This is a pretty important question, but unfortunately we still know only little about the interactions between large investors and their portfolio firms. The reason is that many interactions occur behind the scenes. In the paper, “Behind the Scenes: The Corporate Governance Preferences of Institutional Investors”, me and my co-authors Joseph McCahery and Laura T. Starks try to rectify this knowledge gap by conducting a survey among institutional investors. The paper is forthcoming in the Journal of Finance and available here
Institutional investors have two active choices when they become unhappy with a portfolio firm:
- they can engage with management to try to institute change (“voice”); or
- they can leave the firm by selling shares (“exit”).
The respondents to our survey, mostly very large institutional investors with a long-term focus, indicate that engagement through voice, especially when conducted behind the scenes, is highly important. For example, 63% of the respondents state that, in the past five years, they have engaged in direct discussions with management, and 45% have had private discussions with the board outside of management’s presence.
In addition, we find that the investor’s horizon makes a difference. First, long-term investors intervene more intensively than short-term investors. Second, investors who choose engagement do so more often because of concerns over a firm’s governance or strategy than over short-term issues. Nevertheless, the investors also indicate that they face impediments to their activism, with the most important hurdles being free rider problems and legal concerns over “acting in concert” rules.
A central challenge arises in analyzing whether institutional investors use the threat of exit and whether it is effective in bringing about changes in management behavior. The challenge is that the threat of exit is, by definition, unobservable. In fact, if the threat is credible, exit itself does not take place. Our investors view exit as a viable strategy with 49% (39%) stating that they had exited because of dissatisfaction with performance (governance) in the past five years. Based on their experience, 42% of the investors believe that the exit threat is effective in disciplining management. The investors further believe that exit is a complement to a voice strategy rather than a substitute, and intervention typically occurs prior to a potential exit.
Finally, we consider an increasingly controversial role in corporate governance: the role of proxy advisors. 60% of our respondents use proxy advisors, and about half of these respondents actually use the services of more than one advisor. Although the respondents raise some concerns over conflicts of interest in proxy advisory firms, arising from the offering of consulting services, they find their advice to be of value. They report that proxy advisors help them make better voting decisions, but that they remain their own decision makers. Further, investors that use proxy advisors engage their portfolio companies more intensively through voice, rather than substituting the proxy advice for their own voice. Contrary to some regulatory and media beliefs, this suggests that the use of proxy advisors does not necessarily imply that investors take a passive governance role.