Home > Shareholder Activism > Why do institutional investors “exit” instead of raising their voice?

Why do institutional investors “exit” instead of raising their voice?

A certain time ago, I published a post about Pescanova, (1) a rather small public firm. At the time its problems were unveiled by an investor who didn`t believe the accounts and management´s explanations about the CF trends, no “voice” had been raised against its managers, or its performance, the corporate governance structure, its strategy, capital allocation….What`s more, I remember a chorus of financial analysts that had been broadcasting their recommendations to buy the stock one or two years before. The story (if true as it has been told) is well-known: results had been introduced for some time from outside of the perimeter, while the “third party firms” were in fact firms controlled by the company or its managers, (and were full of debt that finally “exploded”).

Exit or Voice 2

 But I won`t talk about this today. Instead, I will try to guess why no voice had been produced about its corporate governance (CG) practices, that were apparently very defective, (as the Spanish regulator said –after everything was unveiled- ),(2). The distinction between “exit and voice”, or “active versus passive monitoring” was introduced by Hirschman (3) and is described by Tirole, (4).

 I will refer to the exit decision by an otherwise active investor, “Governance for Owners”, which describes its strategy as one that manages “constructive engagement funds”, (see their approach to “Responsible Investment” here, http://goinvestmentpartners.com/responsible-investment/).

 They had apparently tried to engage with the firm`s managers regarding their main levers for value, (ESG), but failed and sold their stake, (5).

 In an article published by Jawen Jiao and Ying Duan in 2016, (6), the authors try to extract en empirical idea of the role institutional investors really play in Corporate Governance. We will try to follow their findings to try to discover why GO acted that way. First of all, they prove that mutual funds have a positive role in CG: they prove they increase their opposition to management when proxy advisors recommend negative votes, both in exit and voice options. This is even more relevant when decisions are tight, (so that mutual funds react more when their votes are decisive). The authors try to guess what benefits and costs drive this behavior:

1.- Controlled firms are usually connected to a larger difficulty of the exit option, given the eventual liquidity restrictions. Significant holdings amounted to 57% at the time in our firm, so apparently this could have prevented GO from “exiting”, but it didn´t. GO was able to sell its stake without major additional losses due to the effect of their stake being marketed.

 2.- They also find that funds with short investment horizons are more prone to “exiting”, but GO is not one of these funds in general. Trying to modify investment risk or return through the improvement of the ESG parameters implies much more than short-time investments. But they exited.

3.- They also argue that mutual funds tend to exit more in firms that may provide wider and lower priced information to investors, which they state is the case in small firms, even if they are public. This might be one of the mechanisms supporting GO`s decision.

 4.- They also find that mutual funds have a preference for exiting when the existence of large insiders`ownership reduces the possibility to use voice effectively. This could have been the case if the other large investors supported the management, or were not very receptive to GO´s messages.

 In an article published in June 2012, Sreedhar T. Bharath, Sudarshan Jayaraman, and Venky Nagar did an empirical analysis of exit strategies, and found that “exit threat” can be an efficient CG tool by blockholders. Why didn´t managers react to the exit threat by GO, (much more credible than “voice threat in an European environment) and let the investor go, accepting the subsequent stock price fall)? What happened later might explain this, and perhaps a lack of true interest alignment between directors and managers and the rest of shareholders, due to the major deficiencies in CG practices.

 Of course,we can add that “active investors”, even if they are increasing their presence in Europe, still remain much less inclined to adopt active or noisy attitudes, (see for example (7).

(1) See the post here: https://joaquinbarquero.wordpress.com/2013/03/26/pescanova-a-fantastic-firm-in-big-trouble/
(2) Elvira Rodríguez (CNMV): “Pescanova parecía una empresa con amo”, El Pais, May 2013, http://economia.elpais.com/economia/2013/05/28/actualidad/1369741004_041394.html
(3) Hirschman A.O. (1970) “Exit, voice and loyalty”, Cambridge MA Harvard University Press, http://www.hup.harvard.edu/catalog.php?isbn=9780674276604
(4) In his book “Theory of Corporate finance”, http://press.princeton.edu/tirole/chap8.pdf
(5) As published in a Spanish local newspaper in April 2013, GO sold their stake in 2012 before the problems were discovered. See: http://www.farodevigo.es/economia/2013/04/28/aviso-socio-rebelde-gigante-nadie-vio/799777.html
(6) See a brief post here https://corpgov.law.harvard.edu/2016/06/30/the-role-of-mutual-funds-in-corporate-governance/ and the full article here: Duan, Ying and Jiao, Yawen, The Role of Mutual Funds in Corporate Governance: Evidence from Mutual Funds’ Proxy Voting and Trading Behavior (June 24, 2014). Journal of Financial and Quantitative Analysis (JFQA), Forthcoming; University of Alberta School of Business Research Paper No. 1894942. Available at SSRN: http://ssrn.com/abstract=1894942 or http://dx.doi.org/10.2139/ssrn.1894942 
(7) Giovinco, Angela, Activism. The Evolution of an Investor Strategy (January 13, 2015). Available at SSRN: http://ssrn.com/abstract=2549179 or http://dx.doi.org/10.2139/ssrn.2549179
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