Do Large Blockholders Reduce Risk?

In the sixth article of our Winter issue, the authors review the role and influence of companies with “blockholders” — shareholders with large positions in a particular company

The conventional assumption in the asset pricing literature is that the identity of a company’s owners is largely irrelevant, but studies of companies with “blockholders”—shareholders with large positions in a particular company—provide grounds for questioning this assumption.  Unlike the well-diversified investors of modern portfolio theory, blockholders have strong incentives to monitor corporate performance and, when necessary, to exert control over ineffective managements and boards. The findings of many studies support the idea that blockholders have a positive effect on rates of return.

The authors of this article report the findings of their recent investigation of whether blockholders might also have a positive effect on shareholder value by reducing the risk of the companies in which their holdings are concentrated. After distinguishing between companies with individual as opposed to corporate blockholders, and those with one share, one vote as opposed to those with dual-class shares, the authors find that ownership of large positions by individuals—but not corporations—was associated with lower systematic risk (when using both Fama-French multiple factor and CAPM models). At the same time, they find that the firm-specific risk of such companies was higher, but “biased” toward positive outcomes—that is, smaller downsides with larger upsides. What’s more, this upward shift in performance and risk-profile was achieved at least partly through increases in productivity as reflected in higher profit margins, profitability, profit per employee, and operating leverage, and lower costs of goods sold, SGA, and cash holdings. By contrast, in the case of blockholders in companies with dual-class share structures, all of these positive associations with blockholders were either significantly weaker, or reversed. That is, whereas the presence of individual blockholders appears to increase productivity and value under a one share, one vote governance regime, blockholders in companies with dual-class structures were associated with higher systematic risk and reduced productivity and value.

Authored by David Newton and Imants Paeglis

How Has Takeover Competition Changed Over Time?

The fifth article of our Winter issue, examines how, since the boom in takeovers in the 1980s, research in both law and financial economics has debated the role of takeover impediments such as poison pills, staggered boards, and state antitakeover laws. Have these impediments entrenched target management to the detriment of shareholders? Or have they increased the bargaining power of target boards of directors and left shareholders, if not better off, then at least unharmed?

In their study published recently in the Journal of Corporate Finance, the authors provide new answers to these questions with a detailed analysis of takeover competition during the period 1981 through 2014. Using a random sample of 388 completed and withdrawn deals from this 34-year period, the authors begin by confirming the already well-documented increase in the use of takeover impediments over time. They then report evidence that takeover competition has not declined during this period.

First of all, takeover premiums—the average percentage over market paid by acquirers to consummate transactions—have remained steady over time. Second, and the most striking of the authors’ findings, is that the corporate auction process has “gone underground” since the 1980s. Although we now see fewer hostile attempts and publicly reported takeover bidding contests, the amount of competition for targets has remained largely unchanged when one takes account of “private” as well as public auctions—that is, contests that, as the authors discovered, included unidentified bidders.

The authors view such a fundamental change in the takeover auction process as a response to the widespread growth of takeover impediments. In this sense, as Bill Schwert commented years ago, “hostile takeovers are less about shirking target management than about the bargaining tactics of targets and bidders.” Or as the authors put it, “the greater bargaining power provided by state laws and other takeover impediments has changed the manner in which takeover auctions are conducted,” but without greatly affecting the goal of economic efficiency that such transactions are designed to help bring about.

Authored by Tingting Liu and Harold Mulherin

The Early Returns to International Hedge Fund Activism: 2000-2010

In the fourth article of our Winter issue,the authors summarize their recent article in the Review of Financial Studies,. They provide an overview of the methods and findings of the first comprehensive study of worldwide hedge fund activism—one that examined the effectiveness of some 1,740 separate “engagements” of public companies by 330 different hedge funds operating in 23 countries in Asia, Europe, and North America during the period 2000-2010.

The study reports, first of all, that the incidence of shareholder activism is greatest in companies and countries with high institutional ownership, particularly U.S. institutions. In virtually all countries, with the possible exception of Japan, large holdings by institutional investors increased the probability that companies would be targeted by activists. Nevertheless, in all countries (except for the United States), foreign institutions—especially U.S. funds investing in non-U.S. companies—have played a more important role than domestic institutional investors in supporting activism.

The authors also report that those engagements that succeeded in producing “outcomes” were accompanied by positive and significant abnormal stock returns, not only upon the announcement of the activist’s block purchase, but throughout the entire holding period. “Outcomes” were identified as taking one of four forms: (1) increases in dividends or stock buybacks; (2) replacement of board members; (3) corporate restructurings such as sales or spinoffs of businesses; and (4) takeover (or sale) of the entire company. But if such outcomes were associated with high shareholder returns, in the many cases where there were no such outcomes, the eventual, holding-period returns to shareholders, even after taking account of the initially positive market reaction to news of the engagement, were indistinguishable from zero.

The authors found that activists succeeded in achieving at least one of their proposed outcomes in roughly one out of two (53%) of the 1,740 engagements. But this success rate varied considerably across countries, ranging from a high of 61% for North American companies, to 50% for European companies, but only 18% engagements of Asian companies—with Japan, again, a country of high disclosure returns but unfulfilled expectations and disappointing outcomes. Outcomes also tended to be strongly associated with the roughly 25% of the total engagements that involved two or more activists (referred to as “wolfpacks”) and produced very high returns.

Authored by Marco Becht, Julian Franks, Jeremy Grant, and Hannes F. Wagner

Does Mandatory Shareholder Voting Prevent Bad Acquisitions? The Case of the United Kingdom

A large number of studies have shown that many companies have made large acquisitions that their own shareholders probably would not have approved if given the opportunity to do so. In this Winter 2019 article, which summarizes the findings of their study published recently in the Review of Financial Studies, the authors present evidence that suggests the effectiveness of shareholder voting as a corporate governance mechanism designed to prevent such value-reducing acquisitions from taking place.

The authors’ study focused on acquisitions in the U.K. where proposed transactions that exceed a series of 25% relative size (target’s as a percentage of the acquirer’s) thresholds are defined as “Class 1” transactions and require shareholder approval. The authors found strikingly positive stock market reactions to the announcements of such Class 1 acquisitions—as compared to zero if not negative average announcement returns for Class 2 transactions that were not subject to a shareholder vote. And when the authors extended their analysis to U.S. M&A markets, they found that the larger (again, in relative size) U.S. deals—large enough that they would have required a shareholder vote in the U.K.—provided returns to their shareholders that were negative, and thus significantly lower than those of their U.K counterparts. In terms of the economic significance of their findings, the authors found that Class 1 transactions were associated with aggregate gains to acquirer shareholders of $13.6 billion. By contrast, U.S. transactions of similar size, which again were not subject to shareholder approval, were associated with aggregate losses of $210 billion for acquirer shareholders; and Class 2 U.K. transactions, also not subject to shareholder approval, were associated with aggregate losses of $3 billion.

In a further series of tests designed to shed light on how mandatory shareholder voting generates such substantial value improvements for acquirer shareholders, the authors also found evidence suggesting that when faced with the requirement of a shareholder vote, CEOs and boards are more likely to resist the temptation to overpay to close a deal. And the fact that the shareholders of the Class 1 acquirers did not end up blocking a single transaction that was submitted to a vote suggests that this mechanism works without the need for shareholders to actually vote down a deal. In other words, mandatory shareholder voting on acquisitions is a powerful deterrent to “bad deals” because, first of all, the vote is triggered automatically by the relative size tests and, second, CEOs and boards, with the help of their bankers, have a pretty good idea well in advance of the vote whether their shareholders are going to vote “no”—and such a vote would be viewed by top management as a major rejection, a strong vote of no confidence.

Authored by Marco Becht, Andrea Polo, and Stefano Rossi

The Effect of Shareholder Approval of Equity Issuances Around the World

Mandatory shareholder approval of equity issuances

Mandatory shareholder approval of equity issuances, and how it varies considerably across and within countries, is the subject of our third Winter 2019 article. In the United States and a few other countries, management typically needs the approval of only its board of directors to issue common stock. In most countries, however, by law or stock exchange rule, shareholders must vote to approve equity issuances when using certain methods or contemplating offers that exceed a specified fraction of outstanding shares. In some countries, shareholders must approve all equity issuances. Even in the United States, shareholder approval is mandatory under certain circumstances.

When managers issue stock without shareholder approval, as in the case of U.S. public offerings, returns are significantly negative and 4% lower, on average, than for shareholder-approved issues.

The differences in the stock market reaction to shareholder-approved equity issuances and to issues undertaken unilaterally by management are strikingly and consistently large. When shareholders approve stock issuances, whether public or rights offerings, or private placements, the average announcement returns are significantly positive, on the order of 2%. But when managers issue stock without shareholder approval, as in the case of U.S. public offerings, returns are significantly negative and 4% lower, on average, than for shareholder-approved issues. What’s more, the closer in time the shareholder vote is to the issue date, and the greater the required plurality (say, two-thirds instead of half the vote required for approval), the more positive is the market reaction to the issue—and these findings hold for each of the three main kinds of offerings that take place in all 23 countries in the author’s sample.

Also telling, in countries where shareholder approval is required, such as Sweden and Malaysia, rights offers predominate over public issues. But in countries like the U.S. and Japan, where managers may generally issue stock without shareholder approval, public offers predominate over rights issues. These findings suggest that agency problems—the tendency of corporate managements to put their own interests before their shareholders’—play a major role in equity issuances. Such findings are also largely inconsistent with the adverse selection, market timing, and signaling explanations that currently dominate academic thinking about equity issuances by public corporations.

Authored by Clifford G. Holdernes

The Rise of Agency Capitalism and the Role of Shareholder Activists in Making It Work

The rise of agency capitalism is the first article in our Winter 2019 issue.The past 50 years have seen a fundamental change in the ownership of U.S. public companies, one in which the relatively small holdings of many individual shareholders have been supplanted by the large holdings of institutional investors, such as pension funds, mutual funds, and bank trust departments. Such large institutional investors are now said to own over 70% of the stock of the largest 1,000 U.S. public corporations; and in many of these companies, as the authors go on to note, “as few as two dozen institutional investors” own enough shares “to exert substantial influence, if not effective control.”

As few as two dozen institutional investors own enough shares to exert substantial influence, if not effective control.

But this reconcentration of ownership does not represent a complete solution to the “agency” problems arising from the “separation of ownership and control” that troubled Berle and Means, the relative powerlessness of shareholders in the face of a class of “professional” corporate managers who owned little if any stock. As the authors note, this shift from an era of “managerial capitalism” to one they identify as “agency capitalism” has come with a somewhat new and different set of “agency conflicts” and associated costs.

The fact that most institutional investors hold highly diversified portfolios and compete (and are compensated) on the basis of “relative performance” provides them with little incentive to engage in the vigorous monitoring of corporate performance and investor activism that could address shortfalls in such performance. As a consequence, such large institutional investors—not to mention the large and growing body of indexers like Vanguard and BlackRock—are likely to appear “rationally apathetic” about corporate governance.

Authored by Ronald J. Gilson and Jeffrey N. Gordon.

How Have Green Companies Fared in Transactions with Banks?

How Have Green Companies Fared in Transactions with Banks?

In the last article of our Fall issue, the authors’ recent study investigates whether and to what extent a company’s environmental practices and record affect the terms of its bank loans. The study reports evidence of a clear association between environment-friendly corporate practices and both lower borrowing costs and less use of restrictive financial covenants. And consistent with the above findings, the authors also report that companies with better environmental practices have more stable income streams, lower leverage ratios, and higher future valuations. The authors also find that relationship (as opposed to first-time) lenders respond to improvements in companies’ environmental records by offering more favorable borrowing terms over time.

Moreover, the authors find that the association between more effective environmental management and lower loan costs is more pronounced for corporate borrowers that operate in industries facing greater industry competition and stricter environmental regulation.

In addition, borrowers with better records for green management are less likely to violate covenants, default on loans, or file for bankruptcy—a conclusion that should shed light on the current green finance policy debate among central banks and regulators as to whether they should reduce capital requirements or offer other policy inducements for bank financing of green assets.

Authored by Dawei Jin, Liuling Liu, Jun Ma, Haizhi Wang, and Desheng Yin

Do Staggered Boards Matter for Firm Value?

Do Staggered Boards Matter for Firm Value?

In the fifth article of our Fall issue, the authors address, and attempt to settle, the heated debate over the effect of staggered boards on corporate performance.  Critics of staggered boards claim they enable the entrenchment of inefficient managements and boards; and by working in tandem with poison pills to discourage hostile takeovers of underperforming companies, such boards end up generally reducing corporate values. 

Consistent with this theory, some institutional investors and shareholder rights advocates have urged companies to eliminate their staggered boards, while the most extreme critics have gone so far as to call for a regulatory ban.  By contrast, supporters of staggered boards argue that they help increase corporate values by allowing managements and boards to focus on long-term goals, and by providing board members a degree of independence from corporate executives who might want them replaced.  The most extreme proponents of staggered boards have proposed that such boards be not only permitted, but indeed mandated.

Both sides of the debate claim to be backed by empirical studies whose findings provide sharply conflicting pictures of the consequences of staggered boards. Whereas the earlier studies found that companies with staggered boards have significantly lower values, more recent studies have concluded that staggered boards lead to higher corporate values.

The authors show that neither side of the debate has convincing empirical support. The earlier studies failed to account or control for important variables and corporate characteristics that explain corporate decisions to stagger their boards, or for changes in the companies’ characteristics over time. For example, to the extent that a company’s poor performance drives its decision to adopt or retain a staggered board provision—presumably to give it more freedom to restructure and improve its operations—the association of staggered boards with poor performance ends up confusing cause and effect.

When the authors control for variables that affect both corporate values and the choice of staggered boards in a sample of close to 3,000 U.S. companies from 1990 to 2013, they find that the effect of a staggered board on firm value becomes generally insignificant.  As the authors put it, “The effect of a staggered board is idiosyncratic; for some firms it increases value, while for other firms it is value destroying.”  On the basis of such findings, the authors caution against legal solutions advocating either wholesale adoption or repeal of staggered boards, urging managements and boards to determine the value-maximizing approach that reflects their own companies’ opportunities and circumstances.

Authored by Yakov Amihud, Markus Schmid, and Steven Davidoff Solomon

Craig Pirrong’s 2017 Predictions – Right on the Money

The LNG Market’s Transformation Continues Apace–and Right On Schedule

When he wrote about the Liquefied Natural Gas (LNG) market “racing towards an inflection point” in our Winter 2017 issue (See “Liquefying a Market: The Transition of LNG to a Traded Commodity” in Volume 29, Issue 1), University of Houston Professor Craig Pirrong made some specific but out-of-the mainstream predictions.

Those predictions turned out rather well.

As he noted in a recent blog post, he had made the following points:

  • First, the traditional linkage in long term LNG contracts to the price of oil (Brent in particular) was an atavism–a “barbarous relic” (echoing Keynes’ characterization of the gold standard) as I phrased it more provocatively in some talks I gave on the subject. The connection between oil values and gas values had become attenuated, and often broken altogether, due in large part to the virtual disappearance of oil as a fuel for electricity generation, and the rise in natural gas in generation. Oil linked contracts were sending the wrong price signals. Bad price signals lead to inefficient allocations of resources.
  • Second, the increasing diversity in LNG production and consumption was mitigating the temporal specificities that impeded the development of spot markets. The sector was evolving to the stage in which participants could rely on markets to provide security of demand and supply. Buyers were not locked into a small number of sellers, and vice versa.
  • Third, a virtuous liquidity cycle would provide a further impetus to development of shorter term trading. Liquidity begets liquidity, and reinforces the willingness of market participants to rely on markets for security of demand and supply, which in turn frees up more volumes for shorter term trading, which enhances liquidity, and so forth.
  • Fourth, development of more liquid spot markets will make market participants willing to enter into contracts indexed to prices from those markets, in lieu of oil-linkages.
  • Fifth, the development of spot markets and gas-on-gas pricing will encourage the development of paper hedging markets, and vice versa.
  • Sixth, the emergence of the US as a supplier would also accelerate these trends. There was already a well-developed and transparent market for natural gas in the US, and a broad and deep hedging market. With US gas able to swing between Asia and Europe and South America depending on supply and demand conditions in these various regions, it was likely to be the marginal source of supply around the world and would hence set price around the world.
  • Moreover, the potential for geographic arbitrages creates short term trading opportunities.

    When pressed about timing, I was reluctant to make a firm forecast because it is always hard to predict when positive feedback mechanisms will take off. But my best guess was in the five year range.

    Those predictions, including the time horizon, are turning out pretty well. There have been a spate of articles recently about the evolution of LNG as a traded commodity, with trading firms like Vitol, Trafigura, and Gunvor, and majors with a trading emphasis like Shell and Total, taking the lead. Here’s a recent example from the FT, and here’s one from Bloomberg. Industry group GIIGNL reports that spot volumes rose from 27 percent of total volumes in 2017 to 32 percent in 2018.

    There are also developments on the contractual front. Last year Trafigura signed a 15 year offtake deal with US exporter Cheniere linked to Henry Hub. In December, Vitol signed a deal with newcomer Tellurian linked to Henry Hub, and last week Tellurian inked heads of agreement with Total for volumes linked to the Platts JKM (Japan-Korea-Marker).* Shell even entered into a deal linked with coal. There was one oil-linked deal signed recently (between NextDecade and Shell), but to give an idea of how things have changed, this met with puzzlement in the industry:

    The pricing mechanism that raised eyebrows this week in Shanghai was NextDecade’s Brent-linked deal with Shell. NextDecade CEO Matt Schatzman said he wanted to sell against Brent because his Rio Grande LNG venture will rely on gas that’s a byproduct of oil drilling in the Permian Basin, where output will likely increase along with oil prices.

    Total CEO Patrick Pouyanne said he didn’t understand that logic.

    “Continuing to price gas linked to oil is somewhat the old world,” Pouyanne said on Wednesday. “I was most surprised to see new contracts linked to Brent, especially from the U.S. Someone will have to explain this to me.”

    I agree! In fact, the NextDecade logic is daft. High oil prices that stimulate oil production will lead to lower gas prices due to the linkage that Schatzman outlines. If you have doubts about that, look at the price of natural gas in the Permian right now–it has been negative, often by $6.00/mmbtu or more. This joint-production aspect will tend to make oil and gas prices less correlated, or even negatively correlated.

    But it’s hard to believe how much the conventional wisdom has changed in 5 years. The whitepaper was released in time for the LNG Asia Summit in Singapore, and I gave a keynote speech at the event to coincide with its release. The speech was in front of the shark tank at the Singapore Aquarium, and from the reception I got I was worried that I might get the same treatment from the audience as Hans Blix did from Kim Jung Il in Team America.

    To say the least, the overwhelming sentiment was that oil links were here to stay, and that any major changes to the industry were decades, rather than a handful of years, away. Fortunately, the sharks went hungry and I’m around to say I told you so.

    I surmise that the main reason that the conventional wisdom was that the old contracting and pricing mechanisms would be sticky was an insufficient appreciation for the nature of liquidity, and how this could induce tipping to a new market organization and new contract and trading norms. These were ideas that I brought from my work in the industrial organization of financial trading markets (“market macrostructure” as I called it), and they were no doubt alien to most people in the LNG industry. Just as ideas about spot trading of oil were alien to most people in the oil industry when Marc Rich and others introduced it in the 1970s.

    Given the self-reinforcing nature of these developments, I believe that the trend will continue, and likely accelerate. Other factors will feed this process. I’ve written in the past about how some traditional contract terms, notably destination clauses, are falling by the wayside due to regulatory pressure in Japan and elsewhere. The number of sources and sinks is increasing, which makes the market thicker and mitigates further temporal specificities. The achievement of scale and greater trading opportunities will encourage investment in infrastructure, notably storage, that facilitates trading. Right now most LNG trading involves only one of the transformations I’ve written about (transformation in space): investment in storage infrastructure will facilitate another (transformation in time)

    It’s been kind of cool (no pun intended, given that LNG is supercooled) to watch this happen in real time. It is particularly interesting to me, as an industrial organization economist, given that many issues that I’ve studied over the years (transactions cost economics, the economics of commodity trading, the nature and dynamics of market liquidity) are all present. I’m sure that the next several years will provide more material for what has already proved to be a fascinating case study in the evolution of contracting and markets.

    *Full disclosure: My elder daughter works for Tellurian, and formerly worked for Cheniere. I have profited from many conversations with her over the last several years. One of my former PhD students is now at Cheniere.

    The Evolution of Corporate Cash

    The Evolution of Corporate Cash

    In another of our Fall 2018 articles, we examine a study published recently in the Review of Financial Studies, where the authors examine, and then attempt to explain, the considerable variation in the cash-to-assets ratios of U.S. public companies over a nearly 100-year period. For example, between 1920 and 1945, the average cash holdings of both small and large U.S. companies tripled.  By 1970, however, the cash levels of both had fallen back to their starting point in the early 1920s.  Then, at the start of the 1980s, the cash policies of small and large companies began to part ways.  Thanks to the very large cash holdings of the wave of companies that went public during the next two decades, the average corporate cash ratio increased sharply from 1980 to 2000—a period when the cash holdings of large, established U.S. companies remained largely unchanged.  But since 2000, it has been the large U.S. companies—many of them multinationals with profits “trapped” overseas—that have experienced the largest increase in cash holdings.

    The authors find especially compelling evidence that the significant increase in average cash holdings from 1980 to 2000 was driven primarily by a “Nasdaq effect” in which a large number of firms went public on the Nasdaq while holding amounts of cash that increased steadily throughout this 20-year period. This Nasdaq effect was most pronounced among unprofitable, largely debt-free, high-growth, and high-volatility firms, most of which operated in the healthcare or high-tech industries. And this trend may well continue in the future, given recent reports of a growing fraction of IPOs by companies that have yet to show profits.

    But along with and apart from this “Nasdaq” effect, the authors also find that for NYSE companies, the sensitivities of company-specific cash holdings to commonly studied variables have been remarkably stable during the past 90 years. The kinds of companies that have operated with high cash-to-assets ratios in recent years—riskier companies with growth opportunities and little if any profits or use of debt—have had large cash holdings in nearly every decade during the last century. And as in the past, relatively low-growth and low-risk public companies producing steady income have continued to operate with lower levels of cash.

    But even with this relative stability of firm-specific cash sensitivities, the authors do not find changes in corporate characteristics helpful in explaining the changes in aggregate cash holdings over time, particularly the large increases during the 1930s and early ’1940s, and the period since 2000. The largest roles in such increases appear to have been played by macroeconomic factors, such as the level of general economic growth and its effect on corporate profitability and investment.

    Nevertheless, in recent times, even after taking these macro and micro factors into account, the authors’ study provides clear evidence that the repatriation tax incentives (that were recently eliminated by the 2018 tax legislation) have played the largest role in the increase in aggregate corporate cash holdings that has taken place since 2000. With the recent elimination of such incentives, the cash holdings of large multinationals are likely to fall toward pre-2000 levels.

    Authored by John R. Graham and Mark T. Leary