Behind the Scenes: The Corporate Governance Preferences of Institutional Investors

• Published date: 01 December 2016
• Date: 01 December 2016
• Author: LAURA T. STARKS,JOSEPH A. McCAHERY,ZACHARIAS SAUTNER
• DOI: http://doi.org/10.1111/jofi.12393

THE JOURNAL OF FINANCE •VOL. LXXI, NO. 6 •DECEMBER 2016

Behind the Scenes: The Corporate Governance

Preferences of Institutional Investors

JOSEPH A. McCAHERY, ZACHARIAS SAUTNER, and LAURA T. STARKS∗

ABSTRACT

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. These gover-

nance mechanisms are viewed as complementary devices, with intervention typically

occurring prior to a potential exit. We further find that long-term investors and in-

vestors that are less concerned about stock liquidity intervene more intensively. Fi-

nally,we find that most investors use proxy advisors and believe that the information

provided by such advisors improves their own voting decisions.

THEORETICAL AND EMPIRICAL research on corporate governance makes assump-

tions and draws inferences about the role of institutional investors. Yetwe have

little direct knowledge regarding how institutional investors engage with port-

folio companies, as many of these interactions occur behind the scenes—unless

institutions publicly express their approval or disapproval of a firm’s activi-

ties or management, their preferences and private engagements with portfolio

∗Joseph McCahery is with Tilburg University. Zacharias Sautner is at the Frankfurt School of

Finance & Management. Laura T.Starks is at the McCombs School of Business, University of Texas

at Austin. This manuscript is a revision of an earlier version circulated under the same name but

based on a different survey. We are grateful to Campbell Harvey, John Graham, Michael Roberts,

an Associate Editor, anonymous referees, those who helped distribute our survey, and most of

all, to the anonymous respondents to the survey. We would also like to thank Donna Anderson,

Marco Becht, Alon Brav, Stephen Brown, Mark Coffeldt, Jonathan Feigelson, Merrit Fox, Stuart

Gillan, Allaudeen Hameed, Bram Hendricks, Paulus Ingram, Jacqueline Johnson, Sanford Leeds,

Amir Licht, Florencio Lopez-de-Silanes, Enrico Perotti, Randall Thomas, and David Yermack for

additional help with the survey design and delivery. We further benefitted from the comments

of Renee Adams, Ines Chaieb, Steve Choi, Amil Dasgupta, Alex Edmans, R¨

udiger Fahlenbrach,

Miguel Ferreira, Marc Gabarro, Mariassunta Giannetti, Ross Levine, Kai Li, Florencio Lopez-de-

Silanes, Ernst Maug, Alexander Nagornov,Enrico Perotti, Luc Renneboog, Armin Schwienbacher,

Holger Spamann, Ren´

e Stulz, Randall Thomas, Jaap Winter, and seminar participants at the

ABFER Meetings, French Finance Association Meetings, AFA Meetings, EFA Meetings, FMA

Asia, FIRS, ALEA Meetings, Harvard Conference on Corporate Governance, the Conferences on

Innovation and Business Law,the Rotterdam Workshop on Executive Compensation and Corporate

Governance, the Vanderbilt/Amsterdam Conference in Cagliari, the LUISS/Tilburg Conference in

Rome, WU Endowment Conference, Ohio State University,Seoul National University, ETH Zurich,

University of Melbourne, University of Amsterdam, and University of Queensland. We have read

the Journal of Finance’s disclosure policy and have no conflicts of interest to disclose.

DOI: 10.1111/jofi.12393

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2906 The Journal of Finance R

firms are not observable.1In this paper, we help fill this knowledge gap by

conducting a survey of institutional investors.

As early as Hirschman (1970), researchers have highlighted two choices

available to institutional investors when they are unhappy with a portfolio

firm: (i) they can engage with management to try to effect change (“voice” or

direct intervention), or (ii) they can leave the firm by selling shares (“exit” or

“voting with their feet”). Theoretical models document the governance benefits

of corrective actions through voice,2and show that the threat of exit can also

discipline management.3This raises the question of whether institutional in-

vestors, when dissatisfied with portfolio firms, take actions that are consistent

with these theories.

Our survey’s 143 respondents, mostly very large institutional investors with

a long-term focus, indicate that voice, especially when conducted behind the

scenes, is important. For example, 63% of respondents state that in the past

five years they have engaged in direct discussions with management, and 45%

state that they have had private discussions with a company’s board outside

of management’s presence.4In addition, we find 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 about a firm’s corporate governance or strategy than

about short-term issues. These findings support the view that interventions are

not driven by short-term, myopic activists who simply aim to reap short-term

gains (e.g., Bebchuk, Brav, and Jiang (2015)).

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.

We also find that investors who are more concerned about liquidity (and hence

probably hold more liquid stocks) use voice less intensively. This result is con-

sistent with Coffee (1991), Bhide (1993), and Back, Li, and Ljungqvist (2014),

who argue that market liquidity discourages intervention.

A challenge arises in analyzing whether institutional investors use the threat

of exit and whether this mechanism is effective in inducing changes in man-

agement behavior, as the threat of exit is, by definition, unobservable—if the

threat is credible, exit does not take place. Our survey sheds light on the exit

mechanism by asking institutions whether they use exit as a governance de-

vice and whether they believe that the threat of exit is effective in disciplining

management.

The investors in our survey view exit as a viable strategy, with 49% (39%)

stating that they had exited a portfolio firm over the past five years because

1For recent anecdotal evidence on behind-the-scenes activism, see Burr (2012).

2See, for example, Shleifer and Vishny (1986), Huddart (1993), Admati, Pfleiderer,and Zechner

(1994), Maug (1998), Kahn and Winton(1998), Bolton and v onThadden (1998), and Faure-Grimaud

and Gromb (2004).

3See Admati and Pfleiderer (2009), Edmans (2009), and Edmans and Manso (2011).

4In the survey, we explicitly asked about engagement through discussions, rather than casual

conversations at, for example, investor relations events.