Institutional investors in Australia: Do they play a homogenous monitoring role?
Introduction
Institutional investors have a notable presence and a growing influence in capital markets across the globe, with the extant literature reporting that institutional investors can wield their influence in numerous ways, resulting in divergent effects on firm performance. Not only do institutional investors exert power by influencing trading activities in the capital market (Chaganti and Damanpour, 1991), but they also change existing power distributions within companies (Sacristán-Navarro et al., 2011), and they play an effective monitoring role by exerting pressure on corporations on specific issues such as excessive executive remuneration (Almazan et al., 2005, Khan et al., 2005, Gillan and Starks, 2003, Gomez-Mejia et al., 2003)1.
Although institutional investors influence the governance of firms both directly and indirectly, leading to improved firm performance (e.g., Hutchinson et al., 2015), there is contrasting evidence in the literature suggesting that some institutional investors have limited incentives to actively and effectively monitor firms, resulting in no improvement (e.g., Pham et al., 2011, Schultz et al., 2010) or even having an adverse effect on firm performance. This evidence suggests that different types of institutional investors have divergent monitoring incentives, which are determined by various factors such as their risk preferences, objectives, and ownership control. As these divergent monitoring incentives have different agency cost outcomes, it is important to adequately identify and classify institutional investors into different types based on these factors rather than treating them holistically as a homogenous group. Accordingly, this study examines the effect that different types (or classes) of institutional investors have on firm performance, since different investors have varying capacities to ameliorate or exacerbate agency costs.
The extant literature documents that the increased presence of institutional investors in corporations provides three types of monitoring situations, each having differing performance outcomes (Pound, 1988). Their presence leads to active monitoring of management (Bushee, 1998, Han and Suk, 1998, McConnell and Servaes, 1990), conflict with management (Agarwal and Ann Elston, 2001), or aligned interest with other shareholders (Lehmann and Weigand, 2000). Indeed agency theory suggests that outside shareholders' interests are protected when power exists to challenge corporate managements' actions (Anderson and Reeb, 2004), hence institutional investors with large stakes in the firm rely on monitoring management to shield their ownership interests (Lasfer, 2006, David and Kochhar, 1996, Jensen, 1993). Thus institutional investors who have an increased presence in firms via their ownership interests will have differing monitoring incentives compared with institutional investors who have a limited presence or no control or only have a short-term relationship with the firm.
For example, institutional investors with substantial control can influence the governance of firms by using the threat of exit2 and voice3 to execute their specific objectives by either buying or threatening to sell their shares (Aggarwal et al., 2011, Del Guercio et al., 2008). The recent expansion of proxy advisory firms such as CGI-Glass Lewis and Institutional Shareholder Services provides these institutional investors with the means to influence management by transmitting voting instructions easily and quickly (Stapledon, 2011). These institutional investors have access to research and other information not available to other types of investors (Gillan, 2006), enabling them to act decisively with these decisions being quickly reflected in their trading activities (Sias et al., 2006).
In contrast, institutional investors exhibiting a limited relationship with the firm such as fund managers who utilize index-type investment strategies that promote overall stock portfolio performance rather than individual stock performance will have limited incentives to actively monitor firms (Del Guercio and Hawkins, 1999). “Free-riding” among some institutional investors can also create problems with initiating collective action, thus hindering governance reforms, and leading to a sell-off in shares when the firm experiences a decline in performance, as this is sometimes an easier option (Admati and Pfleiderer, 2009).
Although the literature has examined the monitoring characteristics of institutional investors in relation to R&D4 (Brossard et al., 2013, Bushee, 1998, David et al., 2001), executive remuneration5 (Almazan et al., 2005, Hartzell and Starks, 2003), earnings management6 (Hsu and Koh, 2005, Koh, 2003, Chung et al., 2002), and corporate performance (Hutchinson et al., 2015, Pham et al., 2011, Schultz et al., 2010), studies in relation to corporate performance have yielded mixed results, depending on the typology used to classify institutional investors. For example, Australian studies by Pham et al. (2011) and Schultz et al. (2010) examined the monitoring effects of institutional investors on firm value, but they found no evidence of improvements in firm value. This could be because both studies assumed that institutional investors are homogenous, using a broad-based typology of institutional investors, which is possibly why these studies yielded no results. More recently, Hutchinson et al. (2015) segregated institutional investors into pressure-resistant and pressure-sensitive categories and found that large institutional investors (with substantial control) who are pressure-resistant are better able to coerce firms to monitor risk, thus increasing both short-term performance and firm value. However, Hutchinson et al.'s sample is limited to the Global Financial Crisis (GFC) period from 2006 to 2008 when Australia coped relatively better than other developed markets such as the US and the UK, making it difficult to generalize their results to other economic conditions.
Our study contributes to the literature in three important ways. As the extant literature documents that “identity of owners may play a crucial role” since investors are driven by differing investment objectives (Lehmann and Weigand, 2000, Kang and Sorensen, 1999), we use more finely granulated typologies of institutional investors to better understand the impact that different types of investors have on firm performance. We extend Hutchinson et al. (2015) and Brickley et al. (1988) classifications of institutional investors and provide more refined sub-classifications within the pressure-resistant and pressure-sensitive groups to better understand variations in firm performance. In addition, we segregate out nominee & trustee investors into a distinctive group to examine their unique contribution to firm performance as not all of these investors represent institutional shareholders. The underlying premise of our paper is that divergent investment objectives by different types of investors will result in differing levels of agency cost, leading to varying impacts on firm performance. In this manner we also extend Pham et al. (2011) and Schultz et al. (2010), who only examined the impact of institutional investors as a homogenous group.
Second, we provide empirical insights on the monitoring effects of institutional investors on firm performance utilizing ownership data of all Australian listed firms from 2000 to 2012. This period encompasses varying economic conditions and legislative changes which have altered the ownership landscape in Australia. By employing a dynamic Generalized Method of Moments (GMM) modeling technique, we not only capture changes in firm performance, but also changes in institutional and large block-holder ownership, thus ensuring that the effects of endogeneity are adequately dealt with.7 Third, we construct the institutional ownership variable by using the top twenty (Top 20) shareholder disclosure provided in the firms' annual reports. Testing the monitoring hypothesis is possible only when the ultimate owners are fully identified within the institutional investor classification. Accordingly, information on the Top 20 shareholders is used to construct the more finely granulated typologies of institutional investors.
Using a panel data set of 6933 firm year observations listed on the Australian Stock Exchange between 2000 and 2012, we examine firm performance as a function of type of institutional investor and firm-specific characteristics. Three broad typologies of institutional investors — pressure-resistant investors who only have an investment relationship with portfolio firms, pressure-sensitive investors who may have a business relationship with portfolio firms, and nominee & trustee investors who hold shares on account of a beneficiary — were initially examined. These typologies were then segregated into a number of sub-groups and each sub-group was re-examined in relation to firm performance. Overall, our results provide evidence that institutional investors are not a homogenous group of investors and that it is important to distinguish them by investment objective and their ability to exert influence. Specifically, while we find that institutional investors taken as a homogenous group appear to play an important governance role in terms of future firm performance, our analyses by the broad typology of institutional investors reveal somewhat differing conclusion.
The broad typology of pressure-resistant institutional investors who are hypothesized to have superior monitoring capabilities, while they significantly improve the short-term performance of Australian listed firms, they do not show any long-term monitoring ability. As expected the pressure-sensitive institutional investors are not associated with firm performance which is in line with the argument that this group of investors has some existing business dealings which reduce their monitoring capacity. Further and more interestingly we find that “faceless” investors via nominees and trustee institutions play an important monitoring role in creating long term firm value. The results also suggest that nominees and trustees, who may not have direct control, nonetheless have the ability to indirectly monitor and influence managers to better align their policies with the interest of shareholders. Our sub-category analyses reveal that with the exception of mutual and pension fund institutions, all other pressure-resistant institutional investors (foundation, fund, venture capital and private equity) do not seem to play a monitoring role.
These findings are important in informing policy makers about the role of institutional investors in monitoring managers. Further, it informs the need for emulating the UK experience by making institutional investors more accountable and persuading them to take an active role in governance matters of listed firms. The Stewardship Code in the UK is the first code in the world which aims at improving the quality of engagement with institutional investors and companies in order to improve long-term returns to shareholders. It is important to note that the role of stewardship in publicly listed firms is shared, in that, while the primary role of this function rests with the board of directors, firm investors, especially institutional investors, play an important role in holding the board accountable for the fulfilment of its responsibilities. Some of the stewardship activities outlined in the UK Stewardship code include monitoring and engaging with companies on matters such as strategy, performance, risk, remuneration and corporate governance as well as voting.
The rest of our paper is organized as follows. Section 2 briefly reviews the literature pertaining to institutional investors and presents the hypotheses. Section 3 describes the data and the methodology. Section 4 discusses the results and Section 5 outlines the conclusions.
Section snippets
Institutional investment in Australia
The Australian capital market landscape has changed considerably in the past decade, with institutional share ownership increasing by approximately 128% over the last 20 years and this growth rate figure is expected to rise even further. Growth in institutional share ownership is attributed to the introduction of superannuation guarantee (SG) legislation from 1 July 1992, which substantially altered the pension fund landscape. The SG legislation requires that employer funded pensions be made
Sample and data
The sample utilized in this study includes all Australian listed firms with complete data from DatAnalysis Premium, Morningstar, and SIRCA databases. We initially start with a panel data set of 10,647 firm year observations over a period of 13 years (2000 and 2012) sourced from Morningstar database. The justification for the selection of this period stems from the surge in institutional share ownership in Australia, which increased by 128% over this period. Consistent with prior literature,
Descriptive statistics
Table 2 panels A, B and C show descriptive statistics for the dependent (firm performance), test (institutional investor ownership) and control (firm characteristics) variables respectively. As shown in panel B, the total average institutional ownership for the total, Top 500 and non-Top 50018 samples is 27.86%, 37.18%
Discussion and conclusion
This paper examines whether the presence of institutional investors in Australian public companies affects firm performance. Our study is motivated by the argument that institutional investors can play an effective monitoring role by exerting pressure on corporations on a number of issues and by recent research, which documents contrasting evidence suggesting that some institutional investors have limited incentives to actively and effectively monitor firms, resulting in no improvement (e.g.,
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