The Threat of Exit: How Investors Manage Management


On April 25, when Wells Fargo held its first shareholder meeting since the fake-bank-accounts scandal, tensions ran high. Four institutional investors, including two California pension funds, publicly opposed the re-election of certain Wells Fargo board members. When Chairman Stephen Sanger kept his role by a slim 56 percent, he acknowledged that “stockholders today have sent the entire board a clear message of dissatisfaction.”

Such open revolts by institutional investors grab headlines, but they’re also relatively rare, says Laura Starks, finance professor at McCombs. In a first-ever survey of 143 investors like mutual, hedge, and pension funds, she and her co-authors found that they pull most of their weight behind the scenes.

Private conversation with management was the top tactic to prompt corporate change, for 63 percent of the funds surveyed. Only 18 percent had made public criticisms at meetings, and only 16 percent had submitted their own shareholder proposals.

“You go and talk to management about changes you’d like to see them make,” she says. “They’re generally much more willing to talk if they know you’re not going to go public and try to embarrass them. Institutional investors usually don’t put in a proposal unless they’ve been unable to reach an agreement with management.”

The survey, which Starks conducted with colleagues Joseph McCahery of Tilburg University and Zacharias Sautner of the Frankfurt School of Finance & Management, fills a research gap that’s intrigued her for a long time. Institutions hold 70 percent of the stocks on the New York Stock Exchange, but little is known about how they wield that power to sway corporate policies.

That’s because discussions between investors and management — while not exactly secretive in nature — don’t happen during public shareholder calls. “I’ve talked to a lot of institutional investors about their activities,” Starks says, “but we couldn’t capture it in data like voting on shareholder proposals or stock market announcements. Now we have more evidence of how much is going on behind the scenes.”

The Threat of Exit
And part of what can happen behind the scenes, the survey discovered, is a strategic threat to dump a stock if executives won’t negotiate. Such warnings, even when unspoken, can change management behavior, said 42 percent of respondents.

“It’s voice versus exit,” Starks says. “Always when you’re talking to the managers, there’s this threat of exit there. You might go and sell a big chunk of their shares on the market.”

Not only can sudden sales depress the stock price, but bad publicity might follow, dragging it down even further. If a CEO’s compensation is also tied to stock, says Starks, “An exit threat can be a threat to their own personal wealth.”

To make that threat effective, an institution needs to own at least 2 percent of a company’s stock, respondents said, or have ties to other big investors who are also prepared to sell.

Still, while threats may be common, following through tends to be a last resort. Nearly 80 percent of respondents say they talk with management before deciding to sell, and only 39 percent have actually sold shares in the past five years over disagreements on corporate governance.

“There’s a tension between the threat of selling and the actual selling,” Starks says. “In some sense, they’re reluctant to give up on the company. They want to try and effect change.”

Playing a Long Game
A key factor in the fight or flight decision is how long an institution plans to keep the shares, the study found. Those who held stocks for at least two years engaged management through greater numbers of channels than did shorter-term investors.

“If you’re a long-term investor, you’re going to care more about the long-term value of the firm, and you’re going to be more interested in intervening,” Starks says. “If you’re a short-term investor, you have no incentive to do that.”

You’re also more concerned about governance issues than about current quarterly income, she adds. The top triggers for shareholder activism included inadequate governance, excessive compensation, and poor corporate strategy, each cited by almost 90 percent of respondents.

Most institutions are betting that fixing governance will eventually produce a better balance sheet, says Starks. “If you have a long-term horizon, then you can ride through the outcomes of the changes you’re trying to effect. You think it’s going to take a while, but it’s going to pay off in the future.”

At the same time, institutions are choosy about which battles to pick. If the benefits aren’t large enough or their stake is too small, 61 percent don’t engage with management at all.

Outsourcing Activism?
Other hurdles are too many firms in their portfolios or limited staff. In fact, stretched staffs are leading to a rise in the use of proxy advisors: consultants like Institutional Shareholder Services and Glass, Lewis & Co., which recommend how institutions should vote their shares. Critics fear that institutions are blindly following advisors’ recommendations.

Starks’ survey found that 60 percent of respondents used at least one proxy advisor, with nearly half of those using two or more. Even so, they stayed active themselves. Institutions that hired proxy advisors engaged with management through more channels than those without advisors. They made their own voting decisions, said 55 percent, but used advisors to make their votes more informed.

“This argues against the idea that investors are turning over their responsibilities to proxy advisors,” Starks says. “They use proxy advisors as complements rather than substitutes for being engaged with a company. They’re trying to get deeper information about a firm or a different perspective about the firm.”

One reason that institutions still do their own research, said half of respondents, is that they suspect their advisors of conflicts of interest: consulting with corporations on how to deal with institutions. “One arm of a proxy advisor is rating a firm while another division is giving the firm information on how to deal with the ratings,” she says. Institutions value the advisors but “take them with a grain of salt.”

Starks hopes the study can help corporate managers understand their biggest investors. She also hopes the results can give investors insights about their competition: other institutional investors. “This can help them think about how much management engagement they should enter into by seeing what their peers are doing.”

Behind the Scenes: The Corporate Governance Preferences of Institutional Investors” was published in the Journal of Finance.


Faculty in this Article

Laura Starks

Professor of Finance

Laura Starks is the Charles E. and Sarah M. Seay Regents Chair in Finance. She received a BA and Ph.D. from The University of Texas at Austin and...

About The Author

Steve Brooks

In a quarter-century as a journalist, Steve Brooks has won two Neal awards for excellence in trade reporting and a Press Club of New Orleans award...

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