1. 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 19 th, 2013, WFA 1

2. 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

3. 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 )  Liquidity results in “no governance” (1) by allowing cut and run: Coffee (1991), Bhide (1993) and (2) 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 “Voice-B” “Voice-G”

4. 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  Liquidity strengthens “exit” by (1) encouraging block formation: Edmans (2009) and (2) by stimulating information acquisition: Edmans (2009), Edmans and Manso (2011) 4 “Exit”

5. 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) 5

6. 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 6

7. 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) 7

8. 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 8

9. 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) 9

10. 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) 10

11. 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 11

12. Effect of Liquidity on Block Formation 12 Voice-GVoice-BExit H1: Stock liquidity increases the likelihood that a hedge fund acquires a block. – (1)(2)(3)(4)(5)(6) Dependent VariablesBLOCK t+1 (=1 if 13D Filing or 13G Filing; 0 if no block acquisition) LIQAM t 0.079 *** 0.171 *** (0.013)(0.021) LIQFHT t 3.975 *** 3.902 *** (0.747)(1.064) DECIMAL 0.299 *** 0.544 *** (0.024)(0.064) Controls Included Year and Industry FE Included Number of Obs. Used88,742 Pseudo R 2 0.0030.0520.0030.0460.0130.044 0.5% v.s. 1.3% unconditional probability =1 if post decimalization; 0 otherwise

13. Effect of Liquidity on Block Formation (Cont’d) 13  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.

14. Voice-GVoice-BExit H2: Conditional upon acquiring a block, stock liquidity reduces the likelihood that the hedge fund files a 13D rather than a 13G. Effect of Liquidity on Governance Mechanisms 14 (1)(2)(3)(4)(5)(6) Dependent Variables13Dvs13G t+1 (=1 if 13D Filing; 0 if 13G Filing) LIQAM t -0.152 *** -0.169 *** (0.046)(0.064) LIQFHT t -4.047 * -6.662 ** (2.456)(3.260) DECIMAL -0.295 *** -0.492 ** (0.084)(0.236) Controls Included Year and Industry FE Included Number of Obs. Used1,135 Pseudo R 2 0.0070.0960.0020.0920.0080.087 7% v.s. 43% unconditional probability DECIMAL is again only significant in the subsample with LOWPRC=1.

15. Voice-GVoice-BExit H3a: A 13G filing leads to a positive event-study return, particularly among liquid firms. Is 13G Filing a Governance Event? 15 (1)(2)(3)(4)(5) PoolingLow LIQAMHigh LIQAMLow LIQFHTHigh LIQFHT Testing CAR_VW(-1, +1)>00.008 *** (0.002) 0.004 (0.004) 0.012 *** (0.003) 0.004 (0.004) 0.012 *** (0.003) Number of Obs. Used630315 Unlikely to be explained by undervaluation Multivariate regression results are consistent. Switching from below- LIQAM-median subsample to above increases CAR_VW by 1.7%. Results are similar if using 3-day CAR over CRSP equal-weighted index. 3-day CAR over CRSP value- weighted index

16. Voice-GVoice-BExit H3b: A 13G filing leads to a positive holding-period return, particularly among liquid firms. Is 13G Filing a Governance Event? (Cont’d) 16 (1)(2)(3)(4)(5) PoolingLow LIQAMHigh LIQAMLow LIQFHTHigh LIQFHT Testing HOLDINGRET_VW>00.053 *** (0.017) 0.015 (0.026) 0.092 *** (0.022) 0.019 (0.025) 0.088 *** (0.023) Number of Obs. Used523262261262261 Holding period raw return over CRSP value- weighted index Results are similar if using holding period raw return over CRSP equal-weighted index.

17. Voice-GVoice-BExit H3c: A 13G filing leads to an increase in operating performance, particularly among liquid firms. Is 13G Filing a Governance Event? (Cont’d) 17 13G firmsControl firmsDiD estimatorT-statistics of DiD Low LIQAM Subsample ∆EBITDA/ASSET -0.021-0.017-0.004-0.35 ∆CFO/ASSET -0.007-0.0190.0121.08 High LIQAM Subsample ∆EBITDA/ASSET 0.011-0.0220.033 ** 2.55 ∆CFO/ASSET -0.003-0.0190.0161.33 Low LIQFHT Subsample ∆EBITDA/ASSET -0.025-0.021-0.004-0.38 ∆CFO/ASSET -0.021-0.0200.000-0.02 High LIQFHT Subsample ∆EBITDA/ASSET 0.015-0.0180.033 *** 2.67 ∆CFO/ASSET 0.011-0.0180.029 ** 2.43 Change in operating performance from year t-1 to t+1

18. Effect of Liquidity on Block Formation: Role of WPS 18 Voice-GVoice-BExit H4a: The effect of liquidity on the probability of block acquisition is stronger in firms with higher managerial sensitivity to price. – – (1)(2)(3) Dependent VariablesBLOCK t+1 (=1 if 13D Filing or 13G Filing; 0 if no block acquisition) LIQAM t 0.180 * (0.101) LIQAM t ×WPS t 0.019 * (0.010) LIQFHT t 8.326 * (5.042) LIQFHT t ×WPS t 0.049 ** (0.021) DECIMAL 0.508 *** (0.079) DECIMAL×WPS t 1.480 * (0.816) WPS t 0.002 * 0.020 ** -0.534 (0.001)(0.009)(0.588) Controls, Year and Industry FEIncluded Number of Obs. Used24,645 Pseudo R 2 0.0870.086 Scaled wealth performance sensitivity (WPS) of Edmans, Gabaix, and Landier (2009) = Total Delta / Annual Pay

19. Effect of Liquidity on Governance: Role of WPS 19 Voice-GVoice-BExit H4b: The effect of liquidity on the probability of filing choices is stronger in firms with higher managerial sensitivity to price. – – (1)(2)(3) Dependent Variables13Dvs13G t+1 (=1 if 13D Filing; 0 if 13G Filing) LIQAM t 0.722 (0.927) LIQAM t ×HIGHWPS t -2.390 * (1.298) LIQFHT t 7.337 (11.494) LIQFHT t ×HIGHWPS t -38.281 * (22.928) DECIMAL 0.852 (0.751) DECIMAL×HIGHWPS t -0.854 * (0.463) HIGHWPS t 0.017-0.0090.373 (0.171)(0.188)(0.509) Controls, Year and Industry FEIncluded Number of Obs. Used322 Pseudo R 2 0.1610.1570.156 A dummy to indicate above-median-WPS

20. Effect of Liquidity on HF Activism 20 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-GVoice-BExit H5: Stock liquidity increases the unconditional likelihood that a hedge fund files Schedule 13D. – (1)(2)(3) Dependent Variables13DFILING t+1 (=1 if 13D Filing; 0 if 13G Filing or no block acquisition) LIQAM t 0.103 *** (0.026) LIQFHT t 3.851 *** (1.435) DECIMAL 0.309 *** (0.088) ControlsIncluded Year and Industry FEIncluded Number of Obs. Used88,742 Pseudo R 2 0.0400.0380.036 0.14% v.s. 0.6% unconditional probability

21. Conclusion 21 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