How Institutional Investor Objectives Affect Firm Valuation and Governance

Over the last 30 years, institutional investors have dramatically increased their stakes in U.S. companies. In the 1980s, they held approximately 20 percent to 30 percent of the average firm in the U.S. By 2010, they held over 65 percent. This increase in institutional holdings coincides with the growing complexity of markets and importance of corporate governance. Prior research has focused on the different effects on firms of the informed “smart money” of the institutional investor in contrast to the less sophisticated individual “retail” investor. Yet, as SEC Commissioner Luis Aguilar said in a recent speech, “Institutional investors are not all the same. They come in many different forms with many different characteristics.” [1]

In our recent paper, we study the impact that different types of institutional investors have on the valuation, corporate governance, and future performance of firms. Specifically, we focus on two fundamental investor characteristics: portfolio turnover and holdings concentration. We begin by using the Bushee (1998, 2001) classification of institutions into “transient” and “dedicated” investor types. [2,3] Institutional investors are “transient” if they take small positions in the firms they hold and have high portfolio turnover. Due to a short investment horizon and lack of focus on particular firms, these investors are likely to be myopic traders looking for short-term gains. On the other hand, “dedicated” investors take highly concentrated positions in the firms they hold and have low portfolio turnover. Both of these portfolio characteristics suggest dedicated investors are more likely to invest for the long run, gathering costly firm-specific information and trading on the growth potential of a firm. Transient institutional investors comprise an increasing share of all institutional investors over time.

We find that companies with higher percentages of transient institutional investors experience more overvaluation, defined as excess firm value relative to firm fundamentals, in the following quarter. They also experience more misvaluation, defined as the absolute deviation from fundamental value, in the next quarter. In contrast, firms with higher percentages of dedicated institutional investors experience less overvaluation and misvaluation. Similarly, firms that experience an increase in their percentage of transient (dedicated) institutional investors experience more (less) overvaluation and misvaluation in the next quarter. These misvaluation effects remain after controlling for common firm characteristics that may affect firm valuation.

To examine whether our results are driven by differences in information gathering, as suggested above, we explore the relationship between institutional investor types and firm valuation around the enactment of SEC Regulation Fair Disclosure (Reg FD). This regulation, enacted in 2000, mandates that, when an issuer discloses material non-public information to specific outsiders (e.g., analysts or institutional investors), this disclosure must be made public, thereby eliminating the informational advantage previously enjoyed by large shareholders in general, and dedicated institutional investors in particular. As expected, dedicated institutional investor ownership reduces overvaluation and misvaluation to a similar degree before and after the regulation, consistent with such investors having access to material information both prior to and after Reg FD. On the other hand, the regulation significantly reduced the subsequent overvaluation and misvaluation for firms with higher levels of transient investors relative to the preceding time period, consistent with an increased access to material information previously enjoyed only by dedicated investors.

Given that different types of institutional investors affect firm valuations differently, we examined whether the same is true with respect to risk, corporate governance, and future firm performance. We document that firms held predominantly by transient institutional investors have more volatile returns, a higher risk of serious financial trouble, and higher average and median executive compensation. They also have less reliable accounting, are less likely to pay dividends, and are unable to take on as much debt relative to those held mainly by dedicated institutional investors. Firms held by transient investors experience superior risk-adjusted performance in the subsequent quarter, whereas those held by dedicated investors experience superior risk-adjusted performance later in the year consistent with longer investment horizons. Firms held by dedicated investors experience positive raw returns unadjusted for risk over the subsequent four quarters, whereas those held by transient investors experience negative or insignificant raw returns over the same period. Specifically, we find that long-term institutions are able to achieve long-term performance: firms with more long-term institutional investors outperform firms with fewer such investors by 2.8 percent on a risk-adjusted basis over the subsequent year.

These findings allow us to contribute to the ongoing debate about the role of institutional investors. Evidence exists that they benefit the markets, through improvements in market efficiency or in corporate governance, alongside evidence that they harm markets through opportunistic investment strategies and pressure on managers to achieve short-term results at the expense of long-term performance. These seemingly conflicting effects can be explained by the different ways dedicated and transient institutional investors affect firm performance. Our findings suggest that distinguishing between those investors can lead to more insightful and accurate results.

ENDNOTES

[1] See the April 13, 2013 speech by SEC Commissioner Luis A. Aguilar on “Institutional Investors: Power and Responsibility” available at: http://www.sec.gov/News/Speech/Detail/Speech/1365171515808

[2] Bushee, B., 1998, The Inffluence of Institutional Investors on Myopic R&D Investment Behavior, The Accounting Review, 73, 305-333.

[3] Bushee, B., 2001, Do Institutional Investors Prefer Near-Term Earnings over Long-run Value?, Contemporary Accounting Research, 18, 207-246.

This post comes to us from Professor Paul Borochin at the University of Connecticut School of Business and Dr. Jie Yang, a senior economist at the Board of Governors of the Federal Reserve System. It is based on their recent paper, “The Effects of Institutional Investor Objectives on Firm Valuation and Governance,” available here. The views in the post are solely those of the authors and do not necessarily reflect those of the Federal Reserve System.