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Guiding Seminar 3 (2020) Flashcards

1
Q

A Survey of Corporate Governance
Schleifer, Vishny

What is Corporate Governance?

A

Corporate governance deals with the ways in which suppliers of finance to corporations can assure themselves of getting a return on their investment.

“Much of the subject of corporate governance deals with constraints that managers put on themselves, or that investors put on managers, to reduce the ex post misallocation and thus induce investors to provide more funds ex ante”

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2
Q

A Survey of Corporate Governance
Schleifer, Vishny

What are Corporate Governance mechanisms?

A

Economic and legal institutions (i.e. rules) that can

be adjusted by the political process.

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3
Q

A Survey of Corporate Governance
Schleifer, Vishny

What is the agency problem in CG?

A

The separation of ownership and control.
In corporations - the separation of finance and management. Financiers face the difficulty in assuring that their funds are not expropriated or wasted on unattractive projects.

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4
Q

A Survey of Corporate Governance
Schleifer, Vishny

Explain why appropriate contracts would solve agency problem, but do not in reality.

A

IDEALLY, a financier would sign a CONTRACT with a manager that SPECIFIES division of profits and manager’s actions in ALL STATES of the world. Such CONTRACT NO EXIST. Also, if everything is specified, managers will not show their own judgement.

Instead, CONTRACTS SHOULD SPECIFY who has RESIDUAL CONTROL RIGHTS (who makes decisions in unforeseen circumstances).

Usually, managers are more skilled than shareholders (otherwise, they would not be managers). Thus, managers have most of the residual control rights.

However, corporate contracts cannot require too much interpretation – otherwise courts might not help (say to rely on business judgment).

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5
Q

A Survey of Corporate Governance
Schleifer, Vishny

Explain the free-rider problem in CG.

A

1) If enough shareholders think that their vote/influence, doesn’t matter, it will give more control for managers.
2) If enough shareholders rely on other shareholders to make sure that managers act accordingly, no one may be actually supervising managers, leaving much control\

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6
Q

A Survey of Corporate Governance
Schleifer, Vishny

What are “bad things” managers can do?

A
  1. DIRECT ABSCONSION (dissapearance) with money
  2. TRANSFER PRICING
  3. EMPIRE BUILDING (attempting to increase the size and scope of an individual or organization’s power and influence)
  4. PURSUING PET PROJECTS (carrying out projects that have the biggest value to you, not to business)
  5. ENTRENCHING (covering up positions, making it so that managers cannot be fired. Most costly)

With these possible actions in mind, investors could provide less funds to the firm.

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7
Q

A Survey of Corporate Governance
Schleifer, Vishny

What is the possible solution for managers being bad boyz?

A

Incentive contracts - making managers interested in increasing shareholder value by:

  1. share ownership
  2. stock options
  3. threat of dismissal
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8
Q

A Survey of Corporate Governance
Schleifer, Vishny

Why incentive contracts do not always work as a solution to manager wrongdoings?

A

Incentive contracts can be turned into a mechanism of self-dealing and is not a solution to the agency problem.

With more information, managers might know when earnings are going to rise, manipulate accounting data, backdate options

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9
Q

A Survey of Corporate Governance
Schleifer, Vishny

What is the evidence for agency costs? (4)

A
  1. If the stock price falls when managers announce a particular action, this action must serve the interest of managers rather than shareholders (acquisition decisions)
  2. Manager’s resistance to the value-enhancing takeover or adoption of Poison Pills signals the existence of PBOC and thus agency problems
  3. Sudden deaths of executives sometimes increase the share price
  4. Large blocks of shares carry more control and thus trade at a large premium. Large blockholders receiving special benefits.
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10
Q

A Survey of Corporate Governance
Schleifer, Vishny

Why do shareholders still invest even if all the problems exist? (How firms can raise money without giving
suppliers of capital any real power?)
(4)

A
  1. Reputation building - Managers repay investors to establish good reputation to ensure access to the capital markets in the future.
  2. Excessive investor optimism - Investors get excited about
    companies, and hence finance them without thinking
    much about getting their money back, simply counting on short run share appreciation. (Ponzi schemes)
  3. Legal Protection
  4. Large Investors
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11
Q

A Survey of Corporate Governance
Schleifer, Vishny

What is a Ponzi scheme?

A

A fraudulent investing scam promising high rates of return with little risk to investors. The Ponzi scheme generates returns for early investors by acquiring new investors.

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12
Q

A Survey of Corporate Governance
Schleifer, Vishny

How Legal Protection helps investors invest at all?

A

External financing is a contract between the firm and the financiers that gives them certain rights to its assets. If managers violate this contract, the financiers can appeal to the courts.

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13
Q

A Survey of Corporate Governance
Schleifer, Vishny

What are the main legal rights of shareholders? What are the problems arising?

A
  1. Vote on important matters – M&A, elections of Board of Directors.
    Problems:
    - too expensive and resourceful, and hard to enforce for small shareholders
    - managers can exert pressure and manipulate votes
  2. Duty of loyalty - the interest of the firm first, no self-dealing
    Problems:
    - hard to interpret, not all legislative bodies recognise it
    - mainly includes restrictions on self-dealing, outright theft, excessive compensation
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14
Q

A Survey of Corporate Governance
Schleifer, Vishny

Do countries differ by legal protection of shareholders?

A

YES. Countries differ by legal obligations of the managers to the financiers and by the ability of courts to enforce these duties.
As Stalin noted, “it is important not how people vote, but who counts the votes”

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15
Q

A Survey of Corporate Governance
Schleifer, Vishny

Why creditors are usually better protected legally than investors?

A

Creditors are usually better protected legally, since default is a straightforward violation of a contract and enforcement is more straightforward

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16
Q

A Survey of Corporate Governance
Schleifer, Vishny

Why Large Shareholders are good for fighting agency problem?

A

Large shareholders can exert pressure on managers and even oust them out.

(Similarly, In the case of a firm’s default or debt covenant violation, large creditors receive substantial control combined with CF rights)

The effectiveness of both of these groups still depend on legal rights they have, specifically on how the voting mechanism works and how they can enforce it in courts.

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17
Q

A Survey of Corporate Governance
Schleifer, Vishny

What is hostile takeover?

A

CONTROL of a firm can be OBTAINED in a hostile takeover, by which a bidder seeks to acquire a large number of dispersed shares and replace or influence the management.
Vulnerable to managerial lobbies, requires liquid markets, expensive, can lead to PBOC problems.

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18
Q

A Survey of Corporate Governance
Schleifer, Vishny

What are the costs of large investors?

A
  1. Large investors also bear larger financial consequences of their actions due to LACK OF DIVERSIFICATION (they have invested a huge amount in one company).
  2. Large investors might PURSUE THEIR OWN INTERESTS, treat themselves preferentially and expropriate other stakeholders (e.g. special dividends). More likely with dual-class shares structure.
  3. Large shareholders might seek the firm to pursue RISKY PROJECTS, as they face upward payoff, while large creditors face potential costs of failure only. Clash of interests!
  4. Large investors might be TOO SOFT due to their own agency problems (e.g. institutional investors). Ability to control does not materialize.
  5. CLOSE MONITORING of managers and employees CAN LOWER their INCENTIVES, large investors scare-away general public investment.
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19
Q

A Survey of Corporate Governance
Schleifer, Vishny

What are the three contractual mechanisms in dealing with agency problems?

A
  1. Debt vs Equity
  2. Leveraged buyouts
  3. State ownership and cooperatives
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20
Q

A Survey of Corporate Governance
Schleifer, Vishny

How does Debt vs. Equity work as a contractual mechanism?

A
  1. Due to information asymmetry, raising equity finance can be costly. Without much information, equity investors face more risk
    and attribute low value to firm’s shares.

Lenders, on the other hand, mainly care about the value of collateral, thus firms frequently issue debt before equity. Debt covenants also pressure the managers.

Due to lenders (banks, especially) having almost monopoly control of the firm in the case of default, concerted action by multiple creditors is not required.

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21
Q

A Survey of Corporate Governance
Schleifer, Vishny

How do Leveraged buyouts work as a contractual mechanism?

A

Leveraged buy outs (LBOs): a group of new investors, highly leveraged, buy enough shares to control the firm.
▪ Large debt infusion to the company’s balance sheet disciplines managers by covenants. Managers are also given shares.
▪ A unified group of investors can now exert a concerted influence to firm’s decisions. No free-rider problem.
▪ Heavy oversight of investors can in fact exert overly excessive pressure to managers. Also, financial discipline decreases firm’s flexibility.
▪ LBOs, due to their operational system, cannot permanently replace public corporations. It is rather a one-shot move.

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22
Q

A Survey of Corporate Governance
Schleifer, Vishny

How does State ownership and cooperatives
work as a contractual mechanism?

A

The question posed: If large greedy investors expropriate other stakeholders, what if we gave firms cooperatives or the state to ensure maximum welfare of the society?

Answer:
State enterprises do not appear to serve the public interest any better. Pollution problems are in fact most severe in the post-communist countries.
▪ CG perspective: bureaucrats in control of state enterprises can be thought of as having concentrated voting rights, but no significant CF rights. Respective agency problems arise.
▪ Goals for the bureaucrats are not determined by social needs, but rather by political interests (catering their lobbyists)

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23
Q

A Survey of Corporate Governance
Schleifer, Vishny

What are the main conclusions?

A
  1. There is no perfect corporate governance system and the paper does not seek to establish one.
  2. SUCCESSFUL CG systems, such as those of the United States, Germany, and Japan, COMBINE significant LEGAL PROTECTION of at least some investors with an IMPORTANT ROLE FOR LARGE INVESTORS.
  3. Large investors are necessary to force managers to distribute profits. They require at least some legal rights to be able to exert pressure through votes and collateral collection.
  4. Minority investors should be protected from expropriation or else very low value would be attributed to minority share blocks leading to underdeveloped financial markets.
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24
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

What are Private Benefits of Control?

A

Benefits that are not shared among all shareholders in
proportion of the shares owned, but are EXCLUSIVELY ENJOYED BY PARTIES IN CONTROL (“psychic” value, outright theft, transfer pricing, using insider info for personal gain)

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25
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

What are the two main ways of
measuring PBOC? What are their drawbacks?

A
  1. CONTROL PREMIUM - the difference between the price per share of the control block and the market price per share.
    Drawbacks: Sales of control blocks are rather rare; delay in incorporating public information to the market price.
2. PRICE DIFFERENCE between shares in a DUAL - CLASS system. Extra voting rights as a proxy for corporate control. 
Drawback: dual class shares are not allowed in every country.

Both measures capture only common value component.

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26
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

What tells about the fact that PBOCs are difficult to measure?

A

If PBOC were easily observable and quantifiable, they would not be private and would be claimed by minority shareholders in court

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27
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

What affects the size of PBOC premium? (name 5)

A
  1. The SIZE of block traded.
  2. PRESENCE of ANOTHER LARGE SHAREHOLDER.
  3. SELLERS BARGAINING POWER
  4. INDUSTRY.
  5. TANGIBILITY OF ASSETS.
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28
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

Why does size of the block traded affect the size of PBOC premium?

A

You will pay more for 51% of shares than 30% because when you have 51% you are in total control. If you have only 30% your dominance might be contested. YES EVIDENCE by the authors.

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29
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

Why does presence of another large shareholder affect the size of PBOC premium?

A

If there is another large shareholder - you have to share your PBOC – you are not happy - you pay
less. NOT SIGNIFICANT.

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30
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

Why does sellers bargaining power affect the size of PBOC premium?

A

Reflects whether seller is in a position to demand more money from the buyers.

- If the company is in a FINANCIAL DISTRESS, a large seller is willing to sell shares for less. PBOC are then undervalued. YES EVIDENCE.
- Whether the buyer is a FOREIGNER. Foreigners pay more (less information and connections => more bargaining power for the seller). YES EVIDENCE.
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31
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

Why does industry affect the size of PBOC premium?

A

PBOC also differ across industries. Controlling a media company gives you enormous power of manipulating public opinion in personally beneficial ways. NOT SIGNIFICANT.

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32
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

Why does tangibility of assets affect the size of PBOC premium?

A

If company’s assets are mostly tangible, they are harder to expropriate due to their visibility, thus lowering PBOC. Finance industry as a contrast. NOT SIGNIFICANT.

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33
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

How PBOC affects financial development (3)?

A
  1. LESS IPOs -> UNDERDEVELOPED EQUITY MARKETS. In countries showing high PBOC, entrepreneurs are reluctant to make their companies public because investors do not factor in the control value.
  2. CONCENTRATED OWNERSHIP -> LESS WIDELY HELD COMPANIES. Potential buyers of smaller stakes also attribute less value to shares taking into account being exploited by majority shareholders.
  3. PRIVATELY NEGOTIATED DEALS. Selling control in private negotiation is more profitable than in the market with dispersed buyers buying many noncontrolling stakes. (To maximize profit, governments should sell companies privately rather than in public offerings).
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34
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

How legal institutions restrain PBOC? (3)

A

LEGAL INSTITUTIONS ARE STRONGLY ASSOCIATED WITH LOWER LEVELS OF PRIVATE BENEFITS

  1. The LEGAL ENVIRONMENT.
  2. DISCLOSURE STANDARDS.
  3. ENFORCEMENT.
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35
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

Why does legal environment restrain PBOC?

A

Greater ability to sue controlling shareholders and greater shareholder protection in general translate into smaller PBOC. WORKS.
(Anti-director rights: the process of director appointment, length of their tenure, ability to protest decisions of the majority, etc.)

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36
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

Why do disclosure standards restrain PBOC?

A

The more extensive and accurate disclosed information is, the more it curbs appropriation by increasing the risk of legal consequences or reputational costs. WORKS.

37
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

Why does enforcement restrain PBOC?

A

Quicker, smoother and more predictable enforcement results in stronger legal protections of shareholders (e.g. the level of corruption and bureaucracy of courts in the country). WORKS.

38
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

How do extra-legal institutions restrain PBOC?

A

The possibility of extracting private benefits is related to managerial discretion (the freedom managers have to pursue their own objectives), courts cannot always restrict that, but others can.

  1. PRODUCT MARKET COMPETITION
  2. PUBLIC OPINION PRESSURE
  3. MORAL NORMS
  4. LABOR AS MONITOR
  5. GOVERNMENT AS MONITOR
39
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

Why does product market competition restrain PBOC?

A

Through prices, competitive markets can verify manipulated transfer prices. Competition also makes tunneling more harmful to firm’s survival. WORKS.

40
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

Why does public opinion pressure competition restrain PBOC?

A

Value appropriation can be limited by expected reputational losses. WORKS.

41
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

Why should moral norms restrain PBOC? Do they?

A

Value appropriation can not be undertaken due to moral considerations. Religious traditions as a proxy? Crime rate? DO NOT WORK.

42
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

Why should labor as monitor mechanism restrain PBOC? Does it?

A

The risk of employees quitting due to dishonest

activities by majority shareholders. What if employees benefit from PBOC? DOES NOT WORK.

43
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

Why does government as monitor mechanism restrain PBOC?

A

Through taxes the state acts as an investor to all companies. It does not have agency/freerider problems, and has power unavailable to regular shareholders –
better tax enforcement can reduce PBOC. WORKS

44
Q

Private Benefits of Control: An International Comparison
Alexander Dyck, Luigi Zingales

What is the effect of legal origins on PBOC?

A

Legal traditions differ in their respect for property rights and thus in their ability to protect minority shareholders.

▪ PBOC are the HIGHEST IN FORMER COMMUNIST countries (36% extra value on equity).
▪ MEDIUM in countries with a FRENCH code (21%): France, Mexico, Luxembourg, Netherlands, etc.
▪ LOWEST in countries with a GERMAN(11%), ENGLISH (5.5%) and SCANDINAVIAN (4.8%) code.

45
Q

Behind the Scenes: The Corporate Governance Preferences of Institutional Investors
Joseph A. McCathery, Zacharias Sautner, Laura T. Starks

What are institutional investors? Give examples

A

Entity which pools money to purchase securities, real property, and other investment assets or originate loans.

Banks, insurance companies, hedge funds, investment advisors, endowments, and mutual funds.

46
Q

Behind the Scenes: The Corporate Governance Preferences of Institutional Investors
Joseph A. McCathery, Zacharias Sautner, Laura T. Starks

According to previous research, what are 2 activities institutional investors do when they are unhappy with the company’s performance?

A
  1. VOICE – engaging with management to try to initiate changes.
  2. EXIT – leave the firm by selling shares.
    ▪ THREAT OF EXIT can also serve as a disciplinary action.
47
Q

Behind the Scenes: The Corporate Governance Preferences of Institutional Investors
Joseph A. McCathery, Zacharias Sautner, Laura T. Starks

Are institutional investors active in expressing their opinion about the firm the invest in? Provide detailed % of results.

A

Institutional investors are ACTIVE OVERALL: ONLY 19% of the surveyed HAVE NOT taken any corrective ACTIONS in the past 5 years.

> 50% have used discussions with management and board and voting against management as corporate governance channel (voice)

39% have sold shares due to dissatisfaction with corporate governance (exit)

15% have used legal actions

13% have used public criticism

48
Q

Behind the Scenes: The Corporate Governance Preferences of Institutional Investors
Joseph A. McCathery, Zacharias Sautner, Laura T. Starks

What are the potential determinants of voice intensity?

A
  1. Liquidity
  2. Investment Horizon
  3. Size (that’s what she said)
49
Q

Behind the Scenes: The Corporate Governance Preferences of Institutional Investors
Joseph A. McCathery, Zacharias Sautner, Laura T. Starks

Why is liquidity a determinant of investor’s voice intensity?

A

Theory:
- 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. If I can sell at a higher price already tomorrow, why not be active?

Paper:
- Indicates negative relationship between liquidity and voice: the more liquid shares institutional investors hold, the less they intervene (simply use exit strategy more)

50
Q

Behind the Scenes: The Corporate Governance Preferences of Institutional Investors
Joseph A. McCathery, Zacharias Sautner, Laura T. Starks

Why is investment horizon a determinant of investor’s voice intensity?

A

Theory:
+ Long-term shareholders might be incentivized to intervene, because they can reap the long-term benefits. Long-term investors might also have more time to gather information for effective intervention.
- Contrary, 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.

+ Paper: Positive relationship between horizon and voice: long-term orientation provides more incentives to monitor and intervene.

51
Q

Behind the Scenes: The Corporate Governance Preferences of Institutional Investors
Joseph A. McCathery, Zacharias Sautner, Laura T. Starks

Why should the size of the stake in the company be a determinant of investor’s voice intensity? Is it?

A

Theory: Positive relationship - Larger share of company means more absolute payoff for intervention – encourages more activism. Larger funds might also have more resources to engage.

Paper: No significant relationship.

52
Q

Behind the Scenes: The Corporate Governance Preferences of Institutional Investors
Joseph A. McCathery, Zacharias Sautner, Laura T. Starks

Why should voice and exit be complements (used simultaneously)?

A

“The chances for voice to function effectively… are
appreciably strengthened if voice is backed up by the threat of exit.”

Managers tend to take discussions with shareholders more seriously in the face of a threat to exit.

53
Q

Behind the Scenes: The Corporate Governance Preferences of Institutional Investors
Joseph A. McCathery, Zacharias Sautner, Laura T. Starks

Why should voice and exit be substitutes (used separately)?

A
  1. Some investors might lack the expertise of intervention and thus rely solely on the exit strategy.
  2. Investors might face capital gains costs when exiting, which makes the option of voice more attractive.
54
Q

Behind the Scenes: The Corporate Governance Preferences of Institutional Investors
Joseph A. McCathery, Zacharias Sautner, Laura T. Starks

Does the paper find that voice and exit are complements or substitutes?

A

Complements. Robust positive correlation between the two variables.

55
Q

Behind the Scenes: The Corporate Governance Preferences of Institutional Investors
Joseph A. McCathery, Zacharias Sautner, Laura T. Starks

Why is threat of exit effective?

A

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 crap, but the public does not know it yet, managers are strongly incentivized to increase firm’s value to avoid exit by informed shareholders.

This happens behind the scenes – threat of exit is in fact empirically unobservable, thus survey results are the only data.

56
Q

Behind the Scenes: The Corporate Governance Preferences of Institutional Investors
Joseph A. McCathery, Zacharias Sautner, Laura T. Starks

When is threat of exit effective?

A
  1. Exit or exit threat by OTHER INVESTORS for the same reason signals that the issue is significant enough to force numerous exits.
  2. In the PRESENCE of MULTIPLE INFORMED SHAREHOLDERS, their trading incorporates more information on firm’s fundamentals, thus, poses more threat to firm’s value in case of the exit.
  3. If MANAGERS OWN EQUITY in the company, exit threat is even more convincing.
  4. SIZE OF THE EQUITY STAKE should be significant for the threat to be effective. (If you are a small shareholder, you will be hardly heard and your exit will have marginal effect on price).
57
Q

Behind the Scenes: The Corporate Governance Preferences of Institutional Investors
Joseph A. McCathery, Zacharias Sautner, Laura T. Starks

What are the factors that discourage shareholder activism? (4) Explain.

A
  1. FREE RIDER PROBLEM - they would personally incur costs of activism while the benefits would be shared among all shareholders.
    - Higher stake size increases net payoff for activism and hinders the “free rider” problem (when you have more money in one company and others have less, you will benefit more from the company performing better than others)
  2. INADEQUATE LEGAL RULES
  • Diversification requirements for mutual funds
  • Engagements can lead to legal consequences (when you too loud yelling and do smth bad)
  • Weak disclosure requirements limits the amount of information that shareholders get providing less opportunities for activism.
  1. CONFLICTS OF INTEREST: Investors might be concerned that aggressive engagement might affect their future relations with firms (private costs).
  2. Fund managers might not bother engaging if they are NOT SUFFICIENTLY REWARDED for activism (compensation problems).
58
Q

Behind the Scenes: The Corporate Governance Preferences of Institutional Investors
Joseph A. McCathery, Zacharias Sautner, Laura T. Starks

What are the factors that encourage shareholder activism? (4)

A
  1. FRAUD
  2. INADEQUATE CORPORATE GOVERNANCE, EXCESSIVE COMPENSATION
  3. DISAGREEMENT WITH STRATEGY, specifically large mergers and acquisitions.
  4. CONTRIBUTIONS TO POLITICIANS

In general, shareholders tend to engage more over long-run strategic issues (e.g. firm’s strategy for overseas markets) than over short-term issues (e.g. low dividends, underperformance).

59
Q

Behind the Scenes: The Corporate Governance Preferences of Institutional Investors
Joseph A. McCathery, Zacharias Sautner, Laura T. Starks

What are proxy advisors?

A

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.

60% of respondents use at least one proxy.

60
Q

Behind the Scenes: The Corporate Governance Preferences of Institutional Investors
Joseph A. McCathery, Zacharias Sautner, Laura T. Starks

What are problems with proxy advisors?

A
  1. Proxy advisors ONLY COMPLEMENT INDIVIDUAL JUDGEMENT and do not imply that investors take passive governance role.
  2. Recommendations of proxy advisers can be TOO STANDARDIZED and ignoring firm-specific cases.
  3. Recommendations are also HARD TO EVALUATE due to LACK OF TRANSPARENCY in their criteria.
  4. They are profit-seeking organizations, are INCENTIVIZED TO CONDUCT LOW-COST ANALYSIS
  5. Some PROXY ADVISORS serve as CORPORATE GOVERNANCE ADVISORY FIRMS firms and make recommendations on voting at the SAME TIME. CONFLICT OF INTEREST might arise.
61
Q

Active Ownership
Elroy Dimson, Oguzhan, Karakas Xi Li

What is the motivation of the paper?

A

Socially responsible investing that seeks to deliver social as well as financial benefits, has attracted increasing attention.

$59tn assets (in 2015) are estimated to be managed by companies incorporating environmental, social and governance (ESG) concerns in their decisions.

While traditional activism of mutual and hedge funds focuses on issues related to shareholders only, ESG activism advocates for the interest of a broader range of stakeholders (e.g. employees, customers, creditors).

However, there is a general ambiguity surrounding the most basic principles of ESG activism: what companies are targeted, what determines its success, how does it affect firm performance

62
Q

Active Ownership
Elroy Dimson, Oguzhan, Karakas Xi Li

Describe typical ESG activities

A

Environmental engagements (E) - climate change, water issues.

Social concerns (S) - human rights, public health and labor standards.

Governance (G) - audit and control, executive compensation

63
Q

Active Ownership
Elroy Dimson, Oguzhan, Karakas Xi Li

Describe Theoretical Effects of Corporate Social Responsibility (CSR) (3).

A
    • CSR practices are based on LONG-TERM STRATEGY on company value, consistent with the interests of institutional investors (e.g. pension funds). Firm value should increase!
    • CSR businesses act as a CHANNEL TO EXPRESS PERSONAL VALUES on behalf of their stakeholders. Delegated philanthropy saves time and information costs of doing charity on one’s own. Firm value should increase!
    • CSR activities are management-initiated, opposed by shareholders, thus revealing AGENCY PROBLEMS. Milton Friedman: corporation should not do charity with others’ money. Firm value should decrease!
64
Q

Active Ownership
Elroy Dimson, Oguzhan, Karakas Xi Li

Describe 4 channels through which ESG activities can
increase firm value.

A
  1. CONSUMERS: Socially conscious consumers have a greater customer loyalty and are willing to pay premium for ESG-induced product differentiation.
  2. EMPLOYEES: Firms with higher employee satisfaction due to social engagement (e.g. diversity) tend to outperform the market.
  3. MORALS: More “virtuous” companies attract broader clientele than “sinful” companies.
  4. PROGRESSIVENESS: Successful ESG interventions signal similarly successful future interventions as well as firm’s openness to improvements in other areas.
65
Q

Active Ownership
Elroy Dimson, Oguzhan, Karakas Xi Li

What are 2 types of engagement in ESG issues by managers?

A
  1. RAISING AWARENESS – warning companies about certain ESG issues.
  2. REQUEST FOR CHANGE – specific changes are asked (more strict step).
66
Q

Active Ownership
Elroy Dimson, Oguzhan, Karakas Xi Li

Why do engagements on environmental and social issues have lower success rate than on corporate governance?

A
  1. Managers doubt the value of engaging in costly project to potentially benefit non-shareholders.
  2. ESG engagement is less aggressive compared to hedge funds’ activism.

Engagements on environmental and social issues have
considerably lower success rate (13.1%) than on corporate governance (24.2%). CG success rate still lags far behind hedge funds’ track record.

67
Q

Active Ownership
Elroy Dimson, Oguzhan, Karakas Xi Li

What are 2 factors when the likelihood of the successful engagement increases?

A
  1. There is successful prior engagement with the same firm.

2. Other shareholders collaborate

68
Q

Active Ownership
Elroy Dimson, Oguzhan, Karakas Xi Li

What are 4 determinants of successful ESG engagement?

A
  1. LARGE AND MATURE FIRMS. Economies of scale enable such companies to consider investing to ESG practices. Constant public coverage also increases reputational concerns.
  2. INSTITUTIONAL OWNERSHIP. Other socially conscious investors (e.g. pension funds) increase the chances of collaboration.
  3. UNDER PERFORMING FIRMS. Lower profitability, stock returns, inferior corporate governance – potential room for improvement.
  4. CONSUMER INDUSTRIES. Consumer-facing and brand-driven firms are more likely succumb to reputational concerns (e.g. Nike).
69
Q

Active Ownership
Elroy Dimson, Oguzhan, Karakas Xi Li

What are factors more important for environmental and social engagement than for corporate governance activism?

A

Compared to CG activism, ES engagement specifically prefers large sized, consumer-based firms, having financial capacity to change and caring for reputation. Collaboration with other shareholders is more important than the stake size.

70
Q

Active Ownership
Elroy Dimson, Oguzhan, Karakas Xi Li

What are the firm benefits to engagement in ESG?

A
  1. Mere ESG engagement generates 2.3% abnormal RETURN of firm stock value. If engagement is successful, abnormal one-year return increases to 7.1% and flattens after.
  2. Successful ESG activism also DECREASES stock VOLATILITY (the firm becomes less risky).
  3. There is NO REACTION market reaction AFTER UNSUCCESSFUL engagement. (win-win situation)
  4. Effect on stock market values: ESG activism lies between traditional shareholder activism and hedge fund activism.

Side note: ESG improvements in the target firms are not a result of superior future performance (as argued before)

71
Q

Active Ownership
Elroy Dimson, Oguzhan, Karakas Xi Li

Please compare CG and ES activities effects on the firm

A
  1. Abnormal returns are highest on corporate governance (8.6%) and climate change issue (10.3%) engagements.
  2. Compared to CG, ES (environmental and social) activism results in higher sales and employee efficiency – consistent with the argument of higher customer base and employee loyalty.
72
Q

Active Ownership
Elroy Dimson, Oguzhan, Karakas Xi Li

If ESG policies are so beneficial, why firms might not voluntarily pursue these strategies? (2)

A
  1. Targeted firms have poorer corporate governance hindering the initiation of ESG policies.
  2. In the absence of active owners, companies might fail to identify ESG opportunities.
73
Q

Active Ownership
Elroy Dimson, Oguzhan, Karakas Xi Li

What are the main conclusions? (2)

A
  1. ESG activism increases stakeholder value when engagements are successful and does not destroy value even when activism fails. It’s a win-win lottery.
  2. Responsible investment initiatives are less confrontational, more collaborative and benefits society at large.
74
Q

The Agency Problems of Institutional Investors
Lucian A. Bebchuk, Alma Cohen, Scott Hirst

Describe how institutional investors have evolved.

A

Widely held corporations with dispersed ownership among small shareholders have been prevalent in the US since early 20th century.

Times are changing: institutional investors saw a rise in the recent decades (from 6.1% of US corporate equity in 1950 to 63% in 2016).

By aggregating the assets of investors, institutional investors hold substantial stakes in corporations to have non-negligible effect when voting.

75
Q

The Agency Problems of Institutional Investors
Lucian A. Bebchuk, Alma Cohen, Scott Hirst

What are stewardship activities? Name 3

A

Engagement with public companies to promote corporate governance practices that are consistent with encouraging long-term value creation for shareholders in the company.

  1. Voting in shareholder meetings (and being informed when voting)
  2. Monitoring corporate managers
  3. Engaging with the management (using voice and exit)

Stewardship activities, expected from the funds, require substantial costs. Performance of these duties is under the discretion of the investment manager. Is he/she fully reliable?

76
Q

The Agency Problems of Institutional Investors
Lucian A. Bebchuk, Alma Cohen, Scott Hirst

What kind of institutional investors are looked at in this reading? (3)

A

Investment funds - Investment funds pool together the assets of many individuals and invest them in a diversified portfolio of securities.

  1. Index funds (Passive)
  2. Active funds (most of them are “closet indexers”)
  3. Hedge funds (very active)
77
Q

The Agency Problems of Institutional Investors
Lucian A. Bebchuk, Alma Cohen, Scott Hirst

Why have Index Funds been growing in popularity?

A
  1. Recognition of their low costs
  2. Tax advantages
  3. Evidence that they actually outperform actively managed funds.
78
Q

The Agency Problems of Institutional Investors
Lucian A. Bebchuk, Alma Cohen, Scott Hirst

What are the agency problems named in the reading? Name 4

A
  1. Costs and compensation
  2. Index Tracking
  3. Active Funds
  4. Private costs
79
Q

The Agency Problems of Institutional Investors
Lucian A. Bebchuk, Alma Cohen, Scott Hirst

Why are costs and compensation agency problems leading to less engagement in stewardship activities?

A

Investment managers of index funds bear full costs of stewardship, but capture only a fraction (as low as 0.12%) of benefits created, because compensation is based on fixed % of assets under management.

Thus, investment manager only undertakes a stewardship if its cost is less than its payoff for her, still based on a fraction of increased value of assets.

80
Q

The Agency Problems of Institutional Investors
Lucian A. Bebchuk, Alma Cohen, Scott Hirst

Funds try to increase the capacity of stewardship by increasing assets under management. How do they measure it?

A
  1. Relative to the index:
    If an index fund spends on stewardship and increases the value of a portfolio this also increases the value of the tracked index, leaving performance relative to it unchanged.
  2. Relative to the the rivals:
    Rivals following the same index experience the same % increase in value.
81
Q

The Agency Problems of Institutional Investors
Lucian A. Bebchuk, Alma Cohen, Scott Hirst

Why are Index funds engaging stewardship activities creating a free-rider problem?

A

Index funds engaging in stewardship do not improve relative performance to attract more assets (because they improve the whole index that others have invested in). Their investors are in fact incentivized to switch to their competitors that free ride on others’ expenses, as they offer the same return without higher fees to finance it.

Example:Index fund Vanguard employs only about 15 staff for voting and stewardship at its 13,000 portolio companies.

82
Q

The Agency Problems of Institutional Investors
Lucian A. Bebchuk, Alma Cohen, Scott Hirst

Describe the agency problem of active funds

A

Most of the active funds are “closet indexers” (i.e. they are not so active) whose holdings highly overlap with the benchmark index, differing only by under- and over- weighting some stocks.

They also capture only a small fraction of benefits arising from stewardship activities.

If stewardship increases the value of an underweight company, index (and funds that track it) benefits more than the active fund, even decreasing its performance relative to the index.

On the contrary, to improve performance relative to the index, increasing the value of an overweight stock actually works.

These relationships are more complex for mutual fund families that organize several funds under one management where multidimensional decision-making takes place, i.e. which funds would be favoured by certain actions.

83
Q

The Agency Problems of Institutional Investors
Lucian A. Bebchuk, Alma Cohen, Scott Hirst

Why are private costs driver of agency problem?

A

Investment managers often run both investment fund and investment services (e.g. cash management, short and long term investments) firms

Investment managers might bear additional private costs (e.g. losing revenue, reputation) from taking positions that corporate managers disfavor.

If stewardship opposes corporate management, investment managers are only willing to undertake a stewardship if the fraction-based payoff is larger than stewardship costs plus private costs.

Investment funds with more business ties with corporations are in fact documented to make more pro-management decisions and avoid aggressive stewardship.

84
Q

The Agency Problems of Institutional Investors
Lucian A. Bebchuk, Alma Cohen, Scott Hirst

What is considered the agency problem in the reading?

A

Institutional investors might not act in the best interest of their clients – institutional investors might not engage in stewardship activities or might not invest enough in stewardship activities because they have no incentives to do so.

Agency problems of institutional investors prevent the full realization of the potential benefits of the increased concentration of shareholders.

85
Q

The Agency Problems of Institutional Investors
Lucian A. Bebchuk, Alma Cohen, Scott Hirst

Why are hedge funds not faced with the agency problem as much as mutual funds?

A
  1. Typical hedge fund manager fee is based on the “2 and 20” scheme. Thus, hedge funds capture a larger value increase compared to the mutual funds.
  2. Hedge funds do not offer consulting or money management services for corporations, thus are not afraid of taking positions adverse to corporate managers- no conflict of interests.
  3. Hedge funds hold significant (10%+) stakes in a few companies, capturing much more value from stewardship activities relative to mutual funds or the index.
  4. Hedge funds devote more person-per-hour and have representatives on the board of directors in each company in their portfolio
  5. The returns of activist hedge funds are weakly correlated with each other. Every slight performance difference signals fund superiority.
86
Q

The Agency Problems of Institutional Investors
Lucian A. Bebchuk, Alma Cohen, Scott Hirst

What are the limitations of hedge funds regarding solving the agency problem?

A

Hedge fund managers spend on stewardship only when the resulting value increase is high enough to still give investors a reasonable return after higher fees are charged. Opportunities giving smaller returns are ignored.

To win proxy fights, hedge funds need to acquire support from other institutional investors, many of which suffer are not willing to oppose the management.

Some scholars argue that hedge funds focus on short term returns at the expense of long term value. Mutual funds, on the other hand, prefer long investment horizons.

Without mutual fund support, hedge funds are hardly a threat to the corporate management.

87
Q

The Agency Problems of Institutional Investors
Lucian A. Bebchuk, Alma Cohen, Scott Hirst

What are the main conclusions in the reading?

A

Investment managers have incentives to spend less on stewardship and side with managers than would be optimal for beneficial investors.

The rise of index funds, while having seen as a positive development, raise serious costs for corporate governance.

Modern corporations suffer not from too much shareholder intervention, but rather from too little.

88
Q

The Agency Problems of Institutional Investors
Lucian A. Bebchuk, Alma Cohen, Scott Hirst

What could be possible systematic improvements?

A
  1. Adopting disclosure regulations (e.g. on how voting takes place) that would enable beneficial investors identify and assess agency problems themselves.
  2. Adopting incentive-based compensation for mutual fund managers.

FE Readings (10 decks)

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