Companies, Governance, and Markets Wei Jiang Arthur F. Burns Professor of Free and Competitive Enterprise Prepared for the NewDEAL Program Summer 2013
Facts The U.S. economy is dominated by large, diffusely owned public companies. 20% of all types of businesses, 83% of revenues. The median largest shareholder holds 10-20%. Control of large publicly traded firms. Truly widely held: Australia, Canada, UK (no family presence among the top 20 firms), U.S., France, Switzerland. Widely held with cross-ownership: Japan, Korea. Family dominance: Argentina, Hong Kong, Mexico (nearly 100% among the top 20). State dominance: Singapore, China. 2
Parties in corporate governance Potential pairs in conflicts of interest: Manager shareholder. Shareholder Stakeholder. Shareholder shareholder: between controlling shareholder and others (dual class, pyramids, etc.). Forms of corporate governance. External: Market discipline. Investor perspective. Internal: monitoring. Board perspective. Watchdogs: auditors, regulators, rating agency 3
Organizational Structure of Firms Shareholders Elect Board Hires, monitors, dismisses CEO 5
Balancing the power Board effectiveness: Impose fiduciary duties on directors and managers. Board independence. Empowerment of shareholder: Give shareholders rights. Make shareholder voting meaningful. Facilitate effectiveness of activist block investors. Effective market for corporate control (hostile takeovers and proxy contests). Effective external monitors: SEC, auditors and other gatekeepers. 6
Case for board effectiveness The board must be able to stand up to the CEO. A majority of directors of listed companies must be independent. Key board committees should consist of only independent directors. (Dodd-Frank, sec. 952) What does independence mean? No material relationship with the company. Process by which directors are chosen? Friends of the CEO? The all-star board of HP in the early 2000s. 8
Empowerment of Shareholders Vote on increasingly more regular and critical matters. The proxy access. Activism: Some activist shareholders and institutional investors (notably hedge and private equity funds) have successfully influenced company policies and strategies. Hostile takeover: Have decreased dramatically since mid-1980. Most institutional investors are known for being reticent. Why? 9
The inevitable passivity? Prudent man rule for pension and banks. Diversification requirement. Trading liquidity required for open-end funds (mutual funds). Business relations with portfolio firms and other dubious goals. Legal risk.
Two generations of shareholder activism Traditional institutional investors (mutual and pension funds): Incidental and ex post. To contain damage. Wall Street Walk to avoid underperformers. Hedge fund activists. Strategic and ex ante. To make a profit. Seek investment opportunities in underperformers. Defensive vs. offensive activism. 11
Potential impact of a proposed new rule Enable shareholders to nominate up to 25% of a company s board of directors using the company s proxy statement. To nominate directors in this fashion, the shareholder must hold 3% for at least three years (who are they?). 7% Stake of the leading activist 6% 5% 4% 3% 2% 1% 0% q-4 q-3 q-2 q-1 Event quarter q+1 q+2 q+3 q+4
Changing landscape of external governance 300 1600 250 1400 200 1200 150 1000 100 800 50 600 0 400 Proxy contests (left) Activist targeting (left) Hostile takeover (left) S&P 500 (right) 13
Why against shareholder empowerment It weakens internal governance: Shareholder activism is destroying the role, focus, and collegiality of the board of directors. It leads to short-termism: Activists create pressure on boards [and managers] to manage for short-term share performance rather than long-term value. It leads to more, not less conflict of interests: shareholders do not deserve more shareholder democracy because the majority of them are intermediaries, such as pension funds and mutual funds, which have governance problems of their own they may act against the interests of owners. ( Agents watch agents ) Shareholder primacy per se is questionable: Did Jack Welch term it the Dumbest idea in the world? 14
The rationale for shareholder primacy Who are shareholders? Why are shareholders special? Shareholder value maximization needs to observe constraints. Analogy to Winston Churchill s worst form of government. 15
Managing conflict of interest A new genre of institutional investors. Sizable but strictly minority stakes. No other business relations with portfolio firms. Influence instead of control: Not enough to dictate corporate policy. Enough stake for garnering support for the changes they advocate. Support from fellow shareholders important. Sharks, wolf packs, and remoras. Limiting scope for extracting private benefit. 16
Strategy implementation Secrete toehold. Launch public activism, often in the form of a Schedule 13D filing. Start friendly (shareholder proposal), could turn hostile (proxy contest). Usually not interested in seeking control takeover defenses not effective deterrence. Coordinate with other institutional investors.
What do they want and get 60% 0.35 50% 0.3 40% 0.25 30% 0.2 20% 0.15 10% 0.1 0% General undervaluation Capital Structure Business Strategy Sale of Target Company Governance 0.05 % of sample (left) % success (right) % partial success (right) 20
Activist tactics Take control Law suits Proxy contest Threat of proxy contest/law suit Shareholder proposal or campaign Seek board rep without contest Communication with managers 0% 10% 20% 30% 40% 50% 60% % of all events 21
Which firms get targeted? Low relative valuation: a branch of value investing. Mature cash cows. Excess cash but low payout, high diversification, and dubious acquisitions. High takeover defenses and high executive compensation: governance problems. High analyst coverage, high trading liquidity, and high institutional ownership: ease of toehold; and sophisticated shareholder base. Summary: Badly governed firms with strong fundamentals. Better income statements than balance sheets. Issues for correction are general in nature. 22
Does the market (shareholder) like it? Abnormal Buy-and-Hold Return 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 200% 180% 160% 140% 120% 100% 80% 60% 40% 20% Abnormal Share Turnover Relative to (t-100,t-40) -1% 0% Abnormal Share Turnover (Right) Abnormal Buy&Hold Return (Left)
Does the market (bondholder) like it? 240 220 Spreads in basis points 200 180 160 140 120 100-20 -18-16 -14-12 -10-8 -6-4 -2 0 2 4 6 8 10 12 14 16 18 20 Days relative to announcement mean three-year spread median three-year spread 24
There are real effects Peer-adjusted return on assets 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% t-3 t-2 t-1 Event Year t+1 t+2 t+3-2.0% ROA 95% Confidence Intervals
Someone (CEO) loses CEO excess pay to peers ($1,000) CEO abnormal turnover (%) 2000 25% 1500 20% 1000 15% 500 10% 0-500 -1000 t-3 t-2 t-1 Event year t+1 CEO Pay ($1,000) 90% Confidence 5% 0% -5% t-3 t-2 t-1 Event year t+1 %CEO Turnover 90% Confidence
Does activism promote short-termism Any short-termism claim relies on the stock price being inefficient failing to reflect the discounted value of future cash flows. The myopic activists claim is easily tested, but none of the people making the claim conducted any large sample empirical analysis. [f]or companies that are the subject of hedge fund activism and remain independent, what is the impact on their operational performance and stock price performance relative to the benchmark, not just in the short period after announcement of the activist interest, but after a 24-month period. See Wachtell, et al., Bite the Apple; Poison the Apple. 27
The long term evolution of ROA and Q 28
Pump and dump? For the full sample, there is no longer-term reversal of the announcement return. Stock returns after hedge fund exit is neutral to slightly positive. Further investigation of a likely subsample of adversarial interventions: Hostile. Leverage-enhancing, payout-increasing, and investmentreducing. Operating and stock performance are at par with the rest of the sample. Targeted firms fared no worse during the financial crisis years (2008-2009). 29
Summary Separation of ownership and control is the ultimate source of agency problems. Internal governance has limited effectiveness. Ultimately the market imposes basic discipline. Regulation should work through the basic governance mechanisms. 30