Picking Friends Before Picking (Proxy)
Fights: How Mutual Fund Voting Shapes Proxy Contests
Posted by Alon Brav (Duke University), Wei
Jiang (Columbia University), and Tao Li (University of Florida), on
Monday, February 12, 2018
Over the past two decades the frequency of proxy
contests for board representation or control has increased as shareholder
activism has become both an established investment strategy and an important
form of corporate governance. Since dissidents are typically minority
stockholders, a successful campaign, such as Trian Partners’ intervention at
Procter and Gamble Co., requires support from their fellow shareholders. The
general apathy of retail investors towards voting matters implies that it is
usually necessary that dissidents win the support of a majority of institutional
shareholders. Hence, “picking friends”—the selection of a target with a
pro-activist shareholder base—is a crucial element in an activist’s decision on
whether to launch a proxy contest.
In our
paper, Picking
Friends Before Picking (Proxy) Fights: How Mutual Fund Voting Shapes
Proxy Contests, publicly available on SSRN, we study the
determinants of mutual fund voting in proxy contests, in which voting
decisions are arguably more informative as compared with uncontested
meetings where investor votes are mostly precatory. Further, we
explicitly model a simultaneous system consisting of both activists’
target selection and mutual fund voting, which allows us to uncover
the funds’ voting rules for all potential proxy contests based on the
subset of voting records of materialized contests.
Our study relies on a
unique and comprehensive data set of mutual fund voting records for proxy
contests, extracted from the mandatory N-PX filings by U.S. registered
management investment companies. We find that mutual funds are more likely to
support a dissident when the target firm experiences poor recent stock price or
accounting performance. Support for the dissident is higher when two leading
proxy advisory firms, Institutional Shareholder Services and Glass, Lewis & Co.,
issue a “For” recommendation for the dissident rather than when either of the
advisory firms supports the management. We further identify large differences in
fund families’ tendency to follow advisory firms’ recommendations. The families
that are most responsive to proxy advisors are mainly smaller fund families that
lack resources to conduct independent proxy research. We also find that mutual
funds are more likely to vote for hedge fund activists rather than other types
of dissidents, consistent with the notion that investors believe that hedge
funds are more economically driven than other types of activists and are
therefore an effective force of governance. Mutual funds, however, do not
support a dissident’s slate of directors when the dissident has been a
“frequent” activist targeting many companies in the past, but tend to support
those activists whose targeting signals a high commitment in the past (e.g.,
seeking board representation). In other words, institutional investors favor
focused and determined activists and are not necessarily impressed by an
activist’s length of a hostile track record.
Fund characteristics
also predict differential support for dissidents. One salient pattern is that
passively-managed funds are less likely than active funds to vote for
dissidents. The gap between active and passive votes has been persistent across
years, and is larger for small capitalization stocks. To the best of our
knowledge, this is the first study reporting direct evidence that passive funds
are more “friendly” towards management than active funds. This is also confirmed
by our family-level study, which shows that the most pro-dissident fund families
typically have a low fraction of passive funds, while the least pro-dissident
groups tend to have a disproportionately high number of passive funds. One
potential reason is that unlike actively-managed funds, passive funds—index and
exchange-traded funds—are not rewarded by “beating the index.” Instead, they are
usually rewarded by low expense ratios and small tracking errors. We also find
that a mutual fund is significantly more likely to support a dissident when the
abnormal returns of same-industry firms in the fund’s portfolio are higher. This
is consistent with the idea that mutual funds make voting decisions based on the
overall performance of their portfolios. In addition, funds earning a positive
basis-adjusted return (return net of the cost of investment) on the target stock
are less likely to support the dissident than a fund earning a negative return.
This suggests that “unhappy” shareholders, who have lost capital investing in
the stock, tend to favor the changes proposed by the dissident.
Since investors’ voting
decisions and dissidents’ target selection are jointly determined an analysis of
shareholder voting behavior in materialized proxy contests may not fully reveal
the underlying “voting rules” adopted by institutional investors. We therefore
employ a parsimonious system of equations to model the joint contest-voting
dynamics. This system yields a positive coefficient of correlation between the
propensity to target by an activist and the propensity to support the activist
by investors, consistent with the notion that activists tend to target firms
with unobservable characteristics that predict strong shareholder support,
beyond the predictive power of observable attributes. We then proceed to
construct two proxies to capture investors’ “inherent” pro-activist stance. The
first is a fund’s voting tendency to support the dissident, retrieved from their
voting outcome relative to their peers within a given event, while the second
measure is constructed using pair-wise fund ranks based on the funds’ support
for dissidents on the common events that each pair of funds participated in.
Both measures are normalized and orthogonalized to be unrelated to observable
fund characteristics. We find that both proxies strongly predict activist
targeting.
Finally, we propose two
measures of mutual funds’ degree of “persuadability,” that are meant to capture
mutual funds’ willingness to learn from and be persuaded by a dissident. The
first proxy is the tendency of a company’s institutional shareholder base to be
swayed by proxy advisors’ recommendations. The second measure is based on the
idea that a fund willing to carefully assess the merit of each case is likely to
have high variation in the votes cast over time, and we therefore proxy for a
fund’s “persuadability” using the variation in the votes it cast in the past
prior to the proxy contest. For both measures we find that activists are more
likely to target companies whose shareholder base exhibits a high degree of “persuadability,”
consistent with the idea that shareholders’ willingness to learn about the merit
of the intervention is an important factor in activists’ target selection.
The full paper is
available for download here.
Harvard Law School Forum
on Corporate Governance and Financial Regulation
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