Exit as Governance: An Empirical Analysis

• Author: VENKY NAGAR,SUDARSHAN JAYARAMAN,SREEDHAR T. BHARATH
• Date: 01 December 2013
• Published date: 01 December 2013
• DOI: http://doi.org/10.1111/jofi.12073

THE JOURNAL OF FINANCE •VOL. LXVIII, NO. 6 •DECEMBER 2013

Exit as Governance: An Empirical Analysis

SREEDHAR T. BHARATH, SUDARSHAN JAYARAMAN, and VENKY NAGAR∗

ABSTRACT

Recent theory posits a new governance channel available to blockholders: threat of

exit. Threat of exit, as opposed to actual exit, is difficult to measure directly.However,

a crucial property is that it is weaker when stock liquidity is lower and vice versa. We

use natural experiments of financial crises and decimalization as exogenous shocks

to stock liquidity. Firms with larger blockholdings experience greater declines (in-

creases) in firm value during the crises (decimalization), particularly if the manager’s

wealth is sensitive to the stock price and thus to exit threats. Additional tests suggest

exit threats are distinct from blockholder intervention.

TRADITIONAL THEORIES OF BLOCKHOLDER governance focus primarily on block-

holder intervention in management decisions. However, recent theories posit

that blockholders can govern firms even when they have no intervention power.

These theories view blockholders as informed traders who control manage-

ment through “exit,” that is, selling a firm’s stock based on private information

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

Blockholder exit in these models exerts downward pressure on the stock price,

which hurts management through its equity interest in the firm. Management

therefore wants to make sure its actions are such that blockholders are willing

to stay with the firm.

When blockholders are informed traders, management undertakes produc-

tive effort and investment to improve firm value and dissuade blockholders

from exiting. The true governance force therefore comes from the threat of

blockholder exit, not actual exit. Even if no exit is observed, blockholders could

be governing effectively because their exit threat is sufficient to discipline man-

agement.

This study is a first attempt to empirically test the governance impact of

blockholder exit threats. Since threats cannot be directly observed, this study

∗Sreedhar T. Bharath is with Arizona State University, Tempe; Sudarshan Jayaraman is with

Washington University in St. Louis; and Venky Nagar is with the University of Michigan. We are

especially grateful to main reviewer, whose contribution to improving the paper was significant

and substantial. We are also grateful to Editor Campbell Harvey, the Associate Editor, and a final-

stage advisory reviewer for their detailed suggestions. In addition, we thank Anat Admati, Yakov

Amihud, Alex Edmans, and workshop participants and discussants at Emory University, the GIA

conference hosted by the University of North Carolina at Chapel Hill, Indian School of Business,

Journal of Accounting, Auditing and Finance annual conference, Stanford University,the Western

Finance Association annual meeting, University of Alabama, University of Michigan, the Utah

Winter Accounting conferences, and Washington University. All errors remain our own.

DOI: 10.1111/jofi.12073

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focuses instead on a key mechanism that facilitates exit threats, namely, stock

liquidity. Exit threat models suggest that stock liquidity enhances the power of

exit threats and improves firm value. For example, in Edmans (2009)the man-

ager is compensated based on the stock price and can take fundamental actions

to improve firm value. Stock liquidity encourages strategic traders to acquire

more information on firm fundamentals and trade on it in larger volumes (or

blocks). The manager is sensitive to the resulting stock price, and therefore

takes actions to increase firm value and induce (informed) blockholders to stay.

Liquidity thus enhances the power of blockholder exit threats and improves

firm value. This theoretical prediction forms the basis of our empirical tests.

A full structural model of liquidity, blockholdings, and firm value is not only

difficult to construct, but also confounded by the fact that the finance literature

has not converged on a definitive measure of liquidity. We therefore bypass the

structural approach entirely, appealing instead to exogenous liquidity shocks.

We first examine two foreign financial crises, namely, the Russian default crisis

and the Asian financial crisis—unexpected exogenous events (from an individ-

ual firm’s perspective) whose duration was unknown at the time of their onset.

A significant body of work indicates that these events significantly decreased

liquidity in the U.S. stock market (Acharya and Pedersen (2005), Chordia,

Sarkar, and Subrahmanyam (2005)). Wetest how the association between firm

value (Q) and blockholding shifts around the above exogenous liquidity shocks.

We find that firms with larger block ownership were impacted significantly

more during these crises. A one standard deviation increase in block owner-

ship corresponds to a decrease in Qof about 4.1% during the crisis period, an

economically large effect.1Blockholder exit threats thus appear to be strongly

operating in our sample.

Due to the foreign nature of the above crises, we have some confidence in

positing that their impact on the U.S. stock market was primarily through

stock liquidity. However, it is possible that these crises affected Qdirectly. We

therefore pick a noncrisis candidate for an exogenous liquidity shock, namely,

the decimalization in early 2001 when the NYSE and Amex (and subsequently

NASDAQ) started quoting and trading their listed issues in dollars and cents

as opposed to increments of a sixteenth of a dollar. Decimalization is therefore

a liquidity-increasing shock. We expect and find a significantly greater increase

in firm value postdecimalization for firms with larger block holdings. The eco-

nomic magnitude is also significant, with a one standard deviation increase in

block ownership corresponding to an increase in Qof about 7.1%.

One concern with tests using liquidity shocks is that the observed results

could simply be an artifact of an ongoing trend, for example, if the association

between block ownership and firm value was trending downwards before the

crises and upwards before decimalization. In such a case, the continuation of

1We compute the effect of a one standard deviation increase in block ownership on Qduring the

crisis period, relative to the median Qin the sample, separately for the Russian (4.7%) and Asian

(3.5%) financial crises. We then average the effects for the two crisis periods to arrive at the 4.1%

figure.

Exit as Governance: An Empirical Analysis 2517

this trend would be an alternative explanation for our results. To alleviate this

concern, we run falsification tests by constructing periods of “pseudo-shocks” to

denote periods of equal length before the actual liquidity shocks (Russian crisis,

Asian crisis, and decimalization). We do not find any analogous significant

effects around pseudo-shocks, lending further confidence to our interpretation

that the effect of liquidity on the association between firm value and block

ownership is not due to trends, but rather to exit threats.

Finally, we conduct the same analysis for the recent U.S. financial crisis in

2008, and find strong results for this event as well. A one standard deviation

increase in block ownership corresponds to a decrease in Qof about 2.5% during

the crisis period. However, we are cautious in imputing this result solely to exit

threats. The economic impact of the recent crisis on our sample of U.S. firms

extended far beyond just liquidity shocks; the accompanying collapse of the

housing sector and the economic downturn also adversely affected firms’ fun-

damentals (e.g., demand for their products). It is therefore difficult to attribute

Q-based results around the U.S. financial crisis to just liquidity effects.2

The above-mentioned results on the role of stock liquidity in modulating the

association between blockholdings and firm value do not conclusively implicate

exit threats. Liquidity can improve firm valuation even when blockholders

govern through intervention (i.e., “voice”). For example, Maug’s (1998) model

shows that liquidity enhances voice because it allows the blockholder to buy

additional shares at a price that does not reflect the benefits of intervention.

Since both intervention and exit threats could be operating in the data, it is

important to separate the two. One distinction between intervention theories

and exit threat theories is that the sensitivity of managerial wealth to the

stock price (i.e., stock option delta) plays no direct role in the intervention

theories. By contrast, exit threat models predict that the threat of blockholder

exit will be more effective in firms whose managers’ wealth is more sensitive

to the stock price. Accordingly, we find that the impact of liquidity shocks on

the blockholder–firm value association is far more pronounced for firms whose

managers have a significant interest in the firm’s stock price.

We measure management’sinterest in the stock price through management’s

equity incentives. However, management’s equity position also confers control

rights, which could be valuable for deterring blockholder intervention. To test

this possibility,we conduct the analysis with management blockholdings rather

than management sensitivity to stock price, as it is the ownership of shares that

confers control rights. The results indicate that management blockholdings

do not drive our results. The insignificance of management blockholdings is

further consistent with exit threat theories, because, except in cases of severe

internal discord, management is unlikely to threaten itself with exit.

We next make another attempt to separate the threat of exit from interven-

tion. We assume that blockholder intervention, while prevalent, is likely to be

2Analogously, Lemmon and Lins (2003) argue that the Asian financial crisis imparted severe

shocks to investment and expropriation opportunities for firms in the home countries, which in

turn significantly altered these firms’ ownership–performance relations.