When shareholders aren’t watching, managers misbehave

Credit: Michael Byers

Alex Verkhivker | Jan 23, 2017

Sections Finance

Corporate managements may feel besieged by the growing trend of institutional investors, but those powerful critics likely don’t have enough time to closely monitor all the companies they invest in, let alone every listed company. So while institutional investors are busy making demands on some companies’ management, what’s occurring at the neglected companies?

Chicago Booth’s Elisabeth Kempf, along with Bocconi University’s Alberto Manconi and Tilburg University’s Oliver G. Spalt, examines the economic impact of an environment in which shareholders are unable to actively monitor all the companies they invest in. Consistent with the standard principal-agent framework from economic theory, in which agents (managers) act on behalf of principals (shareholders), the researchers find that when shareholders are ”distracted,” executives have greater leeway to maximize private gains, to the detriment of shareholder value.

“We exploit unique features of US institutional holdings data to show that managers respond to temporarily looser monitoring, induced by investors with limited attention focusing their attention elsewhere, by engaging in investments that maximize private benefits at the expense of shareholders,” write Kempf, Manconi, and Spalt. They suggest that investors pay less attention when their focus gets diverted to other industries in their portfolios, such as technology during the dot-com bubble or banks during the 2007–10 financial crisis.

“Managers can get a sense of shareholder distraction from fewer direct phone calls, fewer meeting requests by institutional investors, diminished news coverage, conference calls with fewer critical questions, or from simply observing that many investors are focusing on ‘hot’ or ‘crisis’ industries,” they write.

Taking advantage of investor inattention
Companies pursue more M&A activity when shareholders are looking the other way, and the returns are poorer, research suggests.

 

   Companies with high investor distraction

 

   Companies with low investor distraction

Source: Kempf et al., 2016

The researchers analyze corporate takeovers because those involve executive decisions to make large discretionary investments. Their results suggest that the likelihood of a company announcing a merger is higher when shareholders are distracted, and that acquisitions that diversify a company’s business are nearly twice as likely to happen as compared with general deals.

A diversifying acquisition, expanding the products and services of the merged company, is considered to disproportionately benefit management “for reasons of empire building or job security through more stable cash flows,” according to the researchers. When investors are distracted, managers tend to tilt their budgets toward diversifying acquisitions, which turn out to be value destroying. Kempf, Manconi, and Spalt find that “bidders with distracted shareholders experience substantially negative abnormal returns over the 36 months following the deal.”

The underperformance of firms with distracted shareholders relative to firms with less-distracted shareholders isn’t confined to M&A announcements. The researchers sort all stocks in the Center for Research in Security Prices database into a low-distraction portfolio (below-median distraction measure in a given industry and month) and a high-distraction portfolio (above median). They find a significant underperformance in companies with distracted shareholders, but no abnormal performance for companies whose shareholders are less distracted. This relative underperformance amounts to 15 basis points per month, suggesting that managers engage in value-reducing actions, beyond M&A, on an economically significant scale when their investors aren’t paying attention.

The findings are consistent with the view that managers actively try to take advantage of investor inattention, to the harm of their shareholders. Unmonitored managers are more likely to cut dividends and design merger financing so that a shareholder vote isn’t required, and they are less likely to be fired during periods when the firm’s shareholders are distracted by outside events.

Understanding managers’ behavior in environments where shareholder attention is limited could “significantly improve our understanding of value creation in firms,” write the researchers. Perhaps the best advice to a distracted shareholder is to assume that management is misbehaving when no one is looking.