It is received wisdom that institutional investors have insufficient incentives to cast informed votes because they compete on relative performance. If BlackRock invests in the monitoring of one of its portfolio companies, it will become relatively less competitive vis-à-vis the other institutional investors that hold shares in that company. In fact, other institutions would reap roughly the same benefits as BlackRock from its monitoring effort, without incurring any cost. Yet, there is evidence that institutional investors, whether actively or passively managed, no longer rubberstamp any proposal managers put to a vote. While that is not, in itself, evidence that institutional investors cast informed votes, changes in the marketplace and in the law may go some way explaining why rational apathy is now less pervasive than in the past. First, institutions have grown larger and corporate ownership is more concentrated; second, some institutions have become too-big-to-be-passive; third, the cost of voting and especially of becoming informed on how to vote, thanks to the intermediation of proxy advisors and of activist hedge funds, has dropped; fourth, rules have been relaxed to facilitate coordination among institutions; fifth, there is a reputational risk in being passive and uninformed for mutual fund managers, because their voting record has to be annually disclosed.
Yet, this atomistic approach to understanding institutions’ incentives to become informed may not be enough to understand what is going on. In the article ‘Institutional Investor Voting Behavior: A Network Theory Perspective’ (forthcoming in the University of Illinois Law Review) we suggest a new approach to understand why institutional investors may be more active in corporate governance than the rational reticence problem would predict: institutional investors’ incentives can be properly understood only by accounting for the structure of the network(s) in which they are embedded.
To study the functioning of this network, we rely on tools from network theory, a very lively area of research at the intersection of natural and social sciences. We show how the concepts of ‘multi-level competition’ and ‘inter-clique competition’ help explain why institutional investors increasingly use their voice, even though they should be paralyzed by collective action problems.
For instance, institutional investors owning stakes in the same portfolio firms form a ‘clique’ connected by co-ownership ties. Because there are good reasons to believe that cliques of co-operators outperform cliques of non-co-operators, competition among cliques of institutional investors might increase their incentives to collect information. To put it differently, competition does not take place only at the level of the single institutional investors, but also among cliques thereof. Moreover, competition takes place also at the employees’ level. Employees might believe that discussing ideas on how to handle a given controversial vote at an informal meeting is a good opportunity to impress potential employers. In this vein, self-interested employees will produce information that will circulate across the network of institutional investors.
The key idea is that these dynamics at the level of cliques and at the level of employees create multi-level interactions that are mediated by patterns of interconnections and that influence institutional investors’ behaviour.
Studying the incentives of institutional investors through the lens of network theory also helps shed some light on the current debate on horizontal shareholdings. In particular, we suggest that the proposals advanced to address the alleged anticompetitive concerns associated with horizontal shareholdings are misguided. Because institutional investors have stakes in a complex network of firms, they do not devise their strategies around the concept of a given product market. In this vein, invasive policy reforms that aim at addressing the problems associated with diffuse institutional ownership by focusing on market structure should be avoided.
Luca Enriques is the Allen & Overy Professor of Corportate Law at the University of Oxford.
Alessandro Romano is a researcher at Yale Law School.