Concerns about the governance of public corporations have taken center stage in recent years. Part of the debate on improving governance has focused on policies that will give large shareholders greater influence over corporate decisions.
The underlying view, supported by several theoretical and empirical studies, is that large shareholders have both the ability and incentive to maximize the value of all shareholders. Large shareholders may improve governance, either through active monitoring or through passive selling, and both activities are expected to improve governance.
In this paper, we propose a complementary view which highlights one reason why, in some settings, a large shareholder's joint ability to influence corporate policy and to trade subsequently on his private information may actually weaken corporate governance. We demonstrate this idea in the context of corporate takeovers, showing that even if takeovers destroy firm value on average, a large shareholder would still support a policy to pursue takeover targets as long as this creates sufficient uncertainty about the future value of the firm.
The intuition is as follows: the large shareholder's ability to collect private information allows him to examine proposed takeover deals and trade on his private information before the true value of the deals becomes publicly known. The large shareholder will therefore purchase more shares if he receives a positive signal and sell shares if he receives a negative signal. The ability to collect private information, and trade on it, creates an endogenous wedge between the expected profits to the large shareholder and those of uninformed small shareholders. As a result, the large shareholder may find it optimal to support a more aggressive takeover policy ex ante, even if such a policy hurts small shareholders’ value.
Our model makes predictions on how large shareholders will trade during the takeover process. We test our predictions by examining mutual fund (our large shareholder) trading of acquirer stocks over different stages of the takeover process.
We consider all acquirers who announced takeovers between 1980 and 2012 and explore the relation between institutional trading of acquirer shares and ex post merger performance. We find that institutional trading during the bid negotiation period (ie, the period starting from the bid announcement and ending at deal closure), is strongly and positively correlated with ex post merger performance: institutional investors increase (decrease) their holdings of acquirer stocks in mergers with good (bad) long-run performance. We also find that this positive correlation is more pronounced in mergers with good ex post performance, which is consistent with the fact that most institutional investors in our sample are subject to short sale constraints.
We also test our hypotheses on how institutional investors trade before takeover announcements. We find that before takeover announcements, institutional investors increase their holdings of firms that subsequently pursue mergers with more dispersed performance. This finding is consistent with our hypothesis that higher ex ante uncertainty increases institutional investors' expected trading profits.
To further explore the underlying mechanisms of our results, we perform various subsample tests to explore cross-sectional variation in short sale constraints and institutional investors’ incentives and ability in information collecting and trading. We document that our baseline results are stronger for institutions with high initial holdings of acquirer stocks; for institutions that invest a large fraction of their portfolio in the acquirer's stocks; for the subsample of acquisitions with large deal size; and for the subsample of deals with high acquirer stock liquidity. Lastly, we provide additional evidence that our baseline results are most pronounced for mutual funds with high pre-acquisition trading skills.
In sum, our empirical analyses support our hypotheses that large shareholders benefit from takeovers, even when takeovers generate a negative average return to shareholders. This is because takeovers provide an opportunity to trade on privately collected information.
More broadly, we argue that this suggests that large shareholders may not always be strong advocates for limiting managerial over-investment decisions such as takeovers. Finally, note that our findings do not suggest that large shareholders never improve governance: large shareholders may monitor and limit under-investment problems more effectively.