Law; European Banking Center (EBC); European Corporate Governance Institute (ECGI); Duisenberg School of Finance; Tilburg Law and Economics Center (TILEC)

Zacharias Sautner

Frankfurt School of Finance & Management gemeinnützige GmbH

Laura T. Starks

University of Texas at Austin – Department of Finance

June 2015

Journal of Finance, Forthcoming


We survey institutional investors to better understand their role in the corporate governance of firms. Consistent with a number of theories we document widespread behind-the-scenes intervention as well as governance-motivated exit. Both governance mechanisms are viewed as complementary devices, in which intervention typically will occur prior to a potential exit. We find that long-term investors and investors that are less concerned about stock liquidity intervene more intensively. Finally, most investors use proxy advisors and believe that their information improves their own voting decisions.

Behind The Scenes: The Corporate Governance Preferences Of Institutional Investors – Introduction

Theoretical and empirical research on corporate governance makes assumptions and draws inferences regarding the role of institutional investors. Yet, we have little direct knowledge regarding how institutional investors engage with portfolio companies because many of these interactions occur behind the scenes.1 That is, unless institutions publicly express their approval or disapproval of a firm’s activities or management, little is known about their preferences and private engagements with portfolio firms. Our goal in this paper is to rectify this knowledge gap by conducting a survey among institutional investors.

As early as Hirschman (1970), researchers have highlighted the two active choices that institutional investors have when they become unhappy with a portfolio firm: (i) they can engage with management to try to institute change (“voice” or direct intervention); or (ii) they can leave the firm by selling shares (“exit” or “voting with their feet”). Subsequently, theoretical models have documented the governance benefits of corrective actions through voice.2 These theories have recently been complemented by models showing that the threat of exit can also discipline management.3 This raises the question of whether institutional investors, in response to dissatisfaction with portfolio firms, take actions that support the validity of these theories.

The 143 respondents to our survey, mostly very large institutional investors with a long-term focus, indicate that voice, especially when conducted behind the scenes, is highly important. For example, 63% of the respondents state that, in the past five years, they have engaged in direct discussions with management, and 45% have had private discussions with a company’s board outside of management’s presence.4 In addition, we find evidence that the investor’s horizon makes a difference. First, long?term investors intervene more intensively than short?term investors. Second, investors who choose engagement do so more often because of concerns over a firm’s corporate governance or strategy than over short?term issues. Both findings support the view that interventions are not primarily conducted by short-term, myopic activists who intend solely to reap short?term gains (e.g., Bebchuk, Brav, and Jiang (2014)).

Nevertheless, the institutional investors also indicate that they face impediments to their activism, with the most important hurdles being free rider problems (as in Shleifer and Vishny (1986)) and legal concerns over “acting in concert” rules. Our results also show that investors who are more concerned about liquidity (and hence probably hold more liquid stocks) use voice less intensively. This is consistent with Coffee (1991), Bhide (1993), and Back, Li, and Ljungqvist (2014), who argue that market liquidity discourages intervention.

A central challenge arises in analyzing whether institutional investors use the threat of exit and whether it is effective in bringing about changes in management behavior. The challenge is that the threat of exit is, by definition, unobservable. In fact, if the threat is credible, exit itself does not take place. Our survey sheds light on the exit mechanism because we can ask institutions (i) whether they use exit as a governance device; and (ii) whether they believe that the exit threat is an effective disciplinary device.

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