The Wall Street Walk when Blockholders Compete for Flows

• Author: GIORGIA PIACENTINO,AMIL DASGUPTA
• Date: 01 December 2015
• Published date: 01 December 2015
• DOI: http://doi.org/10.1111/jofi.12308

THE JOURNAL OF FINANCE •VOL. LXX, NO. 6 •DECEMBER 2015

The Wall Street Walk when Blockholders

Compete for Flows

AMIL DASGUPTA and GIORGIA PIACENTINO∗

ABSTRACT

Effective monitoring by equity blockholders is important for good corporate gover-

nance. A prominent theoretical literature argues that the threat of block sale (“exit”)

can be an effective governance mechanism. Many blockholders are money managers.

We show that, when money managers compete for investor capital, the threat of exit

loses credibility, weakening its governance role. Money managers with more skin

in the game will govern more successfully using exit. Allowing funds to engage in

activist measures (“voice”) does not alter our qualitative results. Our results link

widely prevalent incentives in the ever-expanding money management industry to

the nature of corporate governance.

EQUITY BLOCKHOLDERS IN PUBLICLY traded corporations who are dissatisfied with

the actions of company management can sell their blocks—the so-called “Wall

Street Walk.” A growing theoretical literature starting with Admati and Pflei-

derer (2009) and Edmans (2009) argues that the Wall Street Walk can be an

effective form of governance. The exit of a blockholder will typically depress

the stock price, punishing management whenever executive compensation is

linked to the market price of equity. Thus, faced with a credible threat of exit,

management will be reluctant to underperform. Admati and Pfleiderer argue

that, when blockholders observe managers underperforming, it is in their own

interest to exit early before information about the manager’s underperformance

becomes public. This makes exit a credible threat that ameliorates managerial

underperformance and enhances firm value. Edmans argues that informed in-

stitutional trading enhances the informational efficiency of the firm’s equity in

∗Dasgupta is at the London School of Economics, and is affiliated with CEPR and ECGI. Pia-

centino is at the Olin Business School at Washington University in St Louis. Wethank the referee,

Associate Editor, and Editor, Cam Harvey, for insightful input. We are grateful to Ulf Axelson,

Alon Brav, Elena Carletti, Alex Edmans, Simon Gervais, Oliver Hart, Wei Jiang, Arvind Krish-

namurthy, Yan Li, Xuewen Liu, Mark Lowenstein, Andrey Malenko, Gustavo Manso, David Reeb,

Zacharias Sautner, Rik Sen, Anand Srinivasan, Dimitri Vayanos, Michela Verardo, Ernst Ludvig

von Thadden, Liyan Yang, and audiences at AFA 2013, Amsterdam, Cambridge, Duke Fuqua,

EUI Florence, FIRS 2012, HKUST, Imperial, Leicester, LSE, Mannheim, Northwestern Kellogg,

Nottingham, NUS, Rome Tor Vergata, Stockholm, Tilburg, WFA 2012, the 5th Conference of the

Paul Woolley Centre, and UCL for helpful comments. We thank the Paul Woolley Centre at LSE

for financial support. Dasgupta thanks the Faculty of Economics at Cambridge University for its

kind hospitality. We have read The Journal of Finance’s disclosure policy and have no conflicts of

interest to disclose.

DOI: 10.1111/jofi.12308

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the secondary market, enabling myopic managers to make better investment

decisions.

The theoretical literature on exit treats the blockholder as a profit-

maximizing principal: she acts as an individual owner of an equity block would.

In contrast, a significant proportion of equity blocks is held by delegated port-

folio managers who manage money for others (for example, mutual funds and

hedge funds).1This matters because money managers often face short-term

incentives that may lead them to behave in ways that are not conducive to

good corporate governance. For example, as the European Commission’s 2011

Green Paper “The EU Corporate Goverence Framework” notes (p. 12–13),

It appears that the way asset managers’ performance is evalu-

ated...encourages asset managers to seek short-term benefits ...The

Commission believes that short-term incentives ...maycontributesignif-

icantly to asset managers’ short-termism, which probably has an impact

on shareholder apathy.

An important reason why money managers may not take a long-term view

is that their investors chase short-term performance, which generates well-

documented short-term flow-performance relationships.2In this paper we build

on Admati and Pfleiderer (2009) to study how the presence of (endogenous)

short-term flow-performance relationships affects the ability of delegated block-

holders to govern via the threat of exit. Our key observation is that, when funds

differ in stock picking ability,exit may be informative about the fund manager ’s

skill and thus affect investor flows. We show that this signaling role of exit

impairs its disciplinary potential. The perverse effect of flow-performance rela-

tionships operates through both linear assets under management (AUM) fees

and convex performance fees (carried interest or “carry”)—the two components

of standard “two and twenty” contracts. Thus, common contractual arrange-

ments in money management foster endogenous short-termism and impair the

effectiveness of exit. We show that offsetting, long-term incentives arise from

the degree to which the fund manager self-invests in her fund: whether a money

manager can successfully govern via the threat of exit depends on the degree

to which she has skin in the game.

We analyze a three-date model with many funds, investors, and firms. Each

fund uses a combination of investor capital and proprietary resources (self-

investment) to hold a block in a firm. Funds are compensated via a combination

of AUM fees and carried interest. At the initial date, each firm manager takes

1Institutional money managers hold over 70% of U.S. equity (see, for example, Gillan and

Starks (2007)), and a significant measure of these holdings is quite concentrated. For example,

Hawley and Williams (2007) show that, in 2005, the 100 largest U.S. institutions owned 52% of

publicly held equity. Gopalan (2008) notes that in 2001 almost 60% of NYSE-listed firms had an

institutional blockholder with at least 5% equity ownership.

2See, for example, Brown, Harlow, and Starks (1996) and Chevalier and Ellison (1997,1999)

for mutual funds, and Agarwal, Daniel, and Naik (2009) and Lim, Sensoy,and Weisbach (2013)for

hedge funds.

The Wall Street Walk 2855

actions that affect firm performance. Each fund can observe whether the man-

ager of the company in which she owns a block underperforms and may then

sell the block at the interim date before the market learns about managerial

actions. At the final date, uncertainty resolves and consumption occurs.

Funds differ in their ability as stock pickers. Funds that are good stock pick-

ers are more likely to invest in companies with better corporate governance.

In such companies, management is less likely to underperform, making block-

holder exit less likely to be necessary. Investors observe the returns generated

by all funds at the interim date, make inferences about stock picking ability,

and allocate their money accordingly.The inferences about funds’ stock picking

ability are relevant because, following the interim date, funds have access to

further investment opportunities, the quality of which are again determined

by their stock picking skills: good stock pickers have access to better opportu-

nities. Accordingly, investors rationally use the interim performance of funds

to make capital allocation decisions.

Suppose that a fund—after acquiring a block in a company—observes that

management is underperforming. The fund can either sell her block in the

underperforming company at the interim date (that is, exit) or wait until the

final date. If she sells early, she may be able to hide her trade behind market

noise and sell her block at a price not reflecting the full reduction in value

implied by management underperformance. If she waits and sells later, she

will liquidate her block at a lower price. Thus, to the extent that the fund

cares directly about her portfolio value due to her self-investment, she will be

inclined to exit.

However, the fund may also be concerned about inferences made in the short

term by investors, which may affect her payoffs via endogenous flows. If she

sells the block early,she will hurt her short-term return relative to other funds,

causing an earlier loss of investor flow. In contrast, if she does not sell her block

early but some other funds do, her short-term return relative to others will

be improved—she will not only keep her own investors, but may also attract

investors from other funds (who may have sold their underperforming blocks

early and thus underperformed). Of course, there will be a price to pay later

in terms of lowered liquidation value. In the meanwhile, however, the fund

will earn AUM fees by retaining her own investors and attracting new ones.

Selling the block early also reduces carried interest: not only will a sale reduce

current carry by lowering today’s marked-to-market portfolio value, but, due

to endogenous outflows, it will also reduce fund size, and thereby limit access

to new investments and reduce future carry. Thus, given flow-performance

relationships, the presence of AUM fees and carried interest discourages funds

from exiting.

Our main result (Proposition 2) formalizes this trade-off. We show that, when

delegated blockholders do not have sufficient self-investment, and when good

and bad funds are sufficiently different (so that investors chase performance),

the threat of exit cannot be credible in equilibrium. The applied implication

of our result is that funds’ ability to govern via exit will be determined by the

relative strength of contractual incentives and self-investment. For a given