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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.
2
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)
“Voice-B”
Liquidity results in “no governance” (1) by allowing cut and run: Coffee
(1991), Bhide (1993) and (2)“Voice-G”
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)
3
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
“Exit”
Liquidity strengthens “exit” by (1) encouraging block formation:
Edmans (2009) and (2) by stimulating information acquisition: Edmans
(2009), Edmans and Manso (2011)
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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 liquidity
 Minimum tick size reduced from 1/16 dollar to 1 cent in early 2001
 Bid-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
H1: Stock liquidity increases the likelihood that a hedge fund
acquires a block.
Dependent Variables
LIQAMt
=1 if post
decimalization;
LIQFHT
0 otherwise
t
DECIMAL
Controls
Year and Industry FE
Number of Obs. Used
Pseudo R2
0.5% v.s. 1.3%
unconditional
(2)
probability
Voice-B
Exit
–
(1)
(3)
(4)
(5)
(6)
BLOCKt+1 (=1 if 13D Filing or 13G Filing; 0 if no block acquisition)
0.079***
0.171***
(0.013)
(0.021)
3.975***
3.902***
(0.747)
(1.064)
0.299***
0.544***
(0.024)
(0.064)
Included
Included
Included
Included
Included
Included
88,742
88,742
88,742
88,742
88,742
88,742
0.003
0.052
0.003
0.046
0.013
0.044
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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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Effect of Liquidity on Governance Mechanisms
Voice-G
Voice-B
Exit
H2: Conditional upon acquiring a block, stock liquidity reduces
the likelihood that the hedge fund files a 13D rather than a 13G.
(1)
Dependent Variables
LIQAMt
-0.152***
(0.046)
LIQFHTt
DECIMAL
Controls
Year and Industry FE
Number of Obs. Used
Pseudo R2
1,135
0.007
7% v.s. 43%
unconditional
(2)
probability
(3)
(4)
(5)
13Dvs13Gt+1 (=1 if 13D Filing; 0 if 13G Filing)
-0.169***
(0.064)
-4.047*
-6.662**
(2.456)
(3.260)
-0.295***
(0.084)
Included
Included
Included
Included
1,135
1,135
1,135
1,135
0.096
0.002
0.092
0.008
DECIMAL is again only significant in the subsample with LOWPRC=1.
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(6)
-0.492**
(0.236)
Included
Included
1,135
0.087
Is 13G Filing a Governance Event?
Voice-G
Voice-B
Exit
H3a: A 13G filing leads to a positive event-study return,
particularly among liquid firms.
3-day CAR over
CRSP valueweighted index
Testing CAR_VW(-1, +1)>0
Number of Obs. Used
(1)
Pooling
(2)
(3)
(4)
(5)
Low LIQAM High LIQAM Low LIQFHT High LIQFHT
0.008***
(0.002)
0.004
(0.004)
0.012***
(0.003)
0.004
(0.004)
0.012***
(0.003)
630
315
315
315
315
•
Unlikely to be explained by undervaluation
•
Multivariate regression results are consistent. Switching from belowLIQAM-median subsample to above increases CAR_VW by 1.7%.
•
Results are similar if using 3-day CAR over CRSP equal-weighted
index.
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Is 13G Filing a Governance Event? (Cont’d)
Voice-G
Voice-B
Exit
H3b: A 13G filing leads to a positive holding-period return,
particularly among liquid firms.
Holding period
raw return over
CRSP valueweighted index
Testing HOLDINGRET_VW>0
Number of Obs. Used
•
(1)
Pooling
(2)
(3)
(4)
(5)
Low LIQAM High LIQAM Low LIQFHT High LIQFHT
0.053***
(0.017)
0.015
(0.026)
0.092***
(0.022)
0.019
(0.025)
0.088***
(0.023)
523
262
261
262
261
Results are similar if using holding period raw return over CRSP
equal-weighted index.
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Is 13G Filing a Governance Event? (Cont’d)
Change in operating
H3c: A 13G filing leads to an increase
in operating
performance
from
particularly among liquid firms. year t-1 to t+1
Low LIQAM Subsample
∆EBITDA/ASSET
∆CFO/ASSET
High LIQAM Subsample
∆EBITDA/ASSET
∆CFO/ASSET
Low LIQFHT Subsample
∆EBITDA/ASSET
∆CFO/ASSET
High LIQFHT Subsample
∆EBITDA/ASSET
∆CFO/ASSET
Voice-G
Voice-B
Exit
performance,
13G firms
Control firms
DiD estimator
T-statistics of DiD
-0.021
-0.007
-0.017
-0.019
-0.004
0.012
-0.35
1.08
0.011
-0.003
-0.022
-0.019
0.033**
0.016
2.55
1.33
-0.025
-0.021
-0.021
-0.020
-0.004
0.000
-0.38
-0.02
0.015
0.011
-0.018
-0.018
0.033***
0.029**
2.67
2.43
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Effect of Liquidity on Block Formation: Role of WPS
Voice-G Voice-B
H4a: The effect of liquidity on the probability of block acquisition is
stronger in firms with higher managerial sensitivity to price.
Dependent Variables
LIQAMt
LIQAMt ×WPSt
LIQFHTt
LIQFHTt ×WPSt
Scaled wealth performance
DECIMAL
sensitivity (WPS) of Edmans,
Gabaix,
Landier (2009)
DECIMAL
×WPSand
t
= Total Delta / Annual Pay
WPSt
Controls, Year and Industry FE
Number of Obs. Used
Pseudo R2
–
–
(1)
(2)
(3)
BLOCKt+1 (=1 if 13D Filing or 13G Filing; 0 if no block acquisition)
0.180*
(0.101)
0.019*
(0.010)
8.326*
(5.042)
0.049**
(0.021)
0.508***
(0.079)
1.480*
(0.816)
*
**
0.002
0.020
-0.534
(0.001)
(0.009)
(0.588)
Included
Included
Included
24,645
24,645
24,645
0.087
0.086
0.086
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Exit
Effect of Liquidity on Governance: Role of WPS
Voice-G Voice-B
H4b: The effect of liquidity on the probability of filing choices is
stronger in firms with higher managerial sensitivity to price.
(1)
dummy to indicate
DependentAVariables
LIQAMt above-median-WPS
LIQAMt ×HIGHWPSt
(2)
13Dvs13Gt+1 (=1 if 13D Filing; 0 if 13G Filing)
(3)
7.337
(11.494)
-38.281*
(22.928)
LIQFHTt ×HIGHWPSt
DECIMAL
DECIMAL×HIGHWPSt
Controls, Year and Industry FE
Number of Obs. Used
Pseudo R2
–
0.722
(0.927)
-2.390*
(1.298)
LIQFHTt
HIGHWPSt
–
0.017
(0.171)
Included
322
0.161
-0.009
(0.188)
Included
322
0.157
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0.852
(0.751)
-0.854*
(0.463)
0.373
(0.509)
Included
322
0.156
Exit
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
H5: Stock liquidity increases the unconditional likelihood that a
0.14% v.s. 0.6%
hedge fund files Schedule 13D.
Dependent Variables
LIQAMt
LIQFHTt
DECIMAL
Controls
Year and Industry FE
Number of Obs. Used
Pseudo R2
Voice-B
Exit
unconditional
(1)
(2)
(3)
probability
13DFILINGt+1 (=1 if 13D Filing; 0 if 13G Filing or no block acquisition)
0.103***
(0.026)
3.851***
(1.435)
0.309***
(0.088)
Included
Included
Included
Included
Included
Included
88,742
88,742
88,742
0.040
0.038
0.036
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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
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