Institutional investors: their incentives for monitoring companies and the effect on corporate governance

This thesis attempts to deepen our understanding of the role of institutional investors in corporate governance. While numerous studies have examined the effectiveness of institutional investors’ monitoring and have taken into account the heterogeneity of the various types of such investors, there has been less research on differences in their portfolios and specifically on the incentives that they may have to monitor individual companies. Due to resource constraints, it would be logical for institutional investors to concentrate their monitoring efforts on a subset of the firms held in their portfolios that offer the greatest likelihood of obtaining benefits that exceed the cost of monitoring. This thesis attempts to identify whether such a policy is actually adopted by institutional investors and assesses the outcome of such attention. The first factor that might plausibly influence investors’ monitoring incentives is the weighting of a firm in their portfolio. When a firm accounts for a greater weighting in the investor’s portfolio, one might reasonably argue that the benefits of monitoring might be expected to exceed the cost. Therefore, the incentive to monitor that firm would be stronger. The first empirical study in this thesis investigates whether firms that tend to be heavily represented in institutional portfolios exhibit more investment efficiency. The study reveals that corporations do significantly improve the efficiency of their investment decisions when their shares represent a greater proportion of the holdings of institutional portfolios. Monitoring may mitigate the tendency of management to focus on their own career aims and build empires rather than enhancing shareholder value. The second empirical study investigates the market valuation of the firm’s cash holdings. Historically, it has been suggested that an increase in cash holding is associated with poorer performance by the firm. This study shows that this effect changes when one takes into account the influence of institutional investors as a result of their monitoring. It demonstrates that the presence of motivated institutional investors appears to significantly increase the marginal value of cash holdings of a firm. It is shown that when a firm accounts for a greater weighting in an institutional portfolio, the adverse effect of high levels of cash held by the firm on its operational performance largely disappears – a result that would be consistent with investors monitoring those firms more effectively. The final empirical chapter studies the relation between investors’ horizons and the monitoring incentive. Since the monitoring cost is borne in the present while any consequent pay-off would occur in the future, institutional investors’ monitoring incentives are likely to be positively related to the investment horizon. I find that the longterm holdings of different types of investors could all improve firm performance. The effect is persistent and long-lasting. These findings support the hypothesis that monitoring attention by institutional investors is related to their holding horizon