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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

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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.

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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-Grimaud and Gromb (2004)

“Voice-B”

“Voice-G”

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Theoretical Framework (Cont’d)

Recent theories: Admati and 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”

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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)

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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

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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 future governance events (Schedule 13 filings) Governance characteristics (future or contemporaneous) can be sticky

Decimalization as an exogenous shock to liquidityMinimum tick size reduced from 1/16 dollar to 1 cent in early 2001Bid-ask spreads fell substantially market wide (Bessembinder 2003)

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Main Findings

1) Liquidity increases the likelihood of block acquisition

2) Conditional on block formation, liquidity encourages 13G over 13D

3) 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

4) Unconditional effect of liquidity on 13D filings is positive

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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)

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Sample Selection

Data sources Factiva: 223 activist HFs for 1995-2010 (Brav et 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)

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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

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Effect of Liquidity on Block Formation

  Voice-G Voice-B ExitH1: Stock liquidity increases the likelihood that a hedge fund acquires a block.

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  (1) (2) (3) (4) (5) (6)Dependent Variables BLOCKt+1 (=1 if 13D Filing or 13G Filing; 0 if no block acquisition)LIQAMt 0.079*** 0.171***          (0.013) (0.021)        LIQFHTt     3.975*** 3.902***          (0.747) (1.064)    DECIMAL         0.299*** 0.544***

          (0.024) (0.064)Controls   Included   Included   IncludedYear and Industry FE   Included   Included   IncludedNumber of Obs. Used 88,742 88,742 88,742 88,742 88,742 88,742Pseudo R2 0.003 0.052 0.003 0.046 0.013 0.044

0.5% v.s. 1.3% unconditional probability

=1 if post decimalization; 0 otherwise

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Effect of Liquidity on Block Formation (Cont’d)

DECIMAL may 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 Δ in liquidity from t-1 to t+1 positively predicts the block formation in t+2, with t indicating the decimalization year.

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  Voice-G Voice-B ExitH2: Conditional upon acquiring a block, stock liquidity reduces the likelihood that the hedge fund files a 13D rather than a 13G.

Effect of Liquidity on Governance Mechanisms

  (1) (2) (3) (4) (5) (6)Dependent Variables 13Dvs13Gt+1 (=1 if 13D Filing; 0 if 13G Filing)LIQAMt -0.152*** -0.169***          (0.046) (0.064)        LIQFHTt     -4.047* -6.662**          (2.456) (3.260)    DECIMAL         -0.295*** -0.492**

          (0.084) (0.236)Controls   Included   Included   IncludedYear and Industry FE   Included   Included   IncludedNumber of Obs. Used 1,135 1,135 1,135 1,135 1,135 1,135Pseudo R2 0.007 0.096 0.002 0.092 0.008 0.087

7% v.s. 43% unconditional probability

DECIMAL is again only significant in the subsample with LOWPRC=1.

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  Voice-G Voice-B ExitH3a: A 13G filing leads to a positive event-study return, particularly among liquid firms.

Is 13G Filing a Governance Event?

  (1) (2) (3) (4) (5)

  Pooling Low LIQAM High LIQAM Low LIQFHT High LIQFHT

Testing CAR_VW(-1, +1)>0 0.008***

(0.002)0.004

(0.004)0.012***

(0.003)0.004

(0.004)0.012***

(0.003)

Number of Obs. Used 630 315 315 315 315

• 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.

3-day CAR over CRSP value-weighted index

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  Voice-G Voice-B ExitH3b: A 13G filing leads to a positive holding-period return, particularly among liquid firms.

Is 13G Filing a Governance Event? (Cont’d)

  (1) (2) (3) (4) (5)

  Pooling Low LIQAM High LIQAM Low LIQFHT High LIQFHT

Testing HOLDINGRET_VW>0 0.053***

(0.017)0.015

(0.026)0.092***

(0.022)0.019

(0.025)0.088***

(0.023)

Number of Obs. Used 523 262 261 262 261

Holding period raw return over CRSP value-weighted index

• Results are similar if using holding period raw return over CRSP equal-weighted index.

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  Voice-G Voice-B ExitH3c: A 13G filing leads to an increase in operating performance, particularly among liquid firms.

Is 13G Filing a Governance Event? (Cont’d)

  13G firms Control firms DiD estimator T-statistics of DiDLow LIQAM Subsample        ∆EBITDA/ASSET -0.021 -0.017 -0.004 -0.35∆CFO/ASSET -0.007 -0.019 0.012 1.08High LIQAM Subsample        ∆EBITDA/ASSET 0.011 -0.022 0.033** 2.55∆CFO/ASSET -0.003 -0.019 0.016 1.33Low LIQFHT Subsample        ∆EBITDA/ASSET -0.025 -0.021 -0.004 -0.38∆CFO/ASSET -0.021 -0.020 0.000 -0.02High LIQFHT Subsample        ∆EBITDA/ASSET 0.015 -0.018 0.033*** 2.67∆CFO/ASSET 0.011 -0.018 0.029** 2.43

Change in operating performance from year t-1 to t+1

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Effect of Liquidity on Block Formation: Role of WPS  Voice-G Voice-B ExitH4a: The effect of liquidity on the probability of block acquisition is stronger in firms with higher managerial sensitivity to price.

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  (1) (2) (3)Dependent Variables BLOCKt+1 (=1 if 13D Filing or 13G Filing; 0 if no block acquisition)LIQAMt 0.180*      (0.101)    LIQAMt ×WPSt 0.019*      (0.010)    LIQFHTt   8.326*      (5.042)  LIQFHTt ×WPSt   0.049**      (0.021)  DECIMAL     0.508***

      (0.079)DECIMAL×WPSt     1.480*

      (0.816)WPSt 0.002* 0.020** -0.534  (0.001) (0.009) (0.588)Controls, Year and Industry FE Included Included IncludedNumber of Obs. Used 24,645 24,645 24,645Pseudo R2 0.087 0.086 0.086

Scaled wealth performance sensitivity (WPS) of Edmans, Gabaix, and Landier (2009)= Total Delta / Annual Pay

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Effect of Liquidity on Governance: Role of WPS  Voice-G Voice-B ExitH4b: The effect of liquidity on the probability of filing choices is stronger in firms with higher managerial sensitivity to price.

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  (1) (2) (3)Dependent Variables 13Dvs13Gt+1 (=1 if 13D Filing; 0 if 13G Filing)LIQAMt 0.722      (0.927)    LIQAMt ×HIGHWPSt -2.390*      (1.298)    LIQFHTt   7.337      (11.494)  LIQFHTt ×HIGHWPSt   -38.281*      (22.928)  DECIMAL     0.852      (0.751)DECIMAL×HIGHWPSt     -0.854*

      (0.463)HIGHWPSt 0.017 -0.009 0.373  (0.171) (0.188) (0.509)Controls, Year and Industry FE Included Included IncludedNumber of Obs. Used 322 322 322Pseudo R2 0.161 0.157 0.156

A dummy to indicate above-median-WPS

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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?

  Voice-G Voice-B ExitH5: Stock liquidity increases the unconditional likelihood that a hedge fund files Schedule 13D.

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  (1) (2) (3)Dependent Variables 13DFILINGt+1 (=1 if 13D Filing; 0 if 13G Filing or no block acquisition)

LIQAMt 0.103***      (0.026)    LIQFHTt   3.851***      (1.435)  DECIMAL     0.309***

      (0.088)Controls Included Included IncludedYear and Industry FE Included Included IncludedNumber of Obs. Used 88,742 88,742 88,742Pseudo R2 0.040 0.038 0.036

0.14% v.s. 0.6% unconditional probability

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Conclusion

1) Liquidity increases the likelihood of block acquisition

2) Conditional on block formation, liquidity encourages 13G over 13D

3) 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

4) Unconditional effect of liquidity on 13D filings is positive

Liquidity improves blockholder governance