Monitoring: Which Institutions Matter?

Worth taking another look, especially in light of the likely upcoming transition at Canadian Pacific (Bill Ackman: ‘A Stake in the Ground, Globe & Mail, 5/11/2012): Li, Kai, Harford, Jarrad and Chen, Xia, Monitoring: Which Institutions Matter?, Available at SSRN. 

Abstract: Within a cost-benefit framework, we hypothesize that independent institutions with long-term investments (ILTIs) will specialize in monitoring and influencing efforts rather than trading. Other institutions will not monitor. Using acquisition decisions to reveal monitoring, we show that only concentrated holdings by independent long-term institutions are related to postmerger performance. Further, the presence of these institutions makes withdrawal of bad bids more likely. These institutions make long-term portfolio adjustments rather than trading for short-term gain and only sell in advance of very bad outcomes. We conclude that independent long-term institutions actively monitor and benefit from their efforts. This benefit has both private and shared components. Examining total institutional holdings or even concentrated holdings by other types of institutions masks important variation in the subset of monitoring institutions.

Conclusion: The results in our study depict a complete and intuitive picture of institutional monitoring versus trading: when monitoring benefits exceed costs, institutional investors will monitor rather than trade; and their monitoring activities offer them informational advantages that they can use to adjust their portfolios over time.

Our evidence on the relation between institutional holdings and acquisition quality shows the following:

• Only concentrated holdings by ILTIs have any relation with post-merger performance;
• Total  institutional holdings and concentrated holdings by other types of institutions show no monitoring effect. Further, bid completion is sensitive to the market reaction to the bid announcement, but only in the presence of concentrated holdings by ILTIs. Thus, these institutions are active in influencing management’s decision to reverse a bad decision.
• Finally, our examination of the trading activity of these independent, long-term monitoring institutions supports the hypothesis that they focus on monitoring and influencing, rather than trading for profit. They show no evidence of profitable short-term trading around bids. Rather, they engage in long-term beneficial adjustments to their holdings.
• Consistent with the hypothesis that the high costs of selling a large stake are part of the motivation to monitor, we find that ILTIs with large stakes only sell in advance of extremely poor bids. 

Thus, ILTIs with concentrated holdings monitor management and take action when they see a problem. They do not trade actively on short-term information. Once management has made a poor decision, they will attempt to have that decision reversed. Over time, if they anticipate a large enough value reduction, and/or they perceive their ability to influence management to be low, they will sell their stakes. Overall, they gain from their monitoring efforts. The gain from effective monitoring is shared with other shareholders, while the gain from long-run portfolio adjustment is private.

Three proxy advisory firms — Institutional Shareholder Services Inc., Glass Lewis & Co., and Egan-Jones Proxy Services — all took the unusual step of recommending shareholders vote for Pershing Square’s entire slate of seven nominees and withhold their votes for several incumbent directors. All three recommended investors not re-elect Mr. Cleghorn and Mr. Green. The Canada Pension Plan Investment Board Friday, threw their support behind Pershing Square’s slate.

Boards seem too timid to do much, fund managers are largely passive. I don’t think it is the best model, but I’m glad we have proxy advisory firms and activist funds like William Ackman’s Pershing Square Capital Management.