Weak Governance by Informed Large Shareholders

Concerns about the governance of public corporations have taken center stage in recent years. Part of the debate on how to improve corporate governance has focused on policies that will give large shareholders (typically institutional investors) greater influence over corporate decisions. Indeed some theoretical and empirical papers support the governance role of large shareholders.

The underlying view is that large shareholders have both the ability and incentive to maximize the value of all shareholders. Large shareholders may improve governance either through active monitoring or through passive selling and both activities are expected to improve governance.

In this paper, we propose a complementary view which highlights one reason why, in some settings, a large shareholder’s joint ability to influence corporate policy and to trade subsequently on his private information may actually weaken corporate governance. We demonstrate this idea in the context of corporate takeovers. We show that even if some takeovers may destroy firm value on average, the large shareholder would still support them as long as they create sufficient uncertainty on the firms’ future value. Hence we challenge the view that relying on large shareholders to improve corporate governance is always good for small shareholders.

The intuition is as follows: The large shareholder’s ability to collect private information allows him to examine proposed takeover deals and trade on his private information before the true value of the deals becomes publicly known. The large shareholder therefore will purchase more shares if he receives a positive signal and sell shares if he receives a negative signal. This ability to collect private information and trade on it creates an endogenous wedge between the expected profits of the informed large shareholder and those of uninformed small shareholders. As a result, the large shareholder may find it optimal to support a more aggressive takeover policy ex ante, even if such a policy hurts small shareholders’ value.

We test our hypotheses by examining mutual fund trading of acquirer stocks over different stages of the takeover process. Our focus on this subset of institutional investors is motivated by previous empirical studies that document mutual funds’ ability of trading on private information.

We construct a sample of acquirers who announced takeovers between 1980 and 2012 and explore the relation between institutional trading of acquirer shares and ex post merger performance (measured using the acquirer’s post-merger buy-and-hold abnormal return). We find that institutional trading during the bid negotiation period (i.e., the period starting from the bid announcement and ending at deal closure), is strongly and positively correlated with ex post merger performance. Specifically, we find that following the bid announcement, institutional investors increase their holdings of acquirer stocks in mergers with good long-run performance and they reduce their holdings of acquirer stocks in mergers with bad long-run performance. We also find that the positive correlation between institutional trading and deal performance is more pronounced in mergers with good ex post performance, which is consistent with the fact that most institutional investors in our sample are subject to short sale constraints.

We also test our hypotheses on how institutional investors trade before takeover announcements. We find that before takeover announcements, institutional investors increase their holdings of firms that subsequently pursue mergers with more dispersed performance. This finding is consistent with our hypothesis that higher ex ante uncertainty increases institutional investors’ expected trading profits.

To further explore the underlying mechanisms of our results, we perform various subsample tests. We first document that our baseline results on the positive association between post announcement trading and deal quality are stronger for the subsample of institutions with high initial holdings of acquirer stocks. High initial holdings increase informed investors’ expected trading profit by allowing them to trade more aggressively on both positive and negative news, because they are less likely to be restricted by short sale constraints.

Second we document that the baseline results are stronger for the subsample of institutions who invest a large fraction of their portfolio in the acquirer’s stocks. For this group of investors, acquisition events have a larger effect on their portfolio returns, which motivates them to collect more information and trade more aggressively after the bids are announced.

Third, we examine the effect of deal size and find that our baseline results are stronger for the subsample of acquisitions with large deal size (relative to the acquirer’s market value). Deals with larger relative size often have a larger effect on the combined firms’ post-merger performance and hence are likely to induce institutional investors to collect more information about these deals.

Fourth, we show that our baseline results are stronger for the subsample of deals with high acquirer stock liquidity. This finding is consistent with the idea that the expected profits from private information are higher if the informed shareholder can better camouflage his trades and hide behind liquidity traders. When the acquirer stock liquidity is high, the price impact of the informed trades is small and, therefore, the informed investor can trade more aggressively on his private information.

Lastly, we provide additional evidence showing that our baseline results are most pronounced for mutual funds with high pre-acquisition trading skills. We show that mutual funds that earn strongly positive abnormal returns pre-acquisitions also exhibit the highest positive correlation between their trades of acquirer shares and the ex post deal performance. In contrast we find that mutual funds with low trading skills cannot capture these opportunities.

In sum, our empirical analyses support our hypotheses: institutional investors benefit from aggressive takeover policies that generate high uncertainty regarding the firm value. Our paper adds to the debate on the corporate governance role of large shareholders. We argue that the large shareholder’s power in influencing managerial decisions and his ability in trading should not be considered isolated and we show that the large shareholder takes into account the effect of his governance decision on his subsequent information advantage, which weakens or even compromises his incentive in corporate governance.

More broadly, we argue that large shareholders may not always be strong advocates for limiting managerial over-investment decisions. Note that our findings do not suggest that large shareholders never improve governance: large shareholders may monitor and limit under-investment problems more effectively than they may do for over-investment problems, especially when such over-investment creates high uncertainty in firm value.

The preceding post comes to us from Eitan Goldman, Associate Professor of Finance and FedEx Faculty Fellow at the Kelley School of Business at Indiana University, and Wenyu Wang, Assistant Professor of Finance at the Kelley School of Business at Indiana University.  The post is based on their recent paper, which is entitled “Weak Governance by Informed Large Shareholders” and available here.