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The Effect of Liquidity on Governance

The Effect of Liquidity on Governance. Alex Edmans , LBS, Wharton, NBER, CEPR, and ECGI Vivian Fang, University of Minnesota Emanuel Zur , University of Maryland June 19 th , 2013, WFA. Background and Research Question .

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The Effect of Liquidity on Governance

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  1. The Effect of Liquidity on Governance Alex Edmans, LBS, Wharton, NBER, CEPR, and ECGI Vivian Fang, University of Minnesota Emanuel Zur, University of Maryland June 19th, 2013, WFA

  2. Background and Research Question • Policy debate: does stock market liquidity improve or weaken corporate governance? • Policies in the 1930s promoted market liquidity. • Some worries enhanced liquidity hinders governance.

  3. Theoretical Framework • Traditional theories:Shleifer and Vishny (1986), Burkart, Gromb, and Panunzi (1997), Kahn and Winton (1998), Bolton and von Thadden (1998) • Under these theories, blockholders govern through “voice” (intervention) • Liquidity results in “no governance” (1) by allowing cut and run: Coffee (1991), Bhide (1993)and (2) by stimulating insider trading:Maug (2002) • Liquidity encourages “voice” (1) by providing camouflage: Maug(1998) and (2) by increasing price informativeness Faure-Grimaudand Gromb (2004) “Voice-B” “Voice-G”

  4. Theoretical Framework (Cont’d) • Recent theories:Admatiand Pfleiderer (2009), Edmans (2009), Edmans and Manso(2011) • Under these theories, “exit” (threat of exit) is a governance mechanism in itself • Liquidity strengthens “exit” by (1) encouraging block formation: Edmans (2009) and (2) by stimulating information acquisition: Edmans (2009), Edmans and Manso (2011) “Exit”

  5. Empirical Challenges • Many blockholders do not engage in “voice”. • Diversification reqts for mutual funds; “Prudent man” rules for pension funds (Del Guercio(1996)); Conflicts of interest (Agrawal(2011)) • We focus on hedge fund activists, as they have • Few conflicts and legal restrictions • The full “menu” to choose from: “Voice”, “Exit”, or “No Governance” • High performance-based pay: Clifford and Lindsey (2011)

  6. Empirical Challenges (Cont’d) • The threat of exit or threat of voice also exerts governance. • Parrino, Sias, and Starks (2003): actual exit • Norli, Ostergaard, and Schindele (2009): actual voice • Lack of actual exit or voice does not necessarily mean no governance • We use Schedule 13D (active) and 13G (passive) filings • Capture monitoring intent rather than instances of actual governance • Filings accurately represent the true monitoring intent • 13G: Legally prohibited from activism • 13D: Onerous filing reqts / Target hostility / Worse credit / Reputation

  7. Empirical Challenges (Cont’d) • Liquidity may be endogenous • Reverse causality/ Omitted control variables • We address the endogeneity issue • Reverse causality is less of a concern • We study futuregovernance events (Schedule 13 filings) • Governance characteristics (future or contemporaneous) can be sticky • Decimalization as an exogenous shock to liquidity • Minimum tick size reduced from 1/16 dollar to 1 cent in early 2001 • Bid-ask spreads fell substantially market wide (Bessembinder 2003)

  8. Main Findings • Liquidity increases the likelihood of block acquisition • Conditional on block formation, liquidity encourages 13G over 13D • A 13G filing represents a governance mechanism • A positive market reaction, a positive holding-period return, and an improvement in operating performance; all stronger in more liquid firms • 1) and 2) are stronger in firms with higher managerial sensitivity to price • Unconditional effect of liquidity on 13D filings is positive

  9. Contribution • Provide insight into the policy and theoretical debate • Literature on the effect of liquidity on firm outcomes • Firm value: Fang, Noe, and Tice (2009), Bharath, Jayaraman, and Nagar (2013) • Voice: Norli, Ostergaard, and Schindele (2009), Gerken(2009) • Literature on the role of hedge funds in governance • Brav et al. (2008), Clifford (2008), Greenwood and Schor(2009), Klein and Zur (2009, 2011), Boyson and Mooradian (2011)

  10. Sample Selection • Data sources • Factiva: 223 activist HFs for 1995-2010 (Bravet al. (2008)) • SEC’s EDGAR: Initial 13D/13G schedules • Filed upon acquiring 5% if intend (do not intend) to engage in activism • CRSP: Daily price, return, and trading volume • Compustat: Firm-year financial data • ExecuComp: Equity incentives • We end up with • 88,742 firm-year obs. between 1995 and 2010 (Full sample) • 1,135 firm-year obs. have initial 13D/13G filings (HF sample)

  11. Regressors • Measuring liquidity • Amihud(2002) ratio; Fong, Holden, and Trzcinka (2011) measure • -1 × natural logarithm of the two illiquidity measures LIQAM= −ln(AMRATIO); LIQFHT= − ln(FHT) • Higher values of LIQAM and LIQFHT correspond to higher liquidity • Control Variables: Firm characteristics following Brav, Jiang, and Kim (2010); year and industry fixed effects

  12. Effect of Liquidity on Block Formation 0.5% v.s. 1.3% unconditional probability =1 if post decimalization; 0 otherwise

  13. Effect of Liquidity on Block Formation (Cont’d) • DECIMALmay capture confounding events around 2001 • Tick size reduction should have a bigger impact on stocks with lower price. • We split sample by LOWPRC. DECIMAL is only significant in the subsample with LOWPRC=1. • Narrow testing window helps to focus on the Δ we intend to capture. • We show Δin liquidity from t-1 to t+1 positively predicts the block formation in t+2, with t indicating the decimalization year.

  14. Effect of Liquidity on Governance Mechanisms 7% v.s. 43% unconditional probability • DECIMAL is again only significant in the subsample with LOWPRC=1.

  15. Is 13G Filing a Governance Event? 3-day CAR over CRSP value-weighted index • Unlikely to be explained by undervaluation • Multivariate regression results are consistent. Switching from below-LIQAM-median subsample to above increases CAR_VW by 1.7%. • Results are similar if using 3-day CAR over CRSP equal-weighted index.

  16. Is 13G Filing a Governance Event? (Cont’d) Holding period raw return over CRSP value-weighted index • Results are similar if using holding period raw return over CRSP equal-weighted index.

  17. Is 13G Filing a Governance Event? (Cont’d) Change in operating performance from year t-1 to t+1

  18. Effect of Liquidity on Block Formation: Role of WPS Scaled wealth performance sensitivity (WPS) of Edmans, Gabaix, and Landier (2009) = Total Delta / Annual Pay

  19. Effect of Liquidity on Governance: Role of WPS A dummy to indicate above-median-WPS

  20. Effect of Liquidity on HF Activism Liquidity increases the likelihood that a HF acquires a block (H1); Conditional on BA, liquidity increases the likelihood of 13G over 13D (H2). Which effect dominates? 0.14% v.s. 0.6% unconditional probability

  21. Conclusion • Liquidity increases the likelihood of block acquisition • Conditional on block formation, liquidity encourages 13G over 13D • A 13G filing represents a governance mechanism • A positive market reaction, a positive holding-period return, and an improvement in operating performance; all stronger in more liquid firms • 1) and 2) are stronger in firms with higher managerial sensitivity to price • Unconditional effect of liquidity on 13D filings is positive Liquidity improves blockholder governance

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