In our recent study, we find that institutional investors follow high-performing directors to new firms and make larger initial investments in those firms than in other firms. Fama (1980) and Fama and Jensen (1983) support our finding and propose that such directors are especially skilled at advising and monitoring their firms to ensure that shareholder interests are protected.
The notion that institutional investors might follow some directors also receives support from recent work that shows that some directors create more shareholder value than others (e.g., Masulis and Mobbs 2011; Masulis and Mobbs 2014). Anecdotal evidence suggests that large institutional investors value some directors more than others and may make larger initial equity investments in firms supervised by those directors. The key question is whether equity connections between directors and institutional investors continue when directors move to new firms.
Using a sample of 20 million observations on funds, firms, and directors from 1997 through 2011, we show that, when a director with whom an institutional investor has an existing equity relationship arrives at a firm, the institutional investor’s initial investment in that firm is 17.7 percent greater, on average, than it is in other firms. Our analysis is within fund-quarter, so we can say that initial investments are larger when they coincide with a director that is new to the firm, but known to the fund. Sensitivity checks show that these larger initial investments are not linked to the number of directors, selection bias, counterfactual choice, or unobserved heterogeneity.
We show that neither director attributes (e.g., independence, title, and busyness) nor firm attributes (e.g., governance or board busyness) completely explain the phenomenon. The only notable relation in the cross section is that the initial investments are smaller when funds follow directors to firms with entrenched management as measured by a high E Index (Bebchuk, Cohen, and Ferrell 2009). Funds will follow directors to firms with weak governance, but temper their expectations with smaller initial investments.
To evaluate whether the decision to follow directors is sensible, we examine prior performance in each new director’s previous employer (the sending firm) and new employer (the receiving firm). On average, sending firms report higher industry-adjusted operating performance as measured by return on assets (ROA) and higher industry-adjusted valuation as measured by market-to-book assets ratio (M/B). On average, receiving firms are neither better nor worse in operating performance and valuation. Further, receiving firms do not significantly improve operating performance or valuation over the next one or two years after the appointment of the followed director.
Although there are no clear long-run performance or valuation improvements, funds that follow directors earn abnormal returns in the quarter of initial investment relative to their other initial investments and existing investments. This result suggests that identifying followed directors may be a strategy with short-term, but not necessarily long-term returns.
Finally, when there is an opportunity to follow a director, funds take advantage of this opportunity and increase their aggregate dollar investment in a followed director’s firms. From a diversification standpoint, this is reasonable. A new appointment allows funds to diversify their investments while increasing their exposure to a followed director.
Our work contributes to the literature on corporate boards and institutional ownership in two ways. First, we show that institutional investors increase investment in a director’s human capital following positive experiences at a director’s previous employer. This complements work on trust, which is defined as confidence in a manager based on familiarity, relationships, and connections to colleagues (Guiso, Sapienza, and Zingales 2004; Gennaioli, Shleifer, and Vishny 2015). Second, institutional investors that follow directors may earn superior returns in the quarter when the followed director is appointed, however there is little evidence that this out-performance extends beyond the first quarter. This result is consistent with the evidence on mutual fund performance, which reports that on average fund managers are unable to beat their risk-adjusted performance benchmarks (Pastor and Stambaugh 2010; Fama and French 2010).
We provide another perspective on corporate governance and a better understanding of the channels through which institutional investors make investment decisions. Right or wrong, high-performing directors whose firms have delivered significant returns to institutional investors garner greater attention from investors when these directors move to new firms. This attention comes in the form of new institutional investments that earn short-term gains, although followed directors have no lasting impact on firm performance. Overall, this suggests that the impact of director ability on performance is firm specific and fails to carry over when directors move to new firms.
 For example, Warren Buffett offered the following insight at the 1996 Berkshire Hathaway shareholder meeting: “We think a 0.350 hitter will continue to be one; we don’t believe the 0.127 hitter who says, hey, I’m different because I got a new bat. Once we see ability, we like to see how they treat shareholders.”
 In related research, Brochet et al. 2014 examine connections between analysts and executives, and show that they continue to matter when executives move to new firms.
 We do not observe the date of initial investment, so we cannot confirm that funds realize the entirety of these abnormal returns.
Bebchuk, Lucian A., Alma Cohen, and Allen Ferrell. 2009. “What Matters in Corporate Governance?” The Review of Financial Studies 22 (2): 783–827.
Brochet, Francois, GS Miller, and S Srinivasan. 2014. “Do Analysts Follow Managers Who Switch Companies? An Analysis of Relationships in the Capital Markets.” The Accounting Review 2 (89): 451–82.
Fama, Eugene F. 1980. “Agency Problems and the Theory of the Firm.” Journal of Political Economy 88 (2): 288–307.
Fama, Eugene F., and Kenneth R. French. 2010. “Luck versus Skill in the Cross Section of Mutual Fund α Estimates.” The Journal of Finance 65 (5): 1915–47.
Fama, Eugene F., and Michael C. Jensen. 1983. “Separation of Ownership and Control.” Journal of Law and Economics 26 (2): 301–25.
Gennaioli, Nicola, Andrei Shleifer, and Robert W. Vishny. 2015. “Money Doctors.” The Journal of Finance 70 (1): 91–114. doi:10.1111/jofi.12188.
Guiso, Luigi, Paola Sapienza, and Luigi Zingales. 2004. “The Role of Social Capital in Financial Development.” The American Economic Review 94 (3): 526–56.
Masulis, Ronald W., and Shawn Mobbs. 2011. “Are All inside Directors the Same? Evidence from the External Directorship Market.” The Journal of Finance 66 (3): 823–72.
———. 2014. “Independent Director Incentives: Where Do Talented Directors Spend Their Limited Time and Energy?” Journal of Financial Economics 111 (2). Elsevier: 406–29. doi:10.1016/j.jfineco.2013.10.011.
Pastor, Lubos, and Robert F. Stambaugh. 2010. “On the Size of the Active Management Industry.”
This post comes to us from Professor Jay Dahya of the Zicklin School of Business at Baruch College, City University of New York, and Professor Richard Herron of Babson College. It is based on their recent paper, “Do investors follow directors?” available here.