Guiding Seminar 3

Financial Economics 2021

Hleb Birylau
hbirylau@sseriga.edu

Huge gratitude to Akaki Tkeshelashvili

Agenda

1. A Survey of Corporate Governance (1997)

2. Private Benefits of Control: An International Comparison
(2004)
3. Behind the Scenes: The Corporate Governance Preferences of
Institutional Investors (2016)
4. Active Ownership (2015)
5. The Agency Problems of Institutional Investors (2017)
Why corporate governance as a topic is
cool
• Lets you see the underlying causes of the decisions
that from the outsider’s perspective seem stupid
• Explains why the models that we study in the
university don’t always work in the real world even
though they are consistent by themselves
• Teaches how to think about politics:
• The decision makers and their motivation are the only
important components of any political event
• Abstractions such as “firm” or “state” are useful in some
sense but are very dangerous when we try to reason about
the real world
1. A survey of corporate
governance

Andrei Shleifer
Robert W. Vishny
The big one with general overview of the
problem. Asks: “why would people even buy
equity?” Answers: “Because they get to make
decisions either (1) by being legally protected,
or (2) because the ownership is concentrated”
What is corporate governance?

▪ Corporate governance deals with the ways in which suppliers of

finance to corporations can assure themselves of getting a return on
their investment. Stems from the separation of ownership.
▪ The fundamental problem of corporate governance is how to assure
financiers that they get a return on their financialinvestment?
▪ CG mechanisms are economic and legal institutions (i.e. rules) that can
be adjusted by the political process.

▪ “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”
 What is the agency problem in the
context of CG?
▪ The general idea of the Agency problem is 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.
▪ 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. But such contracts are
infeasible!
▪ Instead, contracts should specify who has residual control rights
– i.e. who makes decisions in unforeseen circumstances.
▪ Managers are more skilled. As a consequence , managers have most of the residual
control rights.
▪ In practice, problems arise:
▪ Corporate contracts cannot require too much interpretation (i.e. cannot be
very complicated) – otherwise courts might not help (business judgment).
▪ Also, free-rider problem of shareholders. Even more control for managers!
 What are some of the bad things
that the management can do?
▪ Expropriation can happen via direct absconsion with the money as
well as more subtle ways - transfer pricing, empire building,
pursuing pet projects or entrenching in the position.
▪ Knowing this, investors are willing to provide less funds for the
firm. Lack of external financing!

▪ Possible solution - Incentive contracts : making managers

interested in increasing shareholder value (e.g. by share ownership,
stock options, threat of dismissal).
▪ However, with more information, they might know when earnings
are going to rise, manipulate accounting data, backdate options,
etc.
▪ Thus, incentive contracts can be turned into a mechanism of self-
dealing and is not a panacea to the agency problem.
What is the evidence for agency costs?
▪ If the stock price falls when managers announce a particular
action, this action must serve the interest of managers rather than
shareholders. For example, acquisition decisions!
▪ Manager’s resistance to the value-enhancing takeover or
adoption of Poison Pills signals the existence of PBOC (check
reading 2) and thus agency problems.
▪ Sudden deaths of executives sometimes increase the share price.
▪ Large blocks of shares carry more control and thus trade at a large
premium. Large blockholders receiving special benefits? (more in
reading 2)
How firms can raise money without giving
suppliers of capital any real power?
▪ Reputation building - Managers repay investors to establish
good reputation to ensure access to the capital markets in
the future.
▪ 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. For example, Ponzi schemes
like Bitconnect.
▪ Still, we do not believe that investors as a general rule are
prepared to pay good money for securities that are
actually worthless - because managers can steal
everything.
▪ Stronger explanation needed!

So what are some other approaches to

the problem, that explain why investors
invest at all?
Approach nr 1. Legal protection
▪ 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.
▪ Main legal rights of shareholders:
▪ 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; BoD is captured by the management.
▪ 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;
▪ Creditors are usually better protected legally, since default is a
straightforward violation of a contract and enforcement ismore
straightforward
▪ However, countries differ by legal obligations of the managers to
the financiers and by the ability of courts to enforce these
duties. In a fancy language, they differ by legal protection of
shareholders (!). As Stalin noted, "it is important not how people vote, but
who counts the votes,"
 Approach nr. 2 Large investors
▪ CF rights and control rights of large shareholders are better
aligned that addresses agency problem, preventing free-rider
problems. 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.
▪ Control can be also 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.
 What are the costs of large investors?
▪ Concentrated control diminishes some agency problems, but this
comes at a price.
▪ Large investors also bear larger financial consequences of their
actions due to lack of diversification (remember for reading 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.
▪ 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!
▪ Large investors might be too soft due to their own agency problems
(e.g. institutional investors). Ability to control does not materialize.
(check reading 5)
▪ Other: Close monitoring of managers and employees can lower their
incentives, large investors scare-away general public investment.
Contractual mechanisms (I): Debt versus
equity
▪ Perhaps, together with legal protection and concentrated
ownership some of the contractual arrangements can also
address agency problems of CG.
▪ 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 (!).
▪ Still, large shareholders or takeovers can make virtually all
corporate decisions in non-default times
▪ !Equity financing is reasonable for young firms with no
tangible assets (Venture Capital)
 Contractual mechanisms (II): LBOs
▪ 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.
Contractual mechanisms (III):
State ownership and cooperatives
▪ If large greedy investors expropriate other stakeholders, what if we
gave firms to cooperatives or the state to ensure maximum welfare
of the society?
▪ However, 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).
Conclusions
▪ Be it the US, Japan or Germany, there is no perfect corporate
governance system and the paper does not seek to establish one.
▪ Successful corporate governance 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.
▪ 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.
▪ In turn, minority investors should be protected from expropriation or else
very low value would be attributed to minority share blocks leading to
underdeveloped financial markets.
Exam questions
2. Private Benefits of Control: An
International Comparison

Alexander Dyck
Luigi Zingales The one where PBOCs are explained
and measured as the difference
between the controlling stake and
market value of the shares → more
PBOC = less stock market, more
Brazil and Russia, less competition
and weaker institutions
What are private benefits of control?
▪ PBOC – 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.

▪ PBOC involves costs. Maintaining a control

block means lack of diversification. +
Distressed companies might inflict
reputational losses or even legal liabilities to
the controllers.

▪ PBOC not always bad. Managers exploiting profitable

investments without company’s assent might actually create
value. Also, the existence of PBOC makes value- enhancing
and socially beneficial takeovers possible.
What are the two main ways of
measuring PBOC ?
▪ Difficult to measure directly. If PBOC were easily observable and
quantifiable, they would not be private and would be claimed by
minority shareholders in court.
▪ Two methods of quantifying PBOC are used:
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. If
there is a benefit of owning a company that is unique for an
incumbent, it is by definition impossible to find a buyer that
will agree on the value of PBOC in this case.
What affects the size of PBOC premium
(theoretically) ?
▪ The size of block traded. 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. The authors find someevidence.
▪ Presence of another large shareholder. If there is another large
shareholder - you have to share your PBOC – you are not happy - youpay
less. Not significant
▪ Sellers bargaining power - 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/can be negative
because of lack of investor’s diversification. The authors find some
evidence.
▪ Whether the buyer is a foreigner. Foreigners pay more (less
information and connections => more bargaining power for the
seller) The authors find some evidence.
What affects the size of PBOC premium
(theoretically) ?
▪ Industry. PBOC also differ across industries. Controlling a media
company gives you enormous power of manipulating public
opinion in personally beneficial ways. Not significant
▪ Tangibility of assets. 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
How PBOC affects financial development?
▪ In countries showing high PBOC, entrepreneurs are reluctant to
make their companies public because investors do not factor in
the control value (less IPOs)
▪ Potential buyers of smaller stakes also attribute less value to shares
taking into account being exploited by majority shareholders
(concentrated ownership)
▪ As a result, selling control in private negotiation is more profitable
than in the market with dispersed buyers buying many non-
controlling stakes (privately negotiated deals)
▪ Thus, three implications apply to countries with high PBOC:
1. Fewer companies are public, thus the equity markets are
underdeveloped which hinders firm financing.
2. Afraid of ending up in the minority position, incumbents seek to
retain control after going public, thus there should be less widely
held companies.
3. To maximize profit, governments should sell companies privately
rather than in public offerings.
 What curbs PBOC (theoretically)? (I)
Legal institutions:
1. The legal environment. 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.
2. Disclosure standards. The more extensive and accurate disclosed
information is, the more it curbs appropriation by increasing the risk of legal
consequences or reputational costs (SEC in the US). Works
3. Enforcement. Quicker, smoother and more predictable enforcement, the
stronger the legal protections of shareholders (e.g. the level of corruption
and bureaucracy of courts in the country).Works

In sum, they find that legal institutions are strongly associated with lower
levels of private benefits !!!
Works = the authors found some evidence to support the theory
Does not work = the authors did not find evidence to support the theory
 What curbs PBOC (theoretically)? (II)

Extra-Legal institutions

• The possibility of extracting private benefits is intrinsically related

to managerial discretion, i.e. the freedom managers have to
pursue their own objectives.
• Courts cannot easily restrict managerial discretion.
• On the contrary, Extra-Legal institutions may play an important
role in constraining private benefits, both in settings with legal
protections as well as in settings where legal protections are
nonexistent or not enforced.
What curbs PBOC (theoretically)? (II)
Extra-Legal institutions:
1. Product market competition. Through prices, competitive markets can
verify manipulated transfer prices. Competition also makes
tunneling more harmful to firm’s survival. Works
2. Public opinion pressure. Value appropriation can be limited
by expected reputational losses. Works
3. Moral norms. Value appropriation can not be undertaken
due to moral considerations. Religious traditions as a proxy?
Crime rate? Do not work
4. Labor as monitor. The risk of employees quitting due to dishonest
activities by majority shareholders. What if employees benefit from
PBOC? Does not work
5. Government as a monitor through tax enforcement. Through taxes the
state acts as an investor to all companies. It does not have agency/free-
rider problems, and has power unavailable to regular shareholders –
better tax enforcement can reduce PBOC. Works
The effect of legal origins
▪ Legal traditions differ in their respect for property rights and thus in
their ability to protect minority shareholders. Distinctions are more
complex than simply civil versus common law.
▪ 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.
Exam questions
3. Behind the Scenes: The Corporate
Governance Preferences of
Institutional Investors
Joseph A. McCathery
The one where authors ask important
Zacharias Sautner
people how they make the portfolio
Laura T.Starks companies behave (by threatening
exit or telling them what to do)
Exit, voice, and loyalty (Hirschman, 1970)
If you are interested in politics and sociology, check it
out
 What are institutional investors?
▪ An institutional investor is an entity which pools money to purchase
securities, real property, and other investment assets or originate
loans. Institutional investors include banks, insurance companies,
hedge funds, investment advisors, endowments, and mutual funds.
Wikipedia
 Introduction
▪ There is little knowledge how institutional investors engage with
their portfolio companies, because most of the interactions occur
behind the scenes.
▪ Previous research documents two activities that institutional
investors conduct when they are unhappy with company’s
performance:

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.

▪ The paper surveys 143 large institutional investors to assess the

importance of these actions in interacting with management.
Prevalence of voice and exit channels

▪ 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.
▪ 39% have sold shares due to dissatisfaction with corporate
governance.
▪ Only when private discussions and negotiations fail to achieve the
goal, investors tend to take public measures. Explains negative stock
reaction to proposal submissions and why majority of the proposals are
withdrawn just before shareholder meetings.
▪ Aggressive public measures are also extensively used:
▪ 15% have used legal actions (!).
▪ 13% have used public criticism.
Determinants of voice intensity
(I)- Liquidity
▪ Is stock liquidity and effectiveness of voice strategy related?
▪ Theoretical research is not unanimous:
▪ 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?
▪ The paper indicates negative relationship between liquidity and
voice: the more liquid shares institutional investors hold, the less
they intervene.
Determinants of voice intensity (II)-
Investment Horizon
▪ Theory behind investment horizon and voice is not straightforward
either!
▪ 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 to this, 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.
▪ The paper shows positive relationship between horizon and voice:
long-term orientation provides more incentives to monitor and
intervene.
Determinants of voice intensity (III)
-Size

▪ Theoretical relationships between the size of a stake and

voice indicates positive relationship.
▪ Larger share of company means more absolute payoff for intervention
– encourages more activism.
▪ Larger funds might also have more resources to engage.
▪ The paper does no find significant relationship between the size of
stake and voice. Agency problems of institutional investors?
Substitutes or complements
Voice and (threat of) exit are complements (i.e. used simultaneously
or one after the other) due to the following reasons:
▪ “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.
They might be substitutes (used separately, one or the other) as well:
▪ Some investors might lack the expertise of intervention and thus
rely solely on the exit strategy.
▪ Investors might face capital gains costs when exiting, which makes
the option of voice more attractive.
▪ The paper finds robust positive correlation between the two
variables, suggesting that they are complements.
Threat of exit
▪ 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 all happens behind the scenes – threat of exit is in fact
empirically unobservable, thus survey results are the only data.

▪ 51% sometimes engage with management before exiting, while

27% do this often.
▪ 42% believe that the threat of exit causes management to change
behavior.
▪ More than 60% believe equity stake size should be at least 2%for
effectiveness of the exit threat.
When are exit threats effective?

▪ Exit or exit threat by other investors for the same reason signals
that the issue is significant enough to force numerous exits.
▪ 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.
▪ If managers own equity in the company, exit threat is even more
convincing.
▪ If you are a small shareholder, you will be hardly heard. Also, sale of
a small amount of shares will have a marginal effect on their price.
Thus, size of the equity stake should be significant for the threat to
be effective.
What discourages shareholder activism?
▪ Investors face disincentives in becoming activists due to the “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 (More in reading 5).
Inadequate legal rules do affect activism.
▪ Diversification requirements for mutual funds can prevent them from
taking stakes necessary for effective voice strategy.
▪ Some engagements can lead to legal consequences.
▪ Weak disclosure requirements limits the amount of information that
shareholders get providing less opportunities for activism.
▪ Conflicts of interest: Investors might be concerned that aggressive
engagement might affect their future relations with firms (private
costs).
▪ Fund managers might not bother engaging if they are not
sufficiently rewarded for activism (compensation problems).
What encourages shareholder
activism?
▪ 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).

▪ Main drivers of activism:

▪ Fraud
▪ Inadequate corporate governance and excessive compensation.
▪ Disagreement with a firm’s strategy, specifically large mergers and
acquisitions.
▪ Contributions to politicians.
 Proxy advisors
▪ 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.
▪ However, proxy advisors merely complement individual judgement and
do not imply that investors take passive governance role.
▪ As much as 60% of respondents use at least one proxy.
▪ However, recommendations of proxy advisers can be too
standardized and ignoring firm-specific cases.
▪ Recommendations are also hard to evaluate due to lack of
transparency in their criteria.
▪ Proxy advisors, as profit-seeking organizations, are incentivized to
conduct low-cost analyses only.
▪ Some proxy advisors serve as corporate governance advisory firms and
make recommendations on voting at the same time. Conflict of interest
might arise.
Exam examples
4. Active Ownership
Elroy Dimson
Oguzhan
Karakas Xi Li
The one that talks about
how ESG is very great and
wonderful
Introduction
▪ 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.
▪ Environmental engagements typically concern climate change, water
issues.
▪ Social concerns - human rights, public health and labor standards.
▪ Governance - audit and control, executive compensation.
▪ 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…
Theoretical Effects of Corporate Social Responsibility (CSR)
▪ Theoretical literature offers 3 different predictions of how CSR
practices affect firm value:
1. 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!
2. 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!
3. 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!
Channels of the ESG value enhancement

▪ Literature distinguishes 4 channels through which ESG activities can

Increase firm value:
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 (SRI versus “sin stocks”).
4. Progressiveness: Successful ESG interventions signal similarly
successful future interventions as well as firm’s openness to
improvements in other areas.
The process of engagement
▪ Two types of engagements:
1. Raising Awareness – warning companies about certain ESG issues.
2. Request for Change – specific changes are asked (more strict step).
▪ Engagements on environmental and social issues have
considerably lower success rate (13.1%) than on corporate
governance (24.2%). Moreover, CG success rate still lags far behind
hedge funds’ track record. Two reasons why:
1. Managers doubt the value of engaging in costly projects to
potentially benefit non-shareholders.
2. ESG engagement is less aggressive compared to hedge funds’
activism.
▪ Likelihood of the successful engagement increases if:
1. There is successful prior engagement with the same firm.
2. Other shareholders collaborate.
Determinants of successful ESG engagement
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. Underperforming 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).

▪ The stronger these factors, the higher likelihood of engagement success.

▪ (!) 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.
Market responses to ESG activism
▪ Mere ESG engagement generates 2.3% abnormal return of firm
stock value over the one year (!).
▪ If engagement is successful, abnormal one-year return increases to
7.1% (!) and flattens after. Abnormal returns are highest on
corporate governance (8.6%) and climate change issue (10.3%)
engagements. Successful ESG activism also decreases stock
volatility (the firm becomes less risky).
▪ 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.
▪ There is no market reaction after Unsuccessful engagement (!).
▪ In terms of the effect on stock market values, ESG activism lies
between traditional shareholder activism (e.g. nominations of
directors) and hedge fund activism (e.g. M&A, spin-off proposals).
▪ ESG improvements in the target firms are not a result of superior
future performance (as arguedbefore)
Discussion and conclusion

▪ If ESG policies are so beneficial, why firms might not voluntarily

pursue these strategies?
▪ Targeted firms have poorer corporate governance hindering
the initiation of ESG policies.
▪ In the absence of active owners, companies might fail to
identify ESG opportunities.
▪ ESG activism increases stakeholder value when engagements are
successful and does not destroy value even when activism fails. It’s
a win-win lottery.
▪ Responsible investment initiatives are less confrontational, more
collaborative and benefits society at large.
Exam questions
5. The Agency Problems of
Institutional Investors
Lucian A. Bebchuk
Alma Cohen
Scott Hirst

The one that gives us a completely

different story… There is not enough
stewardship because for institutional
investors it costs a lot to be active
towards their portfolio
Rise of the institutional
investors
▪ Widely held corporations with dispersed ownership among small
shareholders has been prevalent in the US since early 20th century.
▪ Free-rider problems associated with dispersed ownership (readings
1-2) arise, thus control is concentrated in managers’ hands.
▪ 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.
What are Stewardship activities?
▪ They are engagement with public companies to promote corporate
governance practices that are consistent with encouraging long-
term value creation for shareholders in the company.
▪ Voting in shareholder meetings (and being informed when
voting)
▪ Monitoring corporate managers
▪ 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?
Types of institutional investors
▪ Investment funds pool together the assets of many individuals and
invest them in a diversified porjolio of securities.
▪ Can be actively or passively.
▪ In this reading we look at 3 types of institutional investors:
▪ Index funds (Passive)
▪ Active funds (most of them are “closet indexers”)
▪ Hedge funds (very active)
▪ Index fund market is dominated by the “Big Three” that collectively
have more than $7.5 trillion assets under management.
▪ Growing popularity of index funds is mainly driven by the
recognition of their low costs, tax advantages and the evidence that
they actually outperform actively managed funds (!).
Agency problems: costs and compensation
▪ Investment managers of index funds bear full costs of stewardship,
but capture only a fraction (as low as 0.12%)of benefits created.
For example: if the value would increase by $1 million, then
investment managers would get only $1,200.
▪ Compensation is based on fixed % of assets under management.
There are no incentive fees on the change of portfolio value.
▪ Any unplanned expenses of stewardship should still be covered by
the fixed fee, thus hindering the flexibility of activism.
▪ 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.
▪ In contrary, an investor without a middleman would be willing to
act if the cost of a stewardship is less than its payoff for her, which
is a full increase in the value of the assets.
Agency problems: index tracking
▪ One way to increase the capacity of stewardship is to increase
assets under management. To do it, relative performance matters:
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.
▪ Index funds engaging in stewardship do not improve relative
performance to attract more assets. Free-rider problem!
▪ 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.
▪ Index fund Vanguard employs about 15 staff for voting and
stewardship at its 13,000 portolio companies (!).
 Agency problems: active funds
▪ 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.
▪ Thus, any stewardships that move the portfolio towards mimicking the
index weights does not enhance performance relative to the index.
▪ Also, 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 multi-
dimensional decision-making takes place, i.e. which funds would be
favoured by certain actions.
 Agency problems: private costs
▪ Investment managers often run both investment fund and
investment services (e.g. cash management, short and long
term investments) firms
▪ Retirement plans like 401(k) plan are a huge part of funds’
portfolios and significant revenue driver for investment
managers.
▪ Investment managers might bear additional private costs (e.g.
losing revenue, having notorious reputation among
corporations) 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.
What is the agency problem here?
▪ It is that intitutional 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.
▪ What are some of the potential sources of these agency
problems?
▪ Most of institutional investors (index funds and closet indexers)
capture only a fraction of the benefits arising from stewardship
activities.
▪ Investing in stewardship activites can reduce relative
performance of the fund (i.e. the fund would preform worse
than other funds and nobody would want to give money to that
fund)
▪ Institutional investors want to keep good relationships with the
managers because managers can in return provide valuable
more business. (Private costs)
 The superiority of hedge funds
▪ Hedge funds (very active) offer services to sophisticated investors, thus
their regulations are more lenient. More risky positions, more
leverage, more activism.
▪ 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.
▪ 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.
▪ Hedge funds hold significant (10%+) stakes in a few companies,
capturing much more value from stewardship activities relative to
mutual funds or the index.
▪ Hedge funds devote more person-per-hour and have representatives
on the board of directors in each company in their portfolio
▪ The returns of activist hedge funds are weakly correlated with each
other. Every slight performance difference signals fund superiority.
The limits of hedge funds
▪ Hedge fund managers spend on stewardship only when the
resulting value increase are 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. A mismatch of interests?
▪ Without mutual fund support, hedge funds are hardly a threat to
the corporate management.
Implications
▪ Agency problems of institutional investors prevent the full
realization of the potential benefits of the increased concentration
of shareholders.
▪ 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 been 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.
▪ Possible systematic improvements (!):
▪ Adopting disclosure regulations (e.g. on how voting takes place) that would
enable beneficial investors identify and assess agency problems themselves
(e.g. business ties).
▪ Adopting incentive-based compensation for mutual fund managers.
Examples of questions