Investment Duration and Corporate Governance

• Author: Kee H. Chung,Youngjoo Lee
• DOI: http://doi.org/10.1111/ajfs.12080
• Published date: 01 February 2015
• Date: 01 February 2015

Investment Duration and Corporate

Governance*

Youngjoo Lee

Sogang Business School, Sogang University

Kee H. Chung**

School of Management, State University of New York at Buffalo and College of Business and Economics,

Chung-Ang University

Received 17 September 2014; Accepted 23 December 2014

Abstract

In this study we analyze the relation between institutional investment duration and corporate

governance using a new metric of investment duration that accounts for firm-specific invest-

ment durations of each institution. We conjecture that institutional investors that hold a

firm’s shares for a longer duration have greater incentives and ability to influence the firm’s

governance structure. Consistent with this conjecture, we find that a broadly defined index of

corporate governance increases with the duration of institutional ownership. We also show

that the relation between investment duration and corporate governance varies across differ-

ent types of institutions and across firms with different stock market liquidities.

Keywords Corporate governance; Institutional investors; Investment duration; Monitoring

incentive; Shareholder activism

JEL Classification: G20, G34

*This work was supported by the Sogang University Research Grant 201210050.01. The

authors thank Daisy Chung, Kenneth Kim, Alexandra Niessen, Jhinyoung Shin, Cristian Tiu,

Sean Yang, Woongsun Yoo, and seminar participants at SUNY-Buffalo and session partici-

pants at the Financial Management Association (FMA) conference and the Ninth Annual

Conference on Asia-Pacific Financial Markets (CAFM) for their valuable comments and sug-

gestions. Earlier versions of this paper were circulated under the title “Shareholder Activism

and Corporate Governance: The Role of Institutional Investors.” The usual disclaimer

applies.

**Corresponding author: Kee H. Chung, Department of Finance and Managerial Economics,

School of Management, State University of New York (SUNY) at Buffalo, Buffalo, NY 14260,

USA. Tel: 716-645-3262, Fax: 716-645-3823, email: keechung@buffalo.edu.

Asia-Pacific Journal of Financial Studies (2015) 44, 24–58 doi:10.1111/ajfs.12080

24 ©2015 Korean Securities Association

1. Introduction

The role of institutional investors in various financial interactions has received

increasing attention from both public media and academia as the level of institu-

tional ownership in United States corporations has increased dramatically during

the last two decades.

1

In this study we investigate institutional shareholder activism

by analyzing the relation between institutional investment duration (INVDUR) and

a broadly defined index of corporate governance (CGINDEX).

2

The extent to which

institutional investors can influence a firm’s governance structure is likely to depend

on how long they have held the firm’s shares because investment duration affects

their incentives and abilities to influence corporate governance. Institutional inves-

tors with short investment duration have little incentive to spend resources on

corporate governance because they are not likely to remain shareholders and cap-

ture future benefits. In addition, they have less time to learn about the firm and

thus are less able to interfere with the firm’s management due to the lack of exper-

tise and knowledge.

Many institutions index a large portion of their portfolio. For example, Carleton

et al. (1998) find that TIAA-CREF indexes 80% of its domestic equity portfolio.

Large ownership and indexing strategy provide institutional investors with incen-

tives to interfere with management and pursue an activist agenda because they can-

not simply vote with their feet. Prior research finds evidence that institutional

efforts to improve corporate governance and/or firm performance pay off because

they bring benefits to shareholders. For instance, Brav et al. (2008) find that Sche-

dule 13D filings by hedge funds with an activist agenda are associated with positive

abnormal stock returns.

3

Klein and Zur (2009) also find that firms targeted by

activist institutional investors exhibit positive abnormal stock returns around the

initial Schedule 13D filing date and over subsequent periods.

4

Our study contributes to a growing literature that analyzes various ramifications

of investment duration for corporate decisions and market valuation. Gaspar et al.

(2005) find that firms held by short-term investors have a weaker bargaining

1

The Conference Board reports that institutional ownership in the largest 1000 United States

corporations increased from 46.6% in 1987, to 61.4% in 2000, and then to 73% by the end

of 2009.

2

Instead of engaging in shareholder activism, institutional investors may vote with their feet

(i.e. sell shares) when they are dissatisfied with a firm’s management. For example, Parrino

et al. (2003) show that aggregate institutional ownership and the number of institutional

investors decline in the year prior to forced CEO turnover.

3

Investors are required to file Schedule 13D with the SEC within 10 days of transaction after

they acquire more than 5% of any class of a company’s shares.

4

Han et al. (2014) find evidence that good corporate governance helps protect shareholder

value by mitigating information asymmetries between managers and shareholders. Kim et al.

(2013) show that firms with a greater level of governance transparency have a higher firm

value.

Investment Duration and Corporate Governance

©2015 Korean Securities Association 25

position in acquisitions. Yan and Zhang (2009) analyze the relation between institu-

tional trading and future earnings surprises and find that short-term institutions

are better informed than long-term institutions. Cella et al. (2013) show that insti-

tutional investors with short trading horizons magnify the impact of market-wide

negative shocks on share price. Derrien et al. (2013) hold that longer investor hori-

zons attenuate the effect of stock mispricing on various corporate policies.

5

Gaspar

et al. (2013) examine how shareholder investment horizons influence payout policy

choices and show that firms held by short-term investors make repurchases more

often because they care mostly about the short-term price reaction. Harford et al.

(2012) show that firms with longer investor horizons hold more cash and are more

likely to invest in projects with long-term payoffs.

Despite the different roles of long- and short-term institutional investors in

shareholder activism and their potential impact on corporate governance, prior

research provides limited evidence on the issue. Chen et al. (2007 ) conjecture that

only independent institutions with long-term investments make efforts to monitor

and influence managers.

6

In support of this conjecture, they show that only concen-

trated holdings by independent long-term institutions are related to post-merger

performance and the presence of these institutions increases the probability of bad

bid withdrawals. Attig et al. (2012) show that the sensitivity of corporate investment

outlays to internal cash flows is lower with the presence of long-term institutional

investors and interpret this result as evidence that long-term institutional investors

have greater incentives to monitor managers. In a similar vein, Attig et al. (2013)

show that the cost of equity decreases with the presence of long-term institutional

investors. We extend the literature of investment duration (or horizon) by analyzing

the impact of institutional investment duration on corporate governance.

Previous studies (e.g. Bushee, 1998; Gaspar et al., 2005) determine whether an

institution is a long- or short-term investor based on the average turnover ratio or

holding period of its entire portfolio of stocks. This method could be problematic

because it considers an institution a short-term investor if its average turnover ratio

is high although its turnover ratios for some stocks could be quite low. Generally,

institutional investors hold a large number of stocks, and their investment strategies

and holding periods vary considerably across stocks in their portfolio. An institu-

tion may be actively involved with a firm’s management and governance as a long-

term investor, but may be a passive investor with short investment horizons in

other firms. The present study analyzes the effect of investment duration on corpo-

rate governance using a new metric that accounts for firm-specific investment dura-

tions of each institution. Specifically, we measure the mean institutional holding

5

Derrien et al. (2013) show that when a firm is undervalued, greater long-term investor own-

ership is associated with more investment, more equity financing, and less payouts to share-

holders.

6

Chen et al. (2007) define long-term institutions as those institutions that hold a firm’s

shares for more than 1 year.

Y. Lee and K. H. Chung

26 ©2015 Korean Securities Association