Blockholders, Market E ciency, and Managerial Myopia Alex Edmans, Wharton Notre Dame Finance Seminar October 12, 2007 Alex Edmans Blockholders, E ciency, and Myopia October 12, 2007 1
Introduction This paper addresses two questions: How can myopia be attenuated? Why do blockholders exist in the U.S.? Exploiting growth opportunities is critical to the success of many rms, and the overall economy: Zingales (2000), Porter (1992), Blinder (1992), Thurow (1993) But stock price concerns deter intangible investment Porter (1992): The nature of competition has changed, placing a premium on investment in increasingly complex and intangible forms the kind of investment most penalized by the U.S. [capital allocation] system Graham, Harvey and Rajgopal (2005): 78% of CEOs would sacri ce long-run value to meet short-term earnings targets Narayanan (1985), Stein (1988), von Thadden (1995) on causes of myopia Alex Edmans Blockholders, E ciency, and Myopia October 12, 2007 2
Introduction (cont d) This paper: blockholders as a solution Blockholders gather costly information about fundamental value * But information guides exit vs. loyalty ( voting with your feet / Wall Street Rule ), not voice Trade with liquidity investors, so prices re ect fundamental value rather than current earnings Therefore, managers take long-term decisions that maximize fundamental value Alex Edmans Blockholders, E ciency, and Myopia October 12, 2007 3
The Role of Blockholders Blockholders are prevalent in the U.S. and around the world (Holderness (2007)). What role do they play? Shleifer and Vishny (1986), Burkart et al. (1997), Maug (1998), Kahn and Winton (1998), Bolton and von Thadden (1998), Faure-Grimaud and Gromb (2004): intervention Many U.S. blockholders lack signi cant control rights La Porta et al (1999): 80% (90%) of large (medium) U.S. rms do not contain a 20% shareholder Substantial legal and institutional barriers to activism (e.g. Becht et al (2006)) Hirschman (1970): exit, voice and loyalty Admati and P eiderer (2006) Alex Edmans Blockholders, E ciency, and Myopia October 12, 2007 4
Outline of Presentation Analyze relationship between block size and nancial market e ciency Introduce managerial decisions and study e ect on real e ciency Endogenize block size Social optimum Private optimum Discuss empirical implications Real Stock price Second paper: multiple blockholders Alex Edmans Blockholders, E ciency, and Myopia October 12, 2007 5
Blockholders and Market E ciency Blockholder owns α, atomistic shareholders own 1 t = 1: public signal s 2 fs g, s b g about V If s = s b ( bad signal ), V = X h w.p. κ, V = X l w.p. (1 κ) If s = s g, V = X h w.p. 1 t = 2: blockholder exerts monitoring e ort e B, cost 1 2 c B e 2 B to generate signal i 2 fi g, i b g Pr(i g jx h ) = Pr(i b jx l ) = 1 2 + 2 1 e B Pr(i g jx l ) = Pr(i b jx h ) = 2 1 1 2 e B α Alex Edmans Blockholders, E ciency, and Myopia October 12, 2007 6
Blockholders and Market E ciency (cont d) t = 2 continued: Blockholder sells 0 b α * b = 0 if i g, β if i b Liquidity traders demand u U[0, n] where n = ν(1 α) Market maker sees d = b + u and sets P = E [V j d, s b ] as in Kyle (1985) t = 3: V is realized. X = X h Nash equilibrium: X l Market maker s prices are optimal given blockholder s trading strategy Blockholder s trading strategy is optimal given market maker s pricing function Alex Edmans Blockholders, E ciency, and Myopia October 12, 2007 7
Blockholder Trading: β = min( n 2, α) Assume α < n 2 so β = α α κ(1 κ) X n ) c B q E ort is highest when α = 1 1 1+ν < n 2 Monitoring: e B = α( n Allowing purchases does not change the result Alex Edmans Blockholders, E ciency, and Myopia October 12, 2007 8
Market E ciency Proposition q 1: Optimal α for market e ciency is bounded at α, where 1 1 1+ν < α < n 2. E ciency rises (falls) in α for α < (>) α Optimal block size is nite, vs. Shleifer and Vishny (1986), Kahn and Winton (1998) * What matters is not block size per se, but the associated trading volume: min(α, n 2 ) Alex Edmans Blockholders, E ciency, and Myopia October 12, 2007 9
Blockholders and Long-Term Behavior Manager places weight µω on t = 2 price and µ(1 ω) on t = 3 value ω > 0 as takeover threat (Stein (1988)), reputational concerns (Hirshleifer and Thakor (1992), Scharfstein and Stein (1990)), manager sells at t = 2 (Stein (1989)) At t = 0, manager of a high-quality rm chooses θ ɛ [0, 1] At t = 3, V = X h + gθ W.p. yθ 2, the rm emits s b at t = 1; else s g Proposition 2: If α < α, θ is increasing in α E ect is strongest for high y Alex Edmans Blockholders, E ciency, and Myopia October 12, 2007 10
Blockholders and Long-Term Behavior (cont d) Liquidity encourages investment, contrary to Intervention models: liquidity facilitates exit vs. intervention (Bhide (1993)) Conventional wisdom: liquidity encourages selling upon weak earnings, rather than loyalty Investment rises even though blockholder is not long-term and is only motivated by (private) informed trading pro ts α 2 κ(1 κ) X Optimal ν is bounded at 1 α c B e B (1 e B + e B κ) Optimal liquidity is nite, vs. Holmstrom and Tirole (1993), Maug (1998), Faure-Grimaud and Gromb (2004) Alex Edmans Blockholders, E ciency, and Myopia October 12, 2007 11
Endogenizing α Social optimum < α, owing to monitoring costs If θ α is low, nancial e ciency does not a ect real e ciency, echoing Stiglitz (1981) Private optimum: shareholder Cannot trade anonymously: Grossman and Hart (1980) Only enjoys α% of rise in rm value: Shleifer and Vishny (1986) * Consistent with Bhide (1993), government should not always promote dispersed ownership Considers informed trading pro ts Privately optimal α may be too high or too low Alex Edmans Blockholders, E ciency, and Myopia October 12, 2007 12
Empirical Predictions Prediction 1: Blocks should be more prevalent in rms with abundant long-term opportunities that exhibit high information asymmetry Suggests blockholders are useful in start-up rms, R&D-intensive rms, countries with ine cient capital markets Prediction 2: Higher blockholdings are associated with more long-term behavior Cross-sectional approach may have di culty in assigning causality Cronqvist and Fahlenbrach (2006): appearance of certain blockholders increases investment; relationship is causal Prediction 3: Prices are more e cient for rms with larger blockholdings Mispricing anomalies are less pronounced Alex Edmans Blockholders, E ciency, and Myopia October 12, 2007 13
Conclusion What is the role of a blockholder who cannot intervene, and if there is no e ort con ict? To encourage long-term investment, the rst-order problem faced by many modern rms U.S. has not been defeated by Japan Limitations / extensions: Interpretation of θ Paper focuses on blockholders as a solution to myopia. Causes of myopia (ω > 0 and existence of s) are exogenous * Endogenize s: analyze optimal disclosure laws set by the government, and discretionary disclosure policy set by rm * Endogenize ω: analyze of optimal mix of short- and long-term compensation Multiple blockholders Alex Edmans Blockholders, E ciency, and Myopia October 12, 2007 14