Behind the Scenes: The Corporate Governance Preferences of Institutional Investors McCahery, Joseph, Sautner, Starks, 2016

Question 1

CONTEXT

Answer 1

Institutional investors: an entity which pools money to purchase securities, real property, and other
investment assets or originate loans. Institutional investors include banks, insurance companies,
hedge funds, investment advisors, endowments, and mutual funds.
There is little knowledge how institutional investors engage with their portfolio companies,
because most of the interactions occur behind the scenes.
Research documents two activities that institutional investors conduct when they are unhappy with
company’s performance:
1. Voice: engaging with management to try to initiate changes.
2. Exit: leave the firm by selling shares (can also serve as a disciplinary action).

Question 2

SHAREHOLDER ACTIVISM

Answer 2

What encourages shareholder activism?
In general, shareholders tend to engage more over long-run strategic issues. Main drivers of
activism: fraud, inadequate corporate governance and excessive compensation, disagreement
with a firm’s strategy, specifically large mergers and acquisitions, contributions to politicians.
What discourages shareholder activism?
“Free rider” problem, inadequate legal rules do affect activism, diversification requirements for
mutual funds can prevent them from taking stakes necessary for effective voice strategy, weak
disclosure requirements limit the amount of information that shareholders get providing less
opportunities for activism, conflicts of interest, as investors might be concerned that aggressive
engagement might affect their future relations with firms (private costs). Fund managers might not
bother engaging if they are not sufficiently rewarded for activism (compensation problems).

Question 3

VOICE AND EXIT CHANNELS

Answer 3

Institutional investors are active overall: only 19% of the surveyed have not taken any corrective
actions in the past 5 years. Over 50% have used discussions with management and board and
voting against management as corporate governance channel. 39% have sold shares due to
dissatisfaction with corporate governance.
Only when private discussions and negotiations fail to achieve the goal, investors tend to take
public measures. Aggressive public measures are also used: 15% have used legal actions, 13%
have used public criticism.

Question 4

VOICE AND EXIT: SUBSTITUTES OR
COMPLEMENTS

Answer 4

= Complements (that is, used simultaneously or one after the other) due to the following reason:
managers tend to take discussions with shareholders more seriously in the face of a threat to
exit.
They might be substitutes (used separately, one or the other) as well: some investors might lack the
expertise of intervention and thus rely solely on the exit strategy. Investors might face capital gains
costs when exiting, which makes the option of voice more attractive. The paper finds robust
positive correlation between the two variables, suggesting that they are complements!

Question 5

DETERMINANTS OF VOICE INTENSITY

Answer 5

1. Liquidity: Does it matter? Theory isn’t in an agreement: Higher liquidity of shares held encourages
   investors not to bother with activism and liquidate. On the other hand, higher liquidity makes it easier
   to sell at increased price that reflects engagement efforts. The paper indicates negative relationship
   between liquidity and voice: the more liquid shares institutional investors hold, the less they
   intervene.
2. Investment Horizon: Does it matter? Theory isn’t in an agreement: Long-term shareholders might be
   incentivized to intervene, because they can reap the long-term benefits. Contrary to this, it is claimed that
   hedge funds (short-term mostly) sometimes push for actions that are profitable in the short run, but
   detrimental in the long run. The paper shows positive relationship between horizon and voice: longterm orientation provides more incentives to monitor and intervene.
3. Size: Does it matter? The paper does not find significant relationship between the size of stake and
   voice. Agency problems of institutional investors? Larger share of company means more absolute payoff
   for intervention, encourages more activism. Larger funds might also have more resources to engage.

Question 6

THREAT OF EXIT

Answer 6

Shareholders can collect private information on the fundamental value of a firm, which is then
impounded to the price they offer in case of an exit. If a firm is not doing well, but the public does
not know it yet, managers are strongly incentivized to increase firm’s value to avoid exit by
informed shareholders. Threat of exit is empirically unobservable; survey results are the only
data.
When are exit threats effective? Multiple informed shareholders, their trading incorporates more
information on firm’s fundamentals = more threat to firm’s value in case of the exit. If managers
own equity in the company, exit threat is even more convincing. If you are a small shareholder, you
will be hardly heard. Also, sale of a small number of shares will have a marginal effect on their
price. Thus, size of the equity stake should be significant for the threat to be effective.

Question 7

REMARKS: WHAT TO DO

Answer 7

Proxy advisors: Proxy advisory firms provide institutional investors with research, data, and
recommendations on management and shareholder proxy proposals. It reduces the costs of
being informed by monitoring, collecting information and using professional judgment in
recommendations.
Proxy advisors merely complement individual judgement and do not imply that investors take
passive governance role (60% of respondents use at least one proxy). Recommendations of proxy
advisers can be too standardized and ignoring firm-specific cases. As profit-seeking organizations,
they are incentivized to conduct low-cost analyses only. Some proxy advisors serve as corporate
governance advisory firms and make recommendations on voting at the same time.
Conflict of interest might arise.