Home > Shareholder Activism, Voting Rights > Agency Costs and Institutional dominated share ownership: activists and governance

Agency Costs and Institutional dominated share ownership: activists and governance

Summary: Institutional Investors (II) -such as mutual funds- are rational while not doing research and issuing shareholder proposals; activists and hedge funds may have a role issuing those proposals, so that others have an option to increase their voting value. (See (1) and (2) by Gilson, Ronald J. and Gordon, Jeffrey N. and by Bebchuk, Lucian A. and Cohen, Alma and Hirst, Scott respectively.

The fact that property is concentrated in II makes the world of Berle and Means outdated. A new agency problem arises between record owners, (II now) and managers, but also between record owners and beneficial owners, (this is what they call “Agency Capitalism”, where II or agents hold investments on behalf of final or beneficial owners).

II have limited incentives and capacity to monitor business choices, except through stock price performance. The consequence of underperformance is stock selling, not engagement nor intervention. And this is the conflict, because in some cases, intervention could be more in the interest of their beneficial owners.

Some jurisdictions (UK, EU, Israel…) have tried to impose some duties to II, “stewardship”, or “sustainable engagement”.

Another option is understanding their rational inaction as an endogenous feature of the agency problem, and also the emergence of activist hedge funds as its endogenous result, the solution being one less drastic than a takeover bid, but sometimes this one also. Their power stems from their capacity to convince II that their proposals would generate value, and their incentive the eventual profit of their small stake.

1.- How Capital market`s innovations give rise to governance changes.

The authors state that changes in capital markets generate changes in corporate governance, (not the opposite). They understand public companies spread risk among retail investors rationally, as their diversification allows companies to avoid paying them for assuming unsystematic risk thus reducing their cost of capital. The price is Agency costs between investors and managers. Investors then generate a demand for corporate governance mechanisms, and consequently the supply appears.

Corporate governance is a tool to support the transfer of risk to investors, and uses all financial instruments at hand, provided by financial innovation. So, this innovation gives shape to corporate governance. Conclusion: a) best practice codes could petrify the governance structure; b) ownership may become more concentrated: as systematic risk is more easily transferred, higher investment in firm specific risk by managers can be rational.

2.- Agency capitalism, and retirement security.

Except in the USA and UK, property was concentrated, (controlling shareholders and blockholders). But recently, II have started to show stronger concentration as intermediaries, as they have come to hold some 70% of shares.

That leads to Agency Capitalism, with the two types of agency costs described above. The reasons for this change and results are explained below:

Retirement savings: since the end of WW2, the increase in retirement funds was channeled through private pension entities that have been mainly invested in equity, (whereas the Social Security generally invested in bonds). The ERISA enactment in 1974, as a result of lack of funding and abuses by companies, also gave rise to funds channelled to private II. Finally, the change to contribution defined plans, while reducing the risk exposure by companies, also gave rise to the volume of funds.

– Following Markowitz`s efficiency theory, mutual funds and the like were big enough to diversify, and do an effort in research, which was nevertheless costly.

In what refers to Corporate Governance (CG), mutual funds are potentially powerful; they have shown not to be proactive in shareholder proposals; but they also act against management in some corporate governance matters, (anti-takeover pills, board classification, etc.).

Regulation (UK, EU and Israel, for instance), and academics think they should behave proactively, as stewards, and supervise management, which they stubbornly do not do; so, at the end, governance rights are concentrated in “not acting hands”.

3.- Agency capitalism and undervaluation of governance rights.

The share ownership concentration should in theory undermine the agency problem between shareholders and managers; but mutual funds are reticent to be active. Why do they value voting rights so low? Because II compete with others in relative performance. So when they discover poor governance or poor strategy, they can both (i) use the trading opportunity, which generates a profit for them only, or (ii)  intervene, which benefits them and their competitors, while only they bear the research and intervention costs. So, they rationally do not develop the capacities to intervene. This agency cost, (the different interest between funds and beneficiaries), entails the lock-in of managerial slack.

As a conclusion agency costs remain high as governance rights are undervalued for several reasons: a) diversification acts against; the success of intervention is probabilistic, but the cost certain; b) relative performance assessment also acts against governance; the manager focuses in price opportunities; c) compensation also acts against: no fee can be linked to governance but to relative performance, so good funds at that attract more funds to be taxed with the fee, and this is their success; d) conflicts of interest act against intervention as fund managers receive part of their business from corporations and managers; e) Index fund managers would not invest in research that would increase the value of the portfolio and the benchmark at the same time,

4.- Activism`s role in governance.

The corporate governance gap, the lock-in of managerial slack, gives room for arbitrage specialists. They would specialize in governance and strategy, identify shortages in these areas and underperforming companies, buy a large enough stock slice, and present their value proposition to reticent mutual funds. The governance rights recover part of the value if II eventually favor this new actor and at least analyze their proposals, as voting rights increase their use to favor beneficial owners`s interests.

They don`t always succeed, (only in 29% of cases, see (3)). This specialization better solves the agency problem that having just one actor, (mutual funds). This mechanism needs a supply of enough activist shareholders, and for that a large enough return is necessary. The costs are huge, and regulation has a relevant role both for revenue and cost. But the average activist block is 8%, not a controlling stake. Where does their success come from?

Let`s see the sequence of their activity to identify the source:

  1. They accumulate a toehold stake.
  2. Public knowledge of activism comes with the filing of a certain threshold having been attained, 5% in the UK. There is a non-public negotiation with reticent mutual funds and other shareholders: if approved, the hedge funds goes on, if not it probably withdraws.
  3. Demand negotiation stage, to convince managers to voluntarily adopt the changes.
  4. Board representation stage: the activists menaces to elect directors, threatening with a proxy contest.
  5. The actual contest takes place if managers still refuse.

Returns are in average 40%, and annualized market-adjusted rate of 4%, over the average 19 month campaign duration.

5.- Regulatory issues.

Activists investors face research costs, financing costs, risk cost of concentrated wealth, and campaign costs.

What are the possible revenue sources: a) Mutual funds, but that would require coordination costly efforts; b) the target, but this is difficult as the hedge fund does not intend to control the company; c) stock price appreciation for the toehold position, which depends on the amount of the position, and the disclosure obligations, as only after disclosing the price already increases.

So the crucial points are:

  • ownership threshold for disclosure: there are proposals to reduce it, while including derivative positions.
  • period for disclosure after threshold is reached: there are proposals to let this period go under the current 10 day (Usa) allowed delay, (once the threshold is reached). The argument is shareholders that sell to them should be aware of the move, (but why….) and second, they can have access to a controlling or influencing stake without paying a premium. As for the premium argument, activists don`t really seek control positions, as the eventual losses could be huge. Basically, the proposals could do away with a poison pill at a low threshold, but without shareholder of board approval.
  • use of derivatives in the calculation of threshold: a) derivatives don`t capture voting rights for the proposal; b) it gives credibility for institutional investors; c) it increases the return; d) it gives room for high quality activism. A problem is sometimes, voting rights come with the swap. This could be a solution, just include derivatives in beneficial ownership when voting rights are transferred or mirrored.

Gilson and Gordon provide a satisfactory view of Activist Investors as specialist research and information seekers about CG or strategy (mainly), that complete CG gaps arisen as a result of the new ownership concentration features and the undervaluation of governance rights resulting from mutual funds activity, thus providing new value to voting rights.

 

(1) Gilson, Ronald J. and Gordon, Jeffrey N., The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights (March 11, 2013). Columbia Law Review, 2013 (Forthcoming); ECGI – Law Working Paper No. 197; Columbia Law and Economics Working Paper No. 438; Rock Center for Corporate Governance at Stanford University Working Paper No. 130. Available at SSRN: https://ssrn.com/abstract=2206391

(2) Bebchuk, Lucian A. and Cohen, Alma and Hirst, Scott, The Agency Problems of Institutional Investors (June 1, 2017). Available at SSRN: https://ssrn.com/abstract=2982617

(3) Marco Becht, Julian Franks & Jeremy Grant, Hedge Fund Activism in Europe 5, 20–24 (European Corporate Governance Inst., Finance Working Paper No. 283, 2010), available at http://ssrn.com/abstract=1616340  (on file with the Columbia Law Review).

See also aditional alternatives to undervalued governance rights by James McRitchie his posts appearing in 2013:

https://www.corpgov.net/2013/03/agency-capitalism-corrective-measures-part-1/

https://www.corpgov.net/2013/03/agency-capitalism-corrective-measures-part-2/ and

https://www.corpgov.net/2013/03/agency-capitalism-corrective-measures-part-3/

 

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