The Choice Between Voice and Exit: The Effect of Liquidity on Shareholder Commitment

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Most stock market experts believe shareholder input is good because it presses managers to do their best to maximize returns. But how does liquidity — the availability of shares to buy and sell — affect that shareholder involvement? “It’s something that has inspired both academic debate and policy debate,” says Wharton finance professor Alex Edmans.

When Japan was booming in the 1980s, many market watchers believed the country’s low-liquidity system was a good model. By making it more difficult to buy and sell, it encouraged shareholders to make long-term commitments, giving them a strong incentive to prod managers to perform. In a high-liquidity system like the one in the United States, this view holds, unhappy shareholders can walk away too easily. “One of the views, which was quite prevalent in the 1980s, was that the U.S. having liquid markets was bad because shareholders had a short-term view,” Edmans notes, adding, “They could cut and run. They could just get out rather than stay around to fix any problems.”

But Japan’s “lost decade” of the 1990s raised doubts about the low-liquidity model, while stocks soared in the U.S. despite the higher liquidity. “The superiority of the Japanese system is now questioned,” Edmans says. “The Japanese model was not as good as once thought.”

Still, the debate remained unresolved. Because many factors influence stock prices, it is difficult to tell whether gains or losses during any given period reflect the level of liquidity rather than something else.

To probe this question, Edmans and his colleagues, Vivian W. Fang of Rutgers University and Emanuel Zur of Baruch College, looked at three issues: how liquidity affects the likelihood that a hedge fund acquires a large stake, how liquidity affects the governance mechanism that the hedge fund chooses to employ after acquiring the large stake, and how liquidity affects the stock price reaction to these acquisitions. Their conclusion, described in their paper, “The Effect of Liquidity on Governance, is that higher liquidity does encourage shareholders to behave in ways that effectively press managers to improve returns.

The study found that hedge funds are more likely to acquire large blocks of stock in firms that have liquid trading, and that liquidity alters the governance mechanism that the hedge fund chooses to employ.

The higher the liquidity, the more likely the hedge fund would opt for “passive” rather than “active” ownership. Rather than actively pressing management to improve returns, the hedge funds used an implied threat to sell their shares, a move that would depress the share price. Hence, the threat of an “exit,” or voting with one’s feet, turns out to be a way to improve governance rather than a decision to leave the firm as is.

The study takes a new look at what it means when a large investor like a hedge fund acquires a stake in a given company. In the traditional view, it was thought that investors attempted to influence corporate governance only if they pressed for specific actions, such as a change in management, or an acquisition or divestiture. Simply selling a block of shares, or “the Wall Street Walk,” was thought to weaken corporate governance: By abandoning the field, the investor left the firm unimproved.

Perhaps, Edmans and his colleagues thought, the potential for a large sale, or exit, is also a means of pressuring management. But can that be so, even if the investor does not voice specific demands? “The very act of selling one’s shares is a governance mechanism in itself,” Edmans says of the theory. Selling by a large shareholder increases supply and drives share prices down, jeopardizing the manager’s income and employment. Therefore, even the threat of selling can influence a top manager’s behavior. “He’s going to think twice about doing bad things…. The threat of selling when things go wrong can actually help [improve] governance.”

The study focused on hedge funds because they have more freedom than most other types of institutional investors and often take an activist role. Other institutional investors, such as mutual funds, may be too diversified to use activist strategies, and they often avoid activism to preserve other business relations, such as managing a firm’s 401(k) plan.

Hedge funds and other investors that acquire 5% or more of a company’s stock are required to file one of two publically available documents with the Securities and Exchange Commission. A Schedule 13D is filed if the investor intends to take an active interest in the firm’s governance, such as demanding management changes or launching a proxy fight or a hostile takeover. “It gives you the opportunity to threaten the manager with intervention if things go badly,” Edmans notes.

The alternative is a 13G, a simple notice that the investor has acquired 5% or more of the shares. By filing a 13G, the investor shows it intends to remain passive — that it will not actively press management for specific changes. An investor that does not plan an active role chooses the 13G because it is a significantly cheaper route to take and is less likely to get a hostile reaction from management. Because these filings are public record and often are widely reported, a 13D can signal turmoil to come, depressing the bond price and worsening the terms of debt. A 13G is less likely to do that.

Investors, therefore, use 13Ds if they intend to use their “voice” to improve the company, and they choose the 13G if their dissatisfaction will simply result in an “exit,” or selling the shares. The question, according to Edmans, is whether the liquidity of the firm’s shares affects the choice between voice and exit.

The Nature of Liquidity

Liquidity is not simply a matter of the number of shares a firm has in circulation, but of the availability of willing buyers and sellers. That means a company’s liquidity can change over time, making it difficult to determine whether liquidity affects governance or governance affects liquidity.

To resolve this, Edmans, Fang and Zur focused on the period during 2001 when exchanges started listing stock prices down to the penny instead of a 16th of a dollar, or 6.25 cents. With “decimalization,” a buyer having difficulty getting shares would have to raise his bid on the next try by only a penny instead of 6.25 cents, potentially reducing his cost per share. The ability to adjust bid and asked prices by smaller increments attracts more investors, increasing liquidity. “When you have a smaller spread, it’s just cheaper to trade,” Edmans says.

Most importantly, the increase in liquidity after the switch to decimalization was clearly due to decimalization, not any governance issues with the companies traded on the exchanges. By focusing on this period, the study could look at how liquidity affects governance without worrying that governance might be influencing liquidity.

The study found that an increase in liquidity increases the likelihood that a hedge fund would acquire a company’s stock and file either a 13D or 13G, Edmans notes. The effect is especially strong when the managers have more stock-based incentives, or more to lose if the stock price falls. In any given year, there is a one in 100 chance that a company’s stock will be acquired by a hedge fund, the study found. If the firm shifts from low to high liquidity, that likelihood goes up by about half a percentage point.

Moreover, the higher the liquidity, the more likely the hedge fund will file a 13G rather than a 13D — meaning it favors passive ownership over active. In these cases, the hedge fund could exert pressure on management only through the implied threat of selling a large block of shares. A 13G was especially likely when managers had large stock incentives.

Edmans and his colleagues focused on stock prices during the three-day period surrounding the filing of a 13G. They found that stock prices did tend to rise following this type of filing.  The gain after a 13G indicated that the threat of an exit prodded management to do better even though the hedge fund had not made specific demands. “In general, the filing of a 13G leads to a stock price going up by one percentage point, and the reaction is one percentage point higher for a liquid firm rather than for an illiquid firm,” he says.

“If the stock is more liquid, then it’s easier for the stockholder to dump the stock,” he adds. It is easier for a passive owner, whose only pressure tactic is the implied threat of a big sale, to influence governance if the sale will be easy to accomplish.

Of course, a hedge fund might buy a stock because it appears to be underpriced. But if that were the only factor, the study would not have found the correlation between higher liquidity and bigger price gains after the SEC filings, Edmans points out, noting that high liquidity leads to more accurate pricing, reducing the chances the hedge funds can simply scoop up bargains.

Hedge funds that file 13Gs do not make specific demands of management. But by accumulating large blocks that could be sold, they send managers a simple message, says Edmans: “To maximize shareholder value … you just have to manage the firm correctly.”

“Liquidity is beneficial,” Edmans notes. It enhances the likelihood that big investors will buy a firm’s stock and, with one technique or the other, exerts pressure on management to improve. Other investors, he concludes, would therefore be wise to buy stocks in companies that are more liquid rather than those that are not.

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