The Changing Face of Corporate Ownership

Do Institutional Owners Affect Firm Performance

Michael J. Rubach

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781136535192
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

This book examines the shareholder activism of institutional investors, and the effect of this activism on portfolio performance. By focusing on 118 institutional investors headquartered in the United States, the book is unique in addressing the shareholder activism of a large sample. Institutional shareholder activism is defined to include both traditional mechanisms of influence (i.e. filing shareholder proposals) and relationship investing. Institutional owners included private and public pension funds, mutual funds, bank trusts, insurance companies, endowments, and foundations. These institutional owners differ substantially, and these differences lead institutions to use their ownership power to pursue different philosophies and actions. Some institutions follow a passive governance policy, While others adopt an activist role. This book seeks to answer four questions: (1) Are institutional owners actively involved in the strategic affairs of companies in their portfolios? (2)Which forms of activism do institutional owners employ (either confrontational mechanisms, such as filing shareholder proposals, or relationship building mechanisms)? (3)Which forms of activism employed are most effective? and (4) Does the institutional type affect its pursuit of shareholder activism? In answering these questions the author suggests new important results that in many cases are contrary to what prior reports of the activities by a small number of institutional owners may intimate.

CHAPTER 1

Introduction

This book examines the shareholder activism of institutional investors and the effect of shareholder activism on portfolio performance. Institutional shareholder activism includes both traditional mechanisms of influence (e.g., filing shareholder proposals) and relationship investing (e.g., long-term interorganizational contacts between owners and a corporation’s top managers).¹ Institutional investors/owners include private and public pension funds, mutual funds, bank trusts, insurance companies, endowments, and foundations. This book is unique in addressing the shareholder activism of a large sample of institutional owners: 118 institutions headquartered in the US.

The interrelationships among the major participants in corporate governance—owners, boards of directors, and top management teams— affect corporate decision making and, ultimately, firm performance. This book investigates the implications of changes in corporate ownership structure caused by the increasing presence of institutional investors and the effects of these ownership changes on how institutional investors manage their portfolios. New patterns of ownership by institutional investors are challenging the traditional paradigm of corporate governance. Understanding the role of institutional owners in the governance picture has importance for theory building, practice, and regulation.

This book, like much of the previous research, often discusses institutional owners as though they are homogeneous or a monolithic group. While often referred to, spoken of, or depicted as homogenous, institutional shareholders are quite heterogeneous, and their owners or beneficiaries, economic motivations, and political contexts differ substantially. Moreover, they function under different legal and regulatory constraints. These differences lead institutions to use the power of share ownership to pursue different philosophies and actions. Some institutions appear to follow a passive governance policy, while others seem to have adopted a more “hands on” position.

Agency theory would indicate that the shareholders of a firm should be the monitors of its operators, its board of directors and top management team. However, there are numerous economic and legal constraints which are disincentives to monitoring. Despite these disincentives, some institutional shareholders continue to act in ways which monitor or constrain companies’ operations. This book examines why institutions are shareholder activists and what is the effect of this activism on corporate operations, structures, and performance. Agency theory has been the predominate paradigm for studying corporate governance structures. However, agency theory provides an incomplete picture.² Constituency theory³ and stewardship theory, which both presume a firm’s management seeks to maximize total organizational performance, have been advanced as alternative frameworks.⁴ This book attempts to add to a better understanding of the position and role of institutional shareholders in US corporate governance by viewing constituency theory and stewardship theory as complements to agency theory.

Recognizing the potential power of institutions to influence corporate decisions, this book seeks to answer four questions: (1) Are institutional owners actively involved in the strategic affairs of companies in their portfolios? (2) Which forms of activism do institutional owners employ (confrontational mechanisms, such as filing shareholder proposals, or relationship building mechanisms)? (3) Which forms of activism employed are most effective? and (4) Does the type of institution affect its pursuit of shareholder activism?

There are claims that the new patterns of decision making, which institutional ownership is creating, will result in enhanced corporate performance.⁵ It is argued that shareholder activism has, and will continue to have, a significant impact on corporate governance structures and processes and on firm leadership.⁶ To the contrary, others suggest that the new ownership structures and the concomitant shareholder activism may, indeed, be the wrong sort of managerial discipline altogether and actually may decrease firm value.⁷ This split of opinion suggests that empirical research is necessary to determine if shareholder activism truly improves firm performance. This book seeks to add to the research in this area.

Contrary to what prior reports of the activities by a small number of institutional owners may intimate, the results from data gathered from a sample of 118 institutional owners suggest that most institutions follow a passive policy; only about 10% report the practice of confrontational activism or relationship investing with boards; some institutions (about 30%) actively attempt to influence firms by establishing relationships with top managers; activism does not benefit their portfolios (shareholder activism does not improve corporate performance); the portfolio returns of institutions that report attempts to influence are lower than those that report making no such attempts; and activism is not related to specific institutional types or investment philosophies (e.g., maximizing financial returns only or maximizing financial and other returns).

Further, most responding institutional owners (over 54%) hire external fund managers. This creates a situation of “agents watching agents watching agents” which suggests that fund management may be a significant determinant of institutional activism. This finding intimates that future research should be aimed at studying the relationships between fund managers/money managers and their principals.

In terms of practical applications, the research has importance for institutional owners and their portfolios managers. In its attempts to determine the efficacy of the various shareholder activism mechanisms, it can provide institutions with empirical support for determining the effectiveness of pursuing various monitoring activities, including relationship investing and interorganizational relations. Indirectly, the results should aid corporate managers in their decision-making. Corporations will continue to be confronted with the growing presence of institutional shareholders. Strategically, in attempting to determine which activist mechanisms have been most effective in terms of firm performance, corporate managers may gain insight into which programs and structures are most beneficial to the corporation and its shareholders.

Finally, prior research has identified that governance systems are not necessarily inevitable results of trade and commerce, but are creatures of politics.⁸ Regulations constrain the activities of institutional owners and the effectiveness of their activism. Some commentators have complained that these regulations have effectively prevented institutional owners from even pursuing activism.⁹ Others have criticized the movement toward shareholder activism as an area ripe for meddling by inexperienced investors and for private gains which are achieved at the expense of the public.¹⁰ This research investigated the efficacy of the present regulatory system. The findings provide evidence which supports the continuance of the present regulatory schema which permits institutional owners to monitor and regulate governance structures through private arrangements, not public regulation.

OUTLINE OF THE BOOK

The remainder of this book is organized into seven chapters. In Chapter 2, the author presents two conflicting views of US corporate governance: the traditional economic model (agency theory) versus the constituency model. An underlying assumption of the research is that there is a separation of ownership from control which creates agency costs.

Chapter 3 describes institutional heterogeneity. The argument is made that institutional owners/investors are not a homogeneous group as has often been depicted in prior writings and research. This book argues that institutional heterogeneity is a factor in the pursuit of shareholder activism.

Chapter 4 surveys the literature on institutional shareholder activism and its effects on corporate performance. The prior literature usually addresses the impact of activism on specific firm’s performance. Few studies address the impact on portfolio performance. Also, most prior research has also centered upon the activities of a few large public pension plans, such as CalPERS. These large public pension plans have been the most vocal in their pursuit of activism, and have been the most studied because their records are accessible. This book differs from previous research by studying the activism of a broader range of institutional investors and institutional shareholder activism.

Chapter 5 describes the research model, identifies institutional owners and the top managers of the corporations. Institutional shareholder activism is defined, and the definition differs from many prior studies because it includes relationship investing as a mechanism of shareholder activism. Four research questions and eight hypotheses are presented. The hypotheses address the four research questions and deal with the extent of shareholder activism, the investment philosophies of institutional owners, the effects of institutional shareholder activism on portfolio performance, and whether the type of institution affects any of these issues.

Chapter 6 describes the methodology of the research. The research is exploratory in nature trying to develop and test the extent of institutional shareholder activism, its determinants, and its effects on portfolio performance. No prior research has attempted to study institutional shareholder activism on a broad scale across institutional types. The independent and dependent variables used in the analysis are defined. The procedures used to collect the data and how that data was analyzed are described. The chapter concludes by discussing the statistical tests used to analyze the data and the appropriateness of these tests.

Chapter 7 presents and analyzes the results. The limitations of the research methodology and the results are identified.

Chapter 8 discusses the implications for institutional owners with respect to the pursuit of activism, for corporate managers with respect to which institutions are activists, and for regulators with respect to the scope of activism. Also, the chapter identifies areas for future research.

NOTES

¹ “Relationship investing” is a cooperative association between an organization’s owners and management. It envisions a long-term advisory relationship with its essence being communication among the parties. This concept is often referred to as “relational investing.” Ian Ayers and Peter Cramton, “Relational Investing and Agency Theory” Cardozo Law Review 15 (1994): 1033–1066. There is some confusion concerning what relational investing encompasses. This is especially true in the finance literature. Therefore, the term “relationship investing” will be used herein.

² Gerald F. Davis and Tracy A. Thompson, “A Social Movement Perspective on Corporate Control,” Administrative Science Quarterly 39 (1994): 141–173.

³ This book uses the term “constituency theory” to describe a school of corporate governance which views the corporation as a system of stakeholders within a larger social system. The use of the term “stakeholder” is avoided in order to avoid confusing constituency theory with general stakeholder theories espoused in corporate ethics and social responsibility debates. Under corporate governance constituency or stakeholder theory, the purpose of the firm is to create wealth or value for all of its constituents or stakeholders. Margaret M. Blair, Ownership and Control: Rethinking Corporate Governance for the Twenty-first Century, (Washington, D.C.: The Brookings Institution, 1995), 332. The theory advocates that constituents or stakeholders should have a voice in corporate decision making, creating alliances between critical constituents and top managers. Michael E. Porter, Capital Choices: Changing the Way America Invests in Industry, (Washington, D.C.: Research report presented by the Council on Competitiveness and cosponsored by the Harvard Business School, 1992). Jeffrey S. Harrison and Caron H. St. John, “Managing and Partnering with External Stakeholders,” Academy of Management Executive 10, no. 2 (1996): 46–60.

⁴ For a brief discussion of constituency or stakeholder theory see Shaun Turnbull, “Corporate Governance: Its Scope, Concerns and Theories,” Corporate Governance 5, no 4 (1997): 180–205. For discussions of stewardship theory, see James H. Davis, F. David Schoorman, and Lex Donaldson, “Towards a Stewardship Theory of Management,” Academy of Management Review 22 (1997): 20–47; Lex Donaldson and J. H. Davis...