Conflicts of Interest Among M&A Advisors

The Importance of M&A

Mergers and acquisitions (M&A) are arguably the most important decision that a company makes. Successful mergers can transform a company by combining complementary assets, unleashing economies of scale or scope, or allowing it to enter new markets or geographies. However, mergers can also destroy billions of dollars of value. Daimler Benz – Chrysler, Sprint – Nextel, Quaker Oats – Snapple, AOL – Time Warner are just four examples, but the list is virtually endless. Indeed, around half of M&A deals end up destroying value for acquirers.

The risk of substantial value destruction is compounded by the fact that CEOs typically lack expertise in M&A, since they make such decisions rarely. As a result, they seek advice from investment banks. Given the banker expertise required, and the importance of getting the M&A decision right, this advice commands very high fees – as a result, M&A is an extremely lucrative career, attracting some of the very top talent from business schools.

Why Might Conflicts Exist?

But, the fee structure in M&A advisory is rather odd. Aside from a small retainer, bankers are only paid upon announcing an M&A deal. Now, success-based fees are common in many other advisory services – such as “no-win-no-fee” agreements with lawyers – and my work on CEO compensation highlights the value of incentivizing success. However, in those contexts, success is reasonably easy to define – winning a case for a lawyer, or increasing the long-run stock price for a CEO. In M&A, the fee structure seems to equate “success” with “announcing a deal” – even though half of M&A deals are actually failures!

Thus, there is enormous potential for conflicts of interest. If a client asks a bank to execute a deal that the bank believes to be bad, it may undertake it anyway since, the bank receives millions irrespective of whether the deal actually creates value. Not only may this lead banks to (receptively) accept value-destructive mandates, but they may (actively) pitch value-destructive mandates.

Of course, one potential mitigant is reputation – surely, clients will get wind of banks that systematically advise them to do bad deals. But, it’s not clear whether this happens in practice. During my first year at Morgan Stanley, I was surprised that ICI continued to hire Goldman Sachs after it advised it to pursue a strategy that involved taking on a ton of debt. Despite this indebtedness now causing ICI major problems, it insisted on using Goldman Sachs to find solutions since they “kindly advised us last time round” (paraphrasing) – even though such advice was probably more motivated by a large fee than kindness, and led to the problems that ICI now faced!

Evidence of Conflicts

But, that was only one anecdote. You can always find an anecdote to show whatever you want to show. And, for every anecdote where reputation is irrelevant, there might be one where it matters. In my second year at Morgan Stanley, Abbey National invited us to pitch to advise them on the sale of Porterbrook (their train leasing subsidiary). We actually advised them not to hire us – in fact not to hire anyone – because now was not the right time to sell Porterbrook. Doing so turned down a potentially large fee. However, Abbey National took this advice. The next year, when Abbey received a takeover bid from Santander, it hired Morgan Stanley as the sole defense advisor, likely in part due to the trust they had in us.

Sadly, I was now a poor PhD student at MIT, and didn’t get to work on that deal. Instead, I was working on my research. And one of my studies, with my classmate Jack Bao (now at the Federal Reserve), we wanted to see whether reputation matters in large-scale data. In our paper, published in the Review of Financial Studies, we found the following results:

  1. Investment Banks Matter! The difference in the average returns to deals advised by banks in the 75th vs 25th percentile is 1.26%. This is significant – given the mean bidder size of $10 billion, it translates into $126 million. Thus, choosing the right investment bank is important.
  2. Past Performance Has No Effect On Future Market Share. An bank’s recent performance (how much shareholder value it created in its recent deals) had no effect on its future market share. So, reputational incentives seem to be almost absent – there is no loss in future business from doing a bad deal.
  3. But Past Market Share Significantly Affects Future Market Share. If clients don’t choose banks based on their past performance, what do they choose them based upon? Past market share. Indeed, this is consistent with practices in the investment banking industry, where market share league tables are widely publicized by both the media and the banks themselves. Virtually every pitchbook ends with a section on the bank’s credentials. This will include a list of similar deals that the bank has worked on in the past (e.g. when pitching a Chemicals M&A deal, this would be a list of past Chemicals M&A deals), plus league tables showing the bank’s market share in Chemicals M&A. Those league tables are extremely important: if I ran the data and Morgan Stanley came in at #2, my boss would ask me to re-run it excluding deals below $10 million, changing the time period etc. – i.e. massaging the data in any way possible to try to get Morgan Stanley to appear #1. Banks’ incentives to do value-destructive deals are thus substantial:
    • You get a large fee today.
    • You boost your position in the all-important market share league tables, helping you to generate fees in the future
    • There is no downside: doing a bad deal today does not reduce the chance that you win mandates in the future.
    • In addition to the bank’s incentives, individual bankers have substantial incentives to do bad deals. Doing so likely gets you promoted, and missing a large deal gets you hauled up in front of a senior committee where you have to explain yourself.
  4. Past Performance Significantly Predicts Future Performance. That clients ignore past performance when awarding mandates need not be inefficient. It could be that past performance doesn’t predict future performance (just like it doesn’t for mutual funds), so it’s right for clients to ignore it. But, we find that performance is highly persistent. The top 20% of banks (based on 2-year performance) outperforms the bottom 20% by 0.94% over the next two years.
  5. But Past Market Share Significantly Negatively Predicts Future Performance. In contrast, market share is significantly negatively related to future performance – perhaps because high-market-share banks are those that indiscriminately accept all mandates, regardless of whether they create or destroy value. Overall, in their selection decisions, clients are ignoring the information (past performance) that they should be using, and using the information (past market share) that they should be ignoring.

Implications for Market Share League Tables

In the light of these results, the almost-exclusive focus on market share league tables seems bizarre. The banking industry seems to have been using market share as a measure of reputation, without ever asking whether market share is actually related to performance – and result (5) above suggests that it is negatively related. Perhaps one might argue that market share shows experience – just like a potential defense lawyer in a murder trial would list the past murder trials that she’s worked on. However, she will likely highlight her past acquittals – listing past clients that got convicted is unlikely to give a new client comfort. Yet, investment banking league tables indiscriminately include all past transactions, ignoring whether they were value-creating (an acquittal) or a value-destroying (a conviction). Indeed, in almost no other industry is market share a sign of quality – McDonald’s sells more food than a Michelin-star restaurant but is not regarded as higher-quality, and retail websites list customer ratings rather than the number of customers who have bought a product.

The results suggest that market share league tables might be supplemented by league tables based on past performance. This would make banks think twice before accepting a mandate they believe to be bad. Moreover, this suggestion is consistent with other practices in the investment banking industry. For IPO underwriting (when banks take companies public), there are league tables for the average performance of the stock after the IPO. However, a high post-IPO return may not actually be good for the client – it could be that the bank sold the shares too cheaply. It seems strange that there are league tables for client stock returns in one banking service (IPO underwriting) where high stock returns may not be beneficial, but no league tables for client stock returns in another banking service (M&A advisory) where high stock returns do benefit clients.

Note that this recommendation does not imply that past performance is the only criterion that a client should select on, so market share league tables need not be eliminated. Market share may be relevant, e.g. clients may want large banks because they can offer other services (e.g. M&A financing in addition to M&A advisory). The recommendation is only for past performance to be more visible, so that it can be one selection criterion.

Appendix: A Note on Measuring Performance

We measure advisor performance using the standard event-study methodology: the acquirer’s stock return in the three days surrounding an M&A announcement, in excess of the market return.

But is this stock return entirely attributable to the bank? It could be that the client is responsible for the return – the client has decided on a bad deal and asks the bank to execute it. There are two schools of thought here:

  1. The bank remains responsible for the return, since it should advise the client not to do the deal – just as a doctor should refuse to perform a surgery that a patient requests, if it is not in the patient’s best interest.
  2. The bank is not responsible for the return, since its goal is to serve its clients, and if the client wishes to execute the deal, the bank should execute it in the best way possible.

While (2) seems inconsistent with how banks market themselves (as providing true advice rather than simply being execution houses), to be conservative we allow for this school of thought. Specifically, for each deal, we extract out the component of the deal’s return that could be attributable to the client – either the client wishing to do bad deals (using measures of whether the client is empire-building, such as free cash flow or governance) or the client being able to come up with good deals (using measures of client quality, such as stock and operating performance), plus client “fixed effects” to capture unobservable measures of client quality or empire-building. We only attribute the remainder to the bank, and the results remain robust.

How Short-Term Activists Create Long-Term Value

Activist hedge funds are often seen as the epitome of all that’s wrong with capitalism. They cut investment, fire employees, and break contracts to boost the short-term stock price, and cash out before the long-term value destruction comes to light.

It’s certainly possible to find examples of this. And such stories make for good journalism so will be reported most prominently. Cases in which an activist quietly created long-term value don’t make for exciting reading, just as “London Bridge failed to collapse today” won’t make a great headline.

The repeated tales of asset-stripping lead many commentators to suggest that these activists must be stopped. Hillary Clinton advocated a sharply higher capital gains tax on shares held for fewer than two years. The “Loi Florange” in France gives extra voting rights to investors that hold stock for more than two years, to hinder allegedly “short-term” activists from wrenching control.

But we can’t base policy on a couple of high-profile anecdotes. To truly understand the effects of activist hedge funds, it’s necessary to look at all the evidence – to study hundreds of cases, in different industries, across different time periods. This is the role of academic research. While academics are often viewed as disconnected from reality – and are indeed less informed about one particular company than (say) a board member – this “disconnect” allows them to undertake large-scale research, unbiased by ties to one particular firm.

And a decade of research by professors Alon Brav (Duke) and Wei Jiang (Columbia), and their coauthors, shows that activist hedge funds create value in both the short run and the long run. Their seminal study, coauthored with Frank Partnoy (San Diego) and Randall Thomas (Vanderbilt) found that, when a hedge fund makes a 13D filing (which is legally required if it acquires a stake of at least 5% and intends to influence control), firm value increases by 7%, with no long-term reversal. Operating performance, payout to investors, and CEO turnover all rise.

But is this correlation or causation? Perhaps the hedge fund didn’t cause the improvements, but predicted them and chose to acquire a large stake in anticipation. In support of their causal interpretation, the authors show that the improvements are stronger when the hedge fund employs hostile tactics; the improvements remain significant even when the hedge fund owned a significant position prior to the 13D (and so did not change its stake much); and the market response to the hedge fund subsequently selling is significantly worse if the fund had not carried out its stated agenda.

Higher payout is often viewed as “smoking gun” evidence of short-termism. However, this payout may be of cash that would otherwise have been wasted on chief executives’ pet projects or salaries. Indeed, the higher payout and chief executive turnover may explain why executives sometimes lampoon activists – not out of concern for long-term value, but instead to entrench themselves and enjoy the quiet life.

The increase in operating performance runs counter to the common belief that hedge funds only create value by piling on debt. Even so, it might result from over-working employees, compromising product quality, or breaching long-term contracts. So a second paper, with Hyunseob Kim (Cornell), investigated its source. It finds operational performance rises because of an increase in plant-level productivity, which in turn stems from higher labour productivity. But, interestingly, the rise in labour productivity is despite working hours not rising and wages not falling. Moreover, productivity also improves in plants sold by hedge funds – thus, such disposals are not asset stripping, but reallocating assets to buyers who can make better use of them.

Brav and Jiang’s newest paper, with Song Ma (Yale) and Xuan Tian (Indiana), studies innovation. This is the smoking gun that hedge funds will fire if they are short-termist – R&D hits the bottom line today, and its benefits don’t arise until many years in the future. And they do cut R&D. But despite the reduction in innovation input, innovation output actually improves, in terms of both the number and quality of future patents.

Investment is absolutely critical for the twenty-first century firm. Equally critical, however, is for the debate to focus on investment output rather than input. Commentators often compare the level of investment across countries, or between private and public firms, assuming that high investment is necessarily a good thing. But it takes no skill to simply spend money.

Responsible companies don’t invest willy-nilly; they do so judiciously. In the 2015/6 English Premier League last season, Leicester City invested far less money than Manchester City, but it invested better as it won the league. Just as spendthrift behavior is not clearly optimal in sports, cutting investment and using the money saved for dividends and repurchases – which can be reallocated to other companies with better growth opportunities – can sometimes be good for both firms and society, in both the short term and long term.

How can this be, since activist funds typically have short holding periods, of about 20 months? Because short holding periods don’t imply short horizons. Even in 20 months (far from a flash of time), hedge funds can make improvements with long-lasting impact, similar to a consultant or turnaround specialist hired for a few months. Their short holding periods give them a sense of urgency, and the option to exit gives them teeth that can overcome managerial entrenchment.

As I discussed in a recent HBR article, “The Answer to Short-Termism Isn’t Asking Investors To Be Patient”, the key characteristic of an investor isn’t so much its holding period as its stake. Only investors with large stakes will have sufficient “skin-in-the-game” to truly engage with a firm, and undertake restructurings that increase productivity and investment efficiency for the benefit of the firm and society as a whole.

(A prior version of this post was originally featured in CityAM)

A Layman’s Guide to Separating Causation from Correlation … and Noticing When Claims of Causation are Invalid

Imagine you’re the Minister for Education, deciding how large to make a school district. Larger school districts offer parents more school choice. You look at data from thousands of school districts and find that, in larger districts, child performance is better. You’re tempted to infer that district size increases child performance. But, as we know, correlation doesn’t imply causation. There are two alternative explanations:

  1. Reverse causality: child performance increases district size. When kids are doing better, a school district is allowed to expand.
  2. Omitted variables: neither district size nor child performance cause each other, but a third variable causes both. If parents care about education, they will both demand school choice (larger school districts) and also tutor their kids at home (increasing child performance).

The problem of separating causality from correlation occurs in virtually every question that we try to study with data.

  • Showing that adults with a degree earn higher salaries doesn’t mean that university is a worthwhile investment. It might be that high-ability kids go to university and their high ability would have led to them earning more anyway (ability is an omitted variable). Or, kids who expect high salaries in the future (e.g. due to being from well-connected families) are more willing to take on the debt to go to university today (reverse causality).
  • Showing that socially responsible firms perform better doesn’t mean that social responsibility pays off. It might be that, only once a firm is already performing well can it invest in social responsibility (reverse causality). Or, a forward-thinking management team (i) performs better, and (ii) gives thought to social issues (management quality is an omitted variable).
  • Showing that firms that cut investment subsequently perform badly doesn’t meant that cutting investment is bad. A McKinsey study makes the very strong causal claim to have found “finally, evidence that managing for the long-term pays off“. Their claim has been accepted as gospel by many, without recognising reverse causality – when a firm knows that its future prospects are poor, it should cut investment today. Presumably, this is what McKinsey advises its clients to do!
  • Showing that firms where a CEO has a high equity stake (owns a lot of shares) subsequently perform better doesn’t mean that equity incentives work. It might be that, when a CEO expects a firm to perform better in the future, she’s more willing to hold shares today.
  • Showing that a fad diet leads to weight loss doesn’t mean the diet caused weight loss. It might be that the desire to lose weight caused a person to choose the diet, and also to exercise more and it’s the latter that led to the weight loss (omitted variables).

The problem is even worse due to confirmation bias, as I explained in my recent TEDx talk, “From Post-Truth to Pro-Truth”. We jump to the conclusion that fits our view of the world.

  • Professors like me are all too eager to believe that our fascinating class is what got students that job.
  • We want to think that “nice guys finish first” – that responsible companies beat irresponsible ones.
  • Those whose view businesses as evil and self-serving will want to think that those who cut investment (to pay dividends or buy back stock) get their comeuppance later.
  • People like me who spend their lives studying on incentive compensation really want to believe that incentives actually matter, and that they’re not wasting their time.
  • Any proponent of a fad diet or slimming pill will claim they’re to thank for your six-pack abs.

We must be very, very careful about interpreting evidence as causal, when it only shows a correlation. Fortunately, there are now clever techniques to separate causality from correlation – (I) instruments, (II) natural experiments, and (III) regression discontinuity. This article aims to explain these techniques in simple language. But before starting, I must caution that these techniques are only valid in very rare cases. Some papers use one of the three “magic phrases” to try to claim that they have identified causality, and then back it up with as technical language as possible to give the aura of statistical sophistication and batter the reader into submission. Instead, as I’ll explain, you don’t need to be a statistical expert to see whether the authors are trying to pull the wool over your eyes. All you need is common sense. For each of these techniques, I have a “Reader Beware” section on what to look for. The intended audience for this post is practitioners, who might use academic research to guide policy or practice, so I will paint with a broad brush. For a more detailed academic treatment, please see Roberts and Whited (2012).

I begin by defining terms. We are interested in the causal effect of an independent variable (e.g. district size, degree) on a dependent variable (e.g. child performance, future income). A causal interpretation is only possible if the independent variable is exogenous (randomly assigned) – if university places were randomly given to some school leavers and not others, and those that went to university earned more, we could infer that the degree caused the higher salary. However, most variables are endogenous. They are not randomly assigned, but the product of something else – the dependent variable itself (expecting a high future income encourages you to get a degree today – reverse causality), or a third variable that also affects the dependent variable (high ability makes you more willing to get a degree – omitted variables).

I. Instruments

How do we solve the problem that the independent variable is endogenous? In a medical trial, you would randomly assign the independent variable (a new drug) by giving it to some patients (a treated group) and a placebo to others (a control group). But, we can’t do this in social sciences – we can’t force some firms to give their CEOs high equity stakes and others to give low equity stakes.

So, what we want is something as-good-as-random. This is an instrument – something that randomly shocks the independent variable, just like random assignment of a new drug. In the school district example, Hoxby (2000) used rivers as a shock to district size. In the U.S., school districts were formed in the 18th century, when crossing a river was difficult due to no cars and few bridges, and so districts very rarely crossed rivers. Hoxby found that school districts that were naturally smaller, due to rivers, exhibited worse performance. Since these districts were “randomly” assigned a small size, the results imply a causal effect from district size to child performance.

A valid instrument must be:

  1. Relevant. It must affect the independent variable of interest. Rivers are relevant, as they placed natural boundaries on district size.
  2. Exogenous. It must not affect the dependent variable except through the independent variable. Rivers are unlikely to affect a child’s performance other than through affecting district size. (Technically, this is referred to as “satisfying the exclusion restriction”; I will use “exogenous” for short).

To give an example of the ingenuity of some valid instruments:

  • Does a family firm perform better when it appoints a family CEOs rather than an external CEO, or worse due to nepotism? If family-run firms perform better, it could be due to reverse causality: if the firm is performing well, the owners will keep it within the family; if it’s not, they will need an outsider to fix it. Bennedsen, Nielsen, Perez-Gonzalez, and Wolfenzon (2007) use the gender of the CEO’s first-born child as an instrument. Gender is:
    1. Relevant: when the first child is male, family owners are more likely to pass on control to a family CEO than when the first child is female.
    2. Exogenous: it’s unlikely that the gender of a CEO’s first child will affect the performance of the family firm other than through affecting whether the next CEO is from within or outside the family.
  • Rather than studying whether firms actually have a family CEO, the authors predict whether firms will have a family CEO based on the gender of the first-born child. They found that firms with a higher probability of having a family CEO (due to having a male first child). Since whether a firm is predicted to have a family CEO is random – because the gender of the first child is random – this implies that family CEOs cause worse performance.
  • Does watching TV cause autism? If the correlation is positive, it may be that autistic kids watch TV more (reverse causality), or neglectful parents both abandon their kids to watch TV, and also cause autism (omitted variables). Waldman, Nicholson, Adilov, and Williams (2008) use rainfall as an instrument. Rainfall is:
    1. Relevant: rainfall causes kids to watch TV, since they can’t play sport outside.
    2. Exogenous: rainfall doesn’t cause autism other than through its impact on TV-watching (it doesn’t suddenly cause parents to be neglectful).
  • Rather than studying the actual number of hours of TV-watching, the authors predict TV-watching based on rainfall. They found that kids with higher predicted TV watching are more likely to be autistic. Since predicted TV-watching is random – because rainfall is random – this implies that watching TV causes autism.

Reader Beware

Often authors will claim causality by using the magic word “instruments” (or “instrumental variables”), when the instruments are actually invalid because they are not exogenous (it is relatively easy to find instruments that are relevant). A reader should ask the following questions:

  • Can the “instrument” affect the dependent variable other than through the independent variable? Let’s return to the earlier question of whether the CEO’s equity stake causes better future performance. We might use CEO age as an instrument for her equity stake, as older CEOs tend to have accumulated more shares. But, CEO age is not exogenous, since it might directly affect firm performance. Older CEOs might perform better as they are more experienced, or worse as they are entrenched.
  • What causes the instrument to vary to begin with, and could this factor also affect the dependent variable?  Even if CEO age did not directly affect firm performance (older CEOs are just as good as younger CEOs), whatever drives cross-sectional variation in age may do so. For example, trouble in the firm’s business model may lead to a firm retaining an old CEO, and also reduce firm performance.
  • Is the instrument a lagged variable? Some papers use last year’s independent variable as an instrument – in our setting, this would be the CEO’s equity stake last year. It’s relevant – last year’s equity stake will be linked to this year’s, since equity stakes tend to be stable over time. Surely it’s also exogenous – since it’s last year’s stake, it was already set in advance of this year? But, whatever causes this year’s stake to be endogenous also likely causes last year’s stake to be endogenous. Last year, the CEO could have forecast performance to be good this year, and so chosen to hold more shares.
    • This is also known as the “post hoc ergo propter hoc” (after this, therefore because of this) fallacy. Just because event Y follows event X, this does not mean X caused Y
  • Is the instrument a group average? Some papers use a group average as an instrument – in our setting, this would be the average equity stake among CEOs in the same industry as firm X. It’s relevant – if rival firms are giving their CEOs lots of equity, firm X must do so too, to remain competitive. Surely it’s also exogenous – the equity stake of other CEOs shouldn’t affect firm X’s performance? But, any endogeneity in firm X’s equity stake is simply soaked up at the industry level (see Section 2.3.4 of Gormley and Matsa (2014) for more detail). If the industry as a whole is performing well, firm X will perform well, and CEOs of other firms in the industry will gladly hold high equity stakes.
  • Are the authors up-front about their instruments? A tell-tale sign is when, in the introduction to a paper, authors say something like “we control for endogeneity using instruments and show that the results remain robust” without explaining what the instruments are until much later in the paper. Finding valid instruments is very difficult and it is the authors’ responsibility to explain what the instruments are and justify why they are relevant and exogenous. Not being up-front about what the instruments are suggests the authors may themselves not be sufficiently convinced about their validity, and so they bury them deep into the paper.

Even though some papers may claim to have statistically proven exogeneity, there is no valid test to do this. So, the best way to assess exogeneity is to use common sense – could the “instrument” (or whatever drives the instrument) affect the dependent variable other than through the independent variable? Note that no instrument will be completely exogenous and one can always spin stories to argue that it is not. For example, one could spin a story that rivers directly affect child performance, because when kids look out onto a river, they get inspired to be more creative. Ultimately, the reader must use common sense to see whether such stories are reasonable.

As an example of how authors might use complex technical language to overwhelm the reader into believing they have shown causality, consider the following extract:

“We reestimated our models using the xtabond2 procedure in STATA, which utilizes the generalized method of moments (GMM) model also known as system GMM. The xtabond2 procedure is designed for panels that may contain fixed effects and heteroscedastic and correlated errors within units, and employs first differencing, which instruments variables with suitable lags of their own first differences, to eliminate these issues and potential sources of omitted variable bias (please see Arellano & Bover, 1995; Blundell & Bond, 1998; Roodman, 2009). Furthermore, and importantly, xtabond2 also allows the ability to specify variables as endogenous to examine whether potential endogeneity is influencing findings.”

Sounds impressive, but when you strip back from the technical language, you see that the authors are using “lags” (i.e. last year’s variable – more precisely, the change in the variable from last year), which is generally invalid for the reasons discussed above. I use the above extract in no way to poke fun at this paper, but to stress that it’s common sense, not technical sophistication, that enables us to assess validity. Other complex terms that authors sometimes use to throw up smoke and mirrors include “dynamic panel VAR models” and “Granger causality”. The latter, despite its name, does not prove causality. It asks whether one variable predicts another, but this is the “post hoc ergo propter hoc” fallacy.

II. Natural Experiments

As discussed earlier, in social sciences, it is hard for the researcher to randomly assign treatments. A natural experiment is when firms are naturally (i.e., without the researcher having to do anything) divided into treated and control groups, for example if a law affects some firms but not others.

Bertrand and Mullainathan (2003) study whether takeover defenses worsen firm performance by entrenching CEOs and allowing them to coast. Their natural experiment is the adoption of state anti-takeover laws. Crucially, different states passed these laws in different years. Consider two plants located in New York, one of which belongs to a Delaware-incorporated firm and the other to a California-incorporated firm. In 1998, Delaware but not California passed anti-takeover laws. The Delaware-owned plant is affected by the law and part of the treated group; the California-owned plant is unaffected by the law and part of the control group.

Assume that, after 1998, we found that the Delaware-owned plant produced 2 (units of output) and the California-owned plant produced 7.  We might conclude that anti-takeover laws reduce output by 5. But, such a conclusion would be premature. Perhaps inefficient firms happen to incorporate in Delaware, and so the Delaware-owned plant was performing poorly even before 1998. Thus, it’s not the law that caused the Delaware-owned plant to perform poorly – it was performing poorly anyway. So, we must perform what’s known as a difference-in-differences analysis, which is best explained by the following (hypothetical) example:

Pre-1998 Post-1998 Difference
Delaware 8 2 -6
California 11 7 -4
Difference -3 -5 -2

Since the Delaware-owned plant is generally more efficient, it was already performing worse than the California plant pre-1998. The difference in their performance was -3 in the bottom row.  After 1998, the difference widened to -5. So, the difference-in-differences – the increase in the difference after 1998 – is -2, and so we can conclude that anti-takeover laws cause performance to fall by 2. Crucially, we use the pre-1998 difference in performance to control for the fact that Delaware-owned plants might be inherent different from California-owned plants.

We could also reach the same -2 conclusion by using the right-hand column, rather than the bottom row. The performance of the Delaware-owned plant fell from 8 to 2 after 1998 – a difference of -6. But, we can’t attribute this decline to the anti-takeover law, because many other events could have happened in 1998 that caused this fall – perhaps the economy went into recession in 1998. This is the role of the control group – the California-owned plant. We can use its difference in performance of -4 to measure the impact of other events that happened in 1998. The difference-in-differences is -2. So, we reach the same conclusion that anti-takeover laws cause performance to fall by 2.

Reader Beware

  • Are the treated and control groups trending in the same direction? The California-owned plant is only a valid control for other events that happened in 1998 if it is affected by the same events as the Delaware-owned plant. This is why Bertrand and Mullainathan use two plants located in New York – if the New York economy suffers a recession, it should have the same effect on both plants. If they had instead compared a plant incorporated and located in Delaware to a plant incorporated and located in California, the latter would not be a good control as Delaware may have suffered a recession in 1998 but not California. So, it is critical that the treated and control groups be trending in the same direction – the change in their performance post-1998 should have been the same if no law had been passed. This is known as the parallel trends assumption.
    • Note that we do not require the treated and control groups to be similar. In the above example, Delaware-owned plants are less efficient than California-owned plants. The level of their productivity is different pre-1998 -we only require the change or trend in their productivity around 1998 to have been the same had no law been passed. We can check this by checking the trends in performance of both plants for several years prior to 1998.
  • Was the natural experiment anticipatedIf the law change was anticipated, firms could respond in anticipation of the law. Then, a researcher might incorrectly conclude that the law had no effect – because the changes had already been made before the law got passed. Moreover, as Hennessy and Strebulaev (2016) show, anticipation may not only cause the measured effect to be weaker, but have the wrong sign.
  • Was the natural experiment exogenous? If firms could have lobbied for the law change, then it is no longer random whether a plant is treated or a control. Perhaps Delaware-incorporated firms knew that their future prospects were poor and lobbied legislators to pass anti-takeover laws in anticipation. As a result, we cannot conduct natural experiments using changes implemented by firms (as some papers do). For example, conducting a “difference-in-differences” between firms who chose to engage in stock splits and firms that do not, would not allow causal inference, since firms endogenously choose whether they are in the treated group (those who split their stock) and whether they are in the control group (those who don’t).
    • The McKinsey study referenced above refers to the “natural experiment of changing [a company’s] outlook during the sample period”. This uses the magic phrase “natural experiment”, but isn’t a natural experiment at all. Companies endogenously choose whether to take a long-term outlook, and they might do this when they know their future prospects are rosy (when times are tight, they need to focus on short-term survival).

III. Regression Discontinuity

Here, randomness occurs due to the independent variable falling either just below or just above a cutoff in an unpredictable way. For example, Cunat, Gine, and Guadalupe (2012) study the effect of shareholder proposals to increase shareholder rights. Showing that firm performance improves after such proposals are passed does not imply that the proposals caused the improvement, because they are endogenous. Perhaps a large engaged blockholder made the proposals, and it could be the blockholder that improved firm performance. So, they compare proposals that narrowly pass (with 51% of the vote) to those that narrowly fail (with 49% of the vote). Whether the vote narrowly passes or narrowly fails is essentially random, and uncorrelated with other factors such as the presence of blockholders – if there were large blockholders, they would likely increase the vote from 49% to (say) 80%, not 51%. They compare the stock price reaction to the vote outcome, as well as changes in long-term performance, of firms where a shareholder proposal narrowly passes to firms where a shareholder proposal narrowly fails (similar to a difference-in-differences). Since the stock price and long-term performance improves significantly more for the former set of firms, they show that increased shareholder rights cause higher firm value and long-term performance.

For other examples of regression discontinuity that I have blogged about, see Flammer and Bansal (2017) on the effect of shareholder proposals to implement long-term incentives, and Malenko and Shen (2016) on the effect of proxy advisors on voting outcomes.

Reader Beware

  • Can firms perfectly manipulate the independent variable, i.e. choose whether they are above or below the threshold? Suppose directors have control over the votes of shares held in an employee benefit trust. Normally, they do not vote these shares, to avoid investor concerns about them distorting vote outcomes. However, in extreme conditions, they may. For close votes, control of these votes allow firms to essentially choose whether the vote is 51% or 49%. They might allow the proposal to pass if it is performing well (since it is not afraid about greater shareholder power), and cause it to fail if it performing poorly. Then, whether the proposal passes or fails is endogenous – it depends on firm performance.
    • Note that if firms can only partially (not perfectly) manipulate the vote, regression discontinuity is still valid as there is still some randomness as to whether the vote narrowly passes or narrowly fails.
  • Are firms comparable on other dimensions above and below the threshold? Firms above the threshold are treated and firms below are controls. The treated and control firms should be comparable on all other dimensions. Comparability might be violated if (hypothetically) firms with higher-quality management were able to predict when the vote is going to be close and persuade “swing” shareholders to vote against the proposal. Thus, management quality might jump when you move from above to below the threshold.

IV. An Alternative Technique: Common Sense

Finding valid instruments, natural experiments, and discontinuities is difficult. So, an alternative approach to get closer towards causality is to use common sense. For example, if your effect is indeed causal, it should be stronger in certain circumstances. If a higher CEO equity stake caused superior firm performance, through providing the CEO with better incentives, the effect should be stronger where CEOs have greatest freedom to slack – in firms with little ownership by institutional investors, poor governance, and low product market competition. This is what von Lilienfeld-Toal and Ruenzi (2014) show, as blogged about here.

Brav, Jiang, Partnoy, and Thomas (2008) show that, after hedge fund activists acquire a large stake in a firm and announce an intention to influence control, performance improves. There could be reverse causality if the hedge fund predicted the improvements and acquired the large stake in anticipation. As blogged about here, the authors support causality by showing that the improvements are stronger when the hedge fund employs hostile tactics, and remain significant even when the hedge fund already had a large stake prior to announcing its activist intent.

Note that common sense does not show causality as cleanly as the first three methods; it can only suggest causality. (In the first example, perhaps the measures of governance are inaccurate). But, it should be added to the toolkit. Just as a discerning reader should use common sense to avoid being impressed by complex, but invalid, statistical techniques, he/she should also be open to common sense approaches to suggesting causality, even if they cannot prove it. Researchers using this approach must be careful not to make strong causal claims.

How Proxy Advisors Influence Voting Outcomes

Proxy advisors are playing an increasingly influential role in corporate governance, by providing investors with guidance on how to vote in director elections or for a manager- or shareholder-sponsored proposal (e.g. on corporate social responsibility or payout policy). Their influence is growing, in part, due to the rapid rise in index funds – since they hold shares in very many companies and may not have the resources to examine the proposals of each company in detail, index funds benefit from proxy advice, although they may not blindly follow it. As a result of their increasing influence, and potential conflicts of interest (blogged about here), the EU Shareholder Rights Directive and the US Proxy Advisory Firm Reform Act recommend greater transparency for proxy advisors.

These reforms are based on the assumption that proxy advisors have a substantial influence on voting outcomes. However, actually proving this influence is difficult. If a proxy advisor recommends voting against proposal A, and proposal A is indeed defeated, it might not be that the proxy advisor is responsible for the defeat. Instead, it may be that the proposal is inherently low-quality, and this jointly caused the proxy advisor to recommend against it, and shareholders to vote against it – indeed, the proposal’s low quality would have led shareholders to vote against it anyway, even without the proxy advisor’s recommendation. In slightly more technical terms, a correlation between proxy advisor recommendations and vote outcomes would not imply causation from the former to the latter. Instead, there could be an omitted variable, proposal quality, which jointly explains both.

An excellent paper in the Review of Financial Studies, by Nadya Malenko (Boston College) and Yao Shen (Baruch College), provides causal evidence of the influence of proxy advisors on voting outcomes. They use data from Institutional Shareholder Services (“ISS”), the leading proxy advisor, and focus specifically on executive compensation proposals. They identify causality using a well-established technique known as Regression Discontinuity (used also in a paper I blogged about here showing a causal effect of long-term executive incentives on innovation and CSR). The idea behind Regression Discontinuity in their setting is as follows:

ISS uses a cutoff (based on 1 and 3 year Total Shareholder Return (“TSR”) to perform an initial screen and only undertakes a deeper analysis for firms below the cutoff. (The authors are not saying whether ISS is right to use the cutoff rule, only that they do use the cutoff rule). Now, of course, whether your TSR is below or above the cutoff (= industry median) could be correlated with proposal quality – very poorly performing firms are likely to attract good proposals to improve executive incentives and fix the poor performance. So, Nadya and Yao compare firms which are just below the cutoff to those that are just above, i.e. in the 49th percentile of TSR to those in the 51st percentile of TSR. Whether you’re just below or just above is essentially random and uncorrelated with proposal quality (a good quality proposal is likely to be triggered by TSR falling from the 51st percentile to the 15th percentile, not the 49th percentile). They show that this randomness “exogenously” shocks the ISS recommendation and use this to causally identify the effect of ISS recommendations on the eventual vote outcome. Specifically, from 2010 to 2011, a negative ISS recommendation on a say-on-pay proposal leads to a 25 percentage point reduction in say-on-pay voting support.

This paper shows that proxy advisors have a substantial influence on voting outcomes. The authors do not claim that such influence is either good or bad. Hypothetically, it could be either – the influence is good if proxy advisors have expert advice that guides shareholders to make more informed decisions, or bad if they use one-size-fits-all recommendations that are not tailored to the specific firm, or affected by conflicts of interest. In both cases, the paper shows that proxy advisors are very important for corporate governance, and so the scrutiny that some regulators are placing on them is justified.



CEOs Cut Investment To Sell Their Own Shares At High Prices

One of the most fundamental concerns with corporations is that they focus on short-term profit rather than investing for the long-term. This is a particular concern in the 21st century, where innovation is particularly critical for competitive success. Moreover, allegations of short-termism have serious social repercussions. Long-term investments, such as reducing carbon emissions, developing blockbuster drugs, or training workers, typically benefit stakeholders as well as shareholders, but short-term profit only goes to shareholders. The concerns that corporations exploit stakeholders to pander to shareholders has led to a substantial loss of trust in business and threatens its social license to operate.

But Where’s The Evidence?

However, actually finding evidence that short-termism even exists is extremely difficult. My prior post discussed several pieces of evidence to the contrary. Indeed, my 2007 “job market paper” (that you take on the academic job market in the final year of your PhD) was a theoretical model of how large shareholders can alleviate short-termism. In the first few minutes of most seminars, I’d get the question “What evidence is there that short-termism is even a problem in the first place?” I had to admit that there was little hard evidence – the best was a 2006 survey of executives where 78% admitted to sacrificing long-term value to meeting earnings targets, but this is only what executives claimed that they did, rather than what they actually did.

“No evidence of short-termism”, however, is not the same as “evidence of no short-termism”. There simply wasn’t evidence either way, since it’s hard to measure a CEO’s short-term concerns. One measure might be the amount of shares that she sells in the short-term. If the CEO sells a ton of shares in Q3 2017, then she wants the stock price to be particularly high in Q3 2017. Thus, she might cut investment in Q3 2017. But, a correlation between CEO equity sales and investment cuts would not imply causation. The problem is that CEO equity sales are endogenous – they are a deliberate choice of the CEO, and so this choice may be driven by other factors that also drive investment. For example, if prospects are looking bleak in Q3 2017, this might cause the CEO to rationally scale back investment, and separately to sell her shares.

Documenting Short-Termism: A New Approach

In a recent paper, Vivian Fang, Katharina Lewellen, and I* initiated a new approach. Rather than studying the shares that the CEO actually sells, we study the amount of shares that are scheduled to vest. For example, if a CEO was given a chunk of shares in Q3 2012, with a 5-year vesting period, they first become saleable in Q3 2017. CEOs typically sell a large portion of their shares when they vest, to diversify their portfolio (we verify this in the data). Thus, if the CEO knows that her shares will be vesting in Q3 2017, and so she’s likely to sell a large portion, she has incentives to cut Q3 2017 investment. Importantly, the driver of Q3 2017 vesting equity is the decision to grant the CEO shares back in Q3 2012. That was five years ago, and so is likely exogenous to (not driven by) Q3 2017 investment opportunities. Thus, any correlation between Q3 vesting equity and Q3 investment cuts is likely to be causal.

We include both shares and options in our measure of vesting equity and estimate this amount at the quarterly level. This is because the highest frequency with which investment is reported is also at the quarterly level. We regressed the change in investment (measured five different ways) on vesting equity and many control variables that may also drive investment cuts (e.g. investment opportunities or financing constraints).

CEOs Cut Investment When Their Equity Vests

We find a significant negative correlation between vesting equity and the growth rate in investment – using all five investment measures. Moreover, these results are robust to:

  • Removing equity grants where vesting depends on hitting certain performance targets, rather than reaching the end of a pre-specified time period (e.g. 5 years)
  • Considering only vesting stock or only vesting options
  • Including or excluding controls
  • Regressing the change in investment not on the amount of vesting equity, but the amount of equity sales that can be predicted by vesting equity

Alternative Explanations

So, the link between vesting equity and investment cuts appears to be robust. This is consistent with the idea that the CEO inefficiently cuts good investment projects to boost short-term earnings and thus the short-term stock price (the myopia hypothesis). But, as I explained in a recent TEDx talk, finding that the data is consistent with a hypothesis does not mean that the data supports the hypothesis – because it could also be consistent with alternative hypotheses.

The main concern is the efficiency hypothesis. Perhaps the CEO cuts bad investment projects, and so the cut in investment is efficient. Let’s say cutting investment is hard. It takes effort to identify wasteful projects and shut them down, and doing so may make the CEO unpopular. CEOs may instead prefer to coast and enjoy the quiet life. But, when the CEO is about to sell her shares, she overcomes her inertia and is willing to take tough decisions. If true, then short-term pressures are motivating, rather than distracting – a bit like how an impending essay deadline forces students to stop procrastinating.

We tested the efficiency hypothesis in two ways. First, if equity vesting causes the CEO to get her act together, you’d expect her to improve efficiency not just by cutting investment, but also by cutting other expenses or increasing sales growth. But, we find no evidence of this. Second, we show that CEOs cut investment less when the cuts are more costly to them (the CEO is younger, so she suffers more from the long-term consequences of scrapping an efficient investment; or the firm is younger or smaller, suggesting that the investment is more valuable). These tests suggest that the investment cut is indeed likely to be inefficient.

How Does the CEO Benefit?

One complication is that Q3 earnings aren’t announced until the start of Q4. So, how does a CEO who sells equity in Q3 benefit from the earnings increase that results from the investment cut? We show that vesting equity increases the likelihood that the CEO issues positive earnings guidance in the same quarter. Doing so boosts the stock price by 2.5%, thus indeed allowing her to cash out at a high price. Indeed, we find that the CEO’s equity sales are concentrated in a small window immediately following the guidance event. So, the full picture appears to be – the CEO knows that her equity is vesting in Q3, so she cuts investment in Q3 and also issues positive earnings guidance in Q3, boosting the stock price and allowing her to sell her shares upon vesting.

If the CEO boosts earnings-per-share by 5c, how much should positive earnings guidance should she give? Probably around 4-5c – then, she will benefit as much as possible from the earnings increase – but not more than that else she will subsequently undeperform expectations. (The same reason explains why the CEO can’t issue positive guidance without the investment cut – both go hand-in-hand). Indeed, we find that, when more equity vests, the firm is particularly likely to beat the analyst forecast by a narrow margin (0-1 cent) but not a wide margin, consistent with the CEO communicating nearly all of the earnings increase ahead of time.

What Does It Mean For CEO Pay Design?

Executive pay is a highly controversial topic. Most people agree that it should be reformed, but the reforms typically focus on the level of pay. As I wrote earlier (see myth #5), the level of average CEO pay in the US is only 0.05% of firm value. Instead, these results suggest that the horizon of pay is more important – it affects the CEO’s incentives to invest, with potentially substantial implications for the company’s long-run success and the value it creates to other stakeholders. Cutting pay in half will win more headlines than extending the vesting horizon from (say) 3 to 7 years, but the latter is likely much more impactful. Indeed, the paper was referenced in the UK government’s Green Paper on Corporate Governance to justify the proposal to extend vesting periods. Here I describe a redesign of executive pay based in part on the results of this paper (since implemented by some companies), and here I summarize a paper by other scholars showing positive causal effects of long-term equity compensation.

Is Short Termism Really A Problem?

“Myopia [short-termism] is a first-order problem faced by the modern firm. In the last century, firms were predominantly capital-intensive, but nowadays competitive success increasingly depends on intangible assets such as human capital and R&D capabilities (Zingales (2000)). Building such competencies requires significant and sustained investment. Indeed, Thurow (1993) argues that investment is an issue of national importance that will critically determine the U.S.s success in global competition.”

So I wrote in my 2007 “job market paper”, later published in the 2009 Journal of Finance. The “job market paper” is the signature paper from your PhD thesis, that you take on the academic job market and often ends up seeding your future research agenda as a faculty member. Indeed, most of my work over the last 10 years has focused on the causes of and potential solutions to short-termism. These include short-term executive contracts, excessive disclosure requirements, the stock market ignoring intangibles, and investors owning too small stakes. So, I have a vested interest in claiming that short-termism is a massive problem. With The Purposeful Company, I have been applying these insights from research to propose policy reforms that will encourage companies, investors, and stakeholders to think more long-term.

But, as with all issues, it is important to consider different perspectives. This will help address the problem of “confirmation bias” – only accepting evidence or arguments that reinforce your viewpoint and rejecting those that contradict it – that I discussed in a recent TED talk, “What to Trust in a Post-Truth World“. Here I summarise an excellent, contrarian article entitled “Are U.S. Companies Too Short-Term Oriented?” by Chicago’s Steve Kaplan, one of the world’s leading authorities on corporate finance. Steve presents a number of cogent arguments for why the problem of short-termism may be exaggerated, which I summarize here.

  1. The Boy Who Cried Wolf

Short-termism is not a new allegation, particularly in the US. My job market paper opened with a 1992 quote from renowned Harvard professor Michael Porter:

The nature of competition has changed, placing a premium on investment in increasingly complex and intangible forms—the kinds of investment most penalized by the U.S. [capital allocation] system.

Porter argued that the US stock market was excessively liquid, leading to shareholders buying and selling companies based on short-term profits rather than long-term value. He advocated a move towards the Japanese system of long-term, stable stakes. However, the evidence of the past 25 years has suggested that the Japanese model has not been the panacea previously thought. While this may be for reasons other than its illiquidity, more direct evidence shows that liquidity has many beneficial effects on firm value.

Steve also includes a 1979 quote from renowned corporate lawyer Marty Lipton, and a 1980 quote by Harvard professors Robert Hayes and William Abernathy, alleging the problem of short-termism. If companies were underinvesting since the 1980s, surely they’ll feel the effects today, after nearly 40 years? But, Steve uses data from 1951 to show that US corporate profits are now near all-time highs, and that the long-term growth in profits has easily outstripped supposedly more “long-term” countries such as Japan. Moreover, the growth in profits was faster after than before 1980s – indeed in the period in which the financial sector, and the focus on shareholder value maximization – both alleged drivers of short-termism – started taking off. Thus, critics alleging short-termism may seem like the boy who cried wolf.

One may argue that corporate profits are not the best measure of value creation, since they are narrowly focused on shareholders. However, evidence suggests that, in the long-term, shareholders and stakeholders are aligned: serving stakeholders ultimately benefits shareholders – and 40 years is a long time period. More direct evidence suggests that society has benefited. Steve cites numbers from the World Bank suggesting that, in 1980, 2 billion people lived in extreme poverty (44% of the world’s population), which by 2012 fell to 900 million (13%). The World Bank projected last year that, for the first time, this number was expected to have fallen below 10%. Steve writes that “while causality is hard to prove and many factors have contributed to this result, US companies – through international outsourcing and globalization – have played an important role in these outcomes.”

  1. No Open Goal
Those who believe that investors are too myopic should celebrate, rather than lament, this behavior. If investors are indeed too focused on the short-term, and thus not financing companies with superb long-term prospects, this gives critics an open goal – the critics can put their money where their mouth is, address the financing gap, and make a killing.

And that’s what venture capital (VC) tries to do. Its end investors commit their capital for 5-10 years, allowing a VC fund to make long-term investments that address the financing gap. So, if (a) short-termism has increased over time, the scope for venture capital has increased over time, and (b) if short-termism is a problem, then venture capital should be unusually profitable.

Steve shows that neither hypothesis is true. Starting with (a), the capital committed to VC funds as a fraction of the stock market has fluctuated in a relatively narrow band of 0.10-0.20% over the last 35 years. This does not suggest there are huge untapped opportunities to invest in innovation. Turning to (b), numerous studies suggest that, while VC funds outperform the market, this outperformance is relatively modest. For every 1% increase in the stock market, VC earns around 1.1-1.2%, and this modest outperformance may not fully control for the greater risk of VC nor be scalable.

Similar results also hold for private equity, which – like VC – also has committed capital and thus the ability to make long-term investments. Also – like VC – it invests in private firms, which are shielded from the alleged short-termism of the stock market, such as the need to report quarterly earnings.

  1. Unicorn Valuations
The Price/Earnings ratio compares the price of a share to its current earnings. If the P/E is high, then the stock market is valuing a firm much more highly than can be justified by its current earnings, because it is taking into account the potential for future profits. The current P/E ratio of the S&P 500 is 25, versus a historical median of 15.  Indeed, the high valuations of unicorns, despite them making little or even negative earnings, suggests that the stock market must forward looking and valuing something other than current profits.

Relatedly, U.S. companies are increasingly less likely to be profitable when they go public. This holds not only for tech IPOs and biotech IPOs. Investors are increasingly likely to back biotech and fracking firms, even though they have significant periods of negative cash flows.

So Why Is Short-Termism Seen As A Problem? 

Given the evidence above, why is short-termism seen as such a problem? Steve points to a number of potential causes:

  • Executives may have a vested interest in claiming that short-termism is a problem, to make them less accountable. Claiming that they shouldn’t be evaluated until 3 years down the line guarantees them employment for at least 3 years.
  • Companies are seen as focusing excessively on share buybacks and dividend payouts rather than investment. In Steve’s words, “This argument is something of a non sequitur. It suggests that in a buyback or dividend, the money simply disappears rather than going to investors who spend it or use it to make other investments. It also suggests that companies that don’t need money should invest it anyway, rather than give it back to shareholders.”
    • Indeed, I believe that the current criticism of dividends and, in particular, buybacks,  stems from substantial misunderstandings. I discuss these misunderstandings (in non-technical language) in p7-8 of my supplementary evidence to the UK House of Commons.
  • Confirmation bias. In the current political climate, many people see companies as evil, and are very willing to accept evidence that supports this view and reject evidence that contradicts it. As Steve writes, “the short-termers ignore a lot of evidence that goes against their position”.

Where Do We Stand?

Has Steve’s paper wiped out a large chunk of my research agenda and policy initiatives? No – it reinforces the need to take an evidence-based, circumspect approach to reform. It points to short-termism being a much more nuanced problem than the media or politicians claim. It is very tempting to make sweeping, unqualified statements (e.g. “all firms are short-termist”), as these are more likely be turned into headlines or Tweeted in 140 characters. But, doing so is very dangerous. Few issues are black-and-white; indeed, despite being a staunch Remainer, I posted on the case for Brexit. Conveying the view that all executives are crooks who sacrifice long-term value for short-term profit contributes to an anti-business sentiment which in turn is a potential contributor to the rise of populism, Trump’s election, and the Brexit vote. Being fast and loose with the evidence has serious consequences. Moreover, the view that short-termism is a universal and pervasive epidemic has supported calls to “throw the baby out of the bathwater”, i.e. abandon the current system – that has led to substantial technological process, rising corporate profits, and diminishing poverty – by mandating workers on boards, making managers less accountable by reducing shareholder rights, and tearing up current corporate forms for untried, untested alternatives.

Instead, diagnosis precedes treatment. Before deciding whether to amputate, a doctor will study whether a condition is local and can instead be spot-treated. Similarly, the optimal response to short-termism depends on how pervasive the problem is, and what the causes are. All the reforms that I have been proposing aim to work within the system, since my reading of the evidence is we do not have an epidemic, and so we do not want to tear up the system that has created many long-term unicorns. Moreover, the specific dimensions to reform should be driven by the evidence, which seems to suggest that buybacks and stock market liquidity are not causes of short-termism, but short-term executive pay and fragmented share ownership may be.

Conflicts of Interest Among Proxy Advisors

The Importance of Proxy Advisors

Proxy advisors play a critical role in corporate governance. One important way in which shareholders exert governance – ensure that executives act in shareholders’ interest, rather than their own interest – is through voting. Votes can be for particular directors (who monitor executives), for or against a say-on-pay vote, or for or against manager or shareholder proposals on issues such as corporate social responsibility, strategy, payout policy, charitable contributions, or corporate governance itself (e.g. shareholder rights).

However, many investors may be uninformed about how to vote, either due to lack of expertise in corporate governance (as may be the case for some, but not all, retail investors) or lack of incentives to become informed due to their small stakes. Even a large institutional investor may only hold a small stake in any one particular company, due to being spread thinly across thousands of companies. These concerns are particularly strong given the rapid growth of index funds who are especially diversified.

Proxy advisors, such as Institutional Shareholder Services (“ISS”) and Glass-Lewis are a potential solution to this problem. Just as credit ratings agencies guide investors on how much to charge for lending to a company, and credit and equity research reports guide investors on whether to buy or sell a company’s debt or equity, proxy advisors can guide an investor on how to vote. Even though some investors may not blindly follow a proxy advisor’s recommendation, their recommendations remain very influential. Exxon Mobil recently stated that “proxy advisors hold a position of unparalleled influence” and estimated that “between 20-25% of the votes cast at Exxon Mobil’s most recent annual meeting were voted automatically in accordance with proxy advisor recommendations.” This is backed up by large-scale causal evidence – investors are significantly more likely to vote for (against) a resolution if ISS recommends voting for (against).

Thus, it is critical that proxy advisor recommendations are unbiased. However, evidence suggests that credit rating agencies may be biased, and the Global Analyst Research Settlement was in response to concerns of equity analyst bias. A forthcoming paper in Management Science by Tao Li of Warwick Business School, based on his PhD dissertation at Columbia Business School, suggests that conflicts may also exist with proxy advisors.

Why Might Conflicts Exist?

What’s the source of such a conflict? Tao studies ISS, who sells not only proxy voting services to investors but also consulting services to firms who are considering management-sponsored proposals. Thus, there is a potential concern that ISS may recommend that investors vote for management if it is a consulting client – either as a “quid pro quo” for commissioning consulting services, or to show that its consulting has succeeded in designing management-sponsored proposals that shareholders are willing to approve. Indeed, the Ohio Public Employees Retirement System dropped ISS’s services in the mid-2000s, commenting that “the thing that tipped us was [ISS’s] actual or perceived conflicts due to the corporate consulting.”

Documenting Potential Conflicts

How did Tao study whether these conflicts actually existed? Simply showing that ISS is more likely to recommend votes for management when also provides consulting services does not suggest bias, because it could be that the consulting genuinely improved proposal quality. So, Tao looks at the entry into the proxy advisory market by Glass Lewis, a major competitor providing no consulting services. The hypothesis is that competition disciplines ISS from issuing biased recommendations, just as it does so with equity analysts.

But, simply showing that ISS recommends “against” more often when Glass Lewis enters will still not suggest that ISS was previously biased. It could be that managers are starting to make more egregious proposals, which both causes ISS to recommend “against” and also encourages Glass Lewis to enter, since investors need more voting guidance. Thus, Tao compares firms that are potential clients of ISS (proxied by large firms) – where conflicts exist – with firms that are not potential ISS clients because they are too small. This “difference-in-differences” analysis controls for time trends. Using a medical analogy, large firms are “treated” firms, where any bias is reduced by Glass Lewis’s entry, and small firms are “placebo” firms – Glass Lewis’s entry is irrelevant, since there were few conflicts to begin with.

Indeed, Tao finds that, when Glass Lewis initially covers a new firm, ISS becomes tougher towards potential clients than non-clients. Also supporting a “conflict” explanation, the effect is stronger for more complex votes where it is easier to be biased (e.g. on proposals related to governance and executive compensation) rather than “no-brainer” votes where bias might appear blatant (e.g. uncontested director elections). For contested director elections, the effect is stronger for first-time director nominations than director reappointments, again potentially because the former are more complex and thus bias was easier before Glass Lewis’s entry.

Moreover, any potential bias has real outcomes – it is important. Tao compares proposals with potentially biased recommendations from ISS that pass by a narrow margin to those that fail by a narrow margin (focusing on narrow margins zones in on proposals where any potential bias was particularly important). Firms with proposals that narrowly pass subsequently outperform those that narrowly fail. These effects are small, but Tao finds that executives at these firms have higher abnormal pay, higher growth in pay, and more cash payments. These results suggest that any potential bias allows managers to extract value at the expense of shareholders.


Tao is careful not to over-interpret his results. While suggestive of conflicts, they do not prove bias. The published paper does not use data on ISS’s actual client base, and can only proxy for it using firm size. (Tao, like any institutional client that purchases ISS’s voting recommendations, was able to check potential conflicts of interest using ISS’s actual client base, but was not allowed to write any papers based on the client list.) Moreover, even if ISS’s recommendations were biased, they may still be informative – a biased recommendation may still be better than no recommendation, and so proxy advisory firms play an important role in compensation. But the result do suggest that, just as investors use credit ratings and analyst reports to guide their investment decisions but do not blindly follow them, investors should similarly use proxy recommendations as an important input to their votes but it is critical that they also do their own analysis. If investors do not have sufficient “skin-in-the-game” to do their own analysis, policymakers should encourage them to take large stakes in firms – potentially by increasing the threshold (currently 5% in the US and EU, and 3% in the UK) at which they need to disclose their holdings. My conversations with a very large, but very diversified, institutional investor revealed that they virtually automatically follow ISS in their voting, which may not lead to the best outcomes.

Corporate Governance in China

China will soon become the largest economy in the world, but many Westerners (myself included) know very little about it. Moreover, the vast majority of research on corporate governance is on the US. We often assume that these findings will apply throughout the world, but this assumption is unwarranted – the institutional setup is very different across different countries.

I thus sought to educate myself on China, and came across an excellent article by Fuxiu Jiang and Kenneth Kim of the Renmin University of China. In addition to providing a non-technical survey into Chinese corporate governance in its own right, it also introduces a special issue of the Journal of Corporate Finance with many papers on Chinese corporate governance. I summarize the article in bullet-point format below. All of these points I learned from the original article, so please cite it (not me) if you use anything from it (Jiang, Fuxiu and Kenneth A. Kim (2015): “Corporate Governance in China: A Modern Perspective”. Journal of Corporate Finance 32, 190-216). I hope you find this as helpful as I did.

Institutional Background

Capital Markets

  • On December 19, 1990 and July 3, 1991 the Shanghai and Shenzhen Stock Exchanges were launched. Shanghai is analogous to NYSE and Shenzhen to Nasdaq.
  • Regular domestic shares are A-shares, denominated in RMB. A small fraction of firms have B-shares, denominated in foreign currency (US or Hong Kong dollars).
    • B shares have the same cash flow rights as A shares, but were originally restricted to foreign investors.
      • Since 2001, Chinese can own B shares
      • Since 2003, qualified foreign institutional investors (QFIIs) can own A-shares
    • B shares are less than 0.5% of the total market cap on the two exchanges
  • Regulator is China Securities Regulatory Commission (CSRC), the equivalent of SEC
  • Shares are divided into tradable shares (TS, 1/3) and nontradable shares (NTS, 2/3). Initially, controlling shareholders (often the state or legal persons) held NTS, and domestic individual investors held TS.
  • Individual investors are typically uninformed speculators, leading to stock market volatility. Government has thus promoted institutional investors
    • In April 1998, the first closed-end fund was introduced. Open-end mutual funds and index funds were subsequently introduced.
    • October 27, 1999: insurance companies were approved to own stocks indirectly through a securities investment fund. October 24, 2004: insurance funds were allowed to invest in stocks directly.
    • As above, QFIIs could hold A-shares from 2003
    • Thus, tradable shares became held also by domestic and foreign institutional investors
  • Split share structure was to ensure that the government could retain control of firms. But, government realised that non-tradability is a problem – since NTS holders don’t benefit from stock price appreciation, they had little incentive to pursue shareholder value maximisation. Thus, conflict between TS and NTS
  • April 2005: government initiated the Split Share Reform, to transform all NTS into TS. Since this would dilute the value of TS, NTS holders had to negotiate a compensation plan with TS holders (typically additional shares)
    • Pilot programs conducted in April and June 2005. Reform expanded to all listed firms in August. By end of 2007, almost all firms had established a plan and timetable to convert NTS into TS. Since 2005, NTS are called “restricted shares” to convey the fact that they will eventually become tradable
  • Turnover is high. Even though it’s fallen, it still remains high by international standards. Average holding period of 1 year (4 months) on Shanghai (Shenzhen) Stock Exchange

Corporate Governance

  • For listed firms, a shareholder meeting is required once per year
    • Interim meetings can be called by large shareholders
  • A listed firm must have 5-19 directors
    • Board must meet at least two times per year
    • Since June 30, 2003, at least 1/3 of the board must be independent (can’t be related to the manager, be one of the top 10 shareholders or own 1% of shares, or have a business relationship with the firm).
    • Since China has concentrated ownership, primary duty of independent directors is to monitor large controlling shareholders on behalf of minority shareholders. In countries with dispersed ownership, it’s to monitor management on behalf of all shareholders.
  • Board structure is two-tier: in addition to the board of directors, there is a board of supervisors. Must have at least three supervisors, include representatives of shareholders, and at least 1/3 must be employees
  • Note that it’s the board chair who’s typically in charge of a company, not the CEO or General Manager (GM is often the title given to the CEO)
    • Chairs typically work full-time and go to work every day, unlike in the UK and US

Internal Governance: Stylized Facts and Interpretation

  • Ownership concentration
    • In 2012, largest shareholder owns, on average, 1/3 of the firm; 5 largest own over half of the firm
    • Ownership concentration has declined over time, particularly from 2005 to 2006 since common compensation in the Split Share Reform was to transfer shares from NTS to TS holders
    • Firms where the large shareholder owners > 50% have higher ROE but lower Q than other firms. Thus, even ignoring causality, it’s hard to say whether large shareholders are good or bad for firm value
    • From 2007, firms with multiple large shareholders outperform firms with single large shareholders in ROE. This may be because 2007 is the first year when firms have more TS than NTS, so governance through exit is strong (one large shareholder can threaten to sell if another large shareholder doesn’t cooperate with it)
    • When the government is a large shareholder, it does not tunnel for private benefits (e.g. perks), but it may sacrifice shareholder value for political objectives such as maintaining employment or overinvesting to prop up GDP
  • Managerial ownership
    • SOEs: managers have very little stake, typically because the manager is a government official appointed by the state
    • Non-SOEs: average ownership is 16%, since most non-SOEs are family firms or founded by entrepreneurs. But, median ownership is 0% in most years and 1.1% in 2012. Managers are rarely given shares or options as compensation; managers only become significant shareholders if it’s a family firm or if they buy the shares personally
  • Managerial pay
    • Pay has rapidly increased in a short period of time, but remains modest globally. In 2012, median pay for top manager of SOEs is RMB 470k ($77k)
    • Pay is not an important incentive for SOE managers. They’re government employees, so are incentivized by being promoted to high-level government positions when their term says firm managers has finished. Also, poorly-performing SOE managers are fired. Thus, incentives still matter, but aren’t provided by pay
  • Institutional ownership
    • Has risen over time, largely driven by emergence of mutual funds
    • But, ownership remains small.
      • In 2012, total institutional (mutual fund) ownership averages 17.4% (7.6%).
      • Median ownership of a mutual fund was 0.067% in 2011
    • In 2011, average holding period for a mutual funds is less than 6 months
  • Board structure
    • CEOs are chairs 25% of the time in non-SOEs, 10% of the time in SOEs
  • Capital structure
    • Average leverage in non-financial firms is 1/3. High compared to UK and US
    • Debt is unlikely to discipline managers in China since creditor rights are weak. Thus, bankruptcies are extremely rare
    • Banks don’t appear to monitor. Qian and Yeung (2015: even when controlling shareholders are tunneling from minority shareholders, banks continue to lend, and loan terms aren’t unfavorable.
  • Dividend policy
    • Dividends are very small: around 1%. Potential reasons:
      • Minority shareholders aren’t able to pressure firms to pay out earnings as dividends, since minority shareholder rights are weak.
      • Turnover is high, and so minority shareholders are speculators going after capital gains rather than caring about dividends
    • Dividends are largely driven by regulations.
      • E.g. Number of paying firms more than doubles in 2000 because a CSRC regulation, with effect from March 2001, required a Chinese-listed firm to pay dividends for three consecutive years if it wants to sell new shares

External Governance

  • As China has transitioned from a centrally planned economy to a market-oriented one, China has issued many laws and securities regulations, but China remains internationally weak in its laws, enforcement, and punishment
  • Government recognizes this and is taking steps. 2002 is referred to as the “Year of Corporate Governance of China”
    • Released Code of Corporate Governance
    • CSRC enacted many governance reforms and regulations, e.g. Improving disclosure requirements when large shareholders change
    • CSRC undertook an unprecedented large-scale review of 1,175 listed firms. Found that 30% had significant governance problems. Many CEOs were fired, many firms were fined.
  • Unlike other countries, little governance through managerial labor market, which is nascent
    • SOEs don’t compete among themselves for the best managers, since the government is the only demand-side entity
    • Many non-SOE firms are family firms, so little external hiring historicallly. May change going forwards as firms become more complex, and China’s one-child policy limits number of family candidates
  • Unlike other countries, little governance through corporate control market, which is nascent
    • State won’t sell SOEs to a raider
    • For non-SOEs, ownership is so concentrated that it would be hard for a raider to gain control
    • But, this may change going forwards given that almost all shares are now tradable
  • Like other countries, product market competition is an effective governance mechanism
  • Many Chinese firms engage in CSR to curry favor with the government, since one of the government’s main roles is to promote social welfare (like other countries). Lin et al. (2015): firms that engage in CSR are more likely to receive government subsidies
  • Cross-listings are likely an effective way for Chinese firms to obtain good governance

China’s Corporate Governance Code

  • Like most codes, contains broad and vague language that describes guiding principles rather than explicit regulations. There are eight chapters
  1. Shareholder rights
  2. Rules for controlling shareholders, including advocating a “reasonably balanced shareholding” (multiple sizable blockholders rather than a single large blockholder)
  3. Rules for directors and board of directors
  4. Duties and responsibilities of the supervisory board. Board is accountable to all shareholders and oversees both directors and senior management
  5. Performance assessments for directors, supervisors, and management
  6. Stakeholders. Firms should be good corporate citizens and cooperate with, inform, listen to, and honor the legal rights of stakeholders
  7. Disclosure. Firms must fully and accurately disclose all information required by law
  8. Code comes into effect on the date of issuance

House of Commons Report on Corporate Governance

Today the House of Commons Select Committee on Business, Energy, and Industrial Strategy (BEIS) published its report on corporate governance, after extensive consultation of oral and written testimony from a wide range of stakeholders. I applaud the Select Committee for such an extensive, thorough job with an issue of national importance, and am personally grateful to them for publishing my initial and supplementary written testimonies as well as inviting me to testify orally in Parliament. I endorse the vast majority of the recommendations and believe that they will help “make Britain a country that works for everyone”, in Prime Minister May’s words. This post aims to summarize the 81 page report into a few simple bullet points, and link them to the evidence.

Executive Pay

  • LTIPs (bonuses based on hitting financial targets) to be scrapped from 2018; no existing LTIPs to be renewed.
  • Instead, give executives equity that they are required to hold for the long term (at least 5 years). The equity must not vest (= become saleable) all in one go
    • See here for the arguments for replacing LTIPs with equity, and here for evidence that CEOs cut investment when their equity vests
    • These ideas are also advocated by The Purposeful Company, a leading consortium of leading executives, investors, consultants, and academics (full report here, short summary here)
    • LTIPs are almost ubiquitous, but used because “we’ve always done it that way” rather than because they are effective. Given this common usage, the proposal is a radical one – but a highly desirable one – and I greatly applaud the Committee for its boldness
  • Where bonuses are used, they should be on wider performance criteria (e.g. qualitative factors) and must be stretching
  • Shareholders’ “say-on-pay” vote will remain advisory, rather than being changed to binding (as initially mooted).
    • However, if an advisory vote has < 75% support, there should be a binding vote the next year and the Remuneration Committee (RemCo) chair should be encouraged to resign
  • Firms should not be forced to put workers on RemCos, but worker representation to be on a comply-or-explain basis
  • Firms, public sector, and large third-sector organisations to publish pay ratios between the CEO and senior management, and the CEO and all UK employees. The ratio must be on a consistent basis each year
    • The actual advocacy of pay ratios was lukewarm, with little justification given. See my Harvard Business Review article for the potential unintended consequences of such disclosure (including for workers themselves).

Directors’ Duties and Reporting

  • More specific and accurate reporting on directors’ duties to other stakeholders, including long-term consequences of decisions
  • Reporting to contain fewer boiler-plate statements. Companies to be more imaginative and agile in communicating directly with stakeholders
  • The report recognises that UK corporate governance is very well regarded internationally. Thus, it strongly supports maintaining
    • The unitary board, where all directors share the same responsibilities
    • The statement of directors’ duties in Section 172 of the Companies Act (that directors “promote the success of the company for the benefit of its members” (i.e. shareholders) while having regard for other stakeholders)
    • “Comply or explain” guidelines (firms do not need to comply with certain guidelines, permitting flexibility – but if they do not, they must explain why not)
  • I particularly applaud the report’s caution against overreacting to the scandals at BHS and Sports Direct. These scandals are tragic, but do not mean that all companies should have to suffer.
    • The Report writes (paragraph 24): “Corporate governance in the UK is still strong and remains an asset to the country’s reputation for doing business. We are conscious that a small number of highly damaging examples of corporate governance failure should not lead to a hasty and disproportionate response. We do not believe that there is a case for a radical overhaul of corporate governance in the UK”

Expanded Role for the Financial Reporting Council (FRC)

  • FRC to introduce a new tiering system (Red, Yellow, Green) for corporate governance
  • FRC to engage and hold directors to account
    • If engagement unsuccessful, report failings to shareholders
    • If still no response, take legal action
  • FRC to be renamed and resourced, to match this expanded role

Private Companies

  • New governance Code for the largest private companies to be developed
    • Compliance to be examined by an expanded FRC, funded by a small levy on businesses

Shareholder Engagement

  • Paragraphs 13-16 recognise the importance of blockholders (large shareholders) and the dangers of the ownerless corporation
    • However, this point is not subsequently picked up. Encouraging large shareholders to form, and helping shareholders to engage with companies, could further help the Government’s mission. See Chapter 4 of The Purposeful Company Policy Report.
  • Investor Forum to facilitate better engagement between boards and shareholders, particularly if rated Yellow or Red by new FRC tiering system
  • Shareholders encouraged to engage more in pay

Stakeholder Representation

  • Companies to be encouraged to consider a Stakeholder Advisory panel, to consult stakeholders other than shareholders
  • Annual Report to contain a section on how firms engage with shareholders
  • Workers on boards should not be mandated, but report highlights that there is nothing in the law to prevent it. Would like it to become the norm by opening up new director positions to all.
    • Worker directors will not be a delegate of the workforce as a whole but act in their own capacity, and have the same rights and responsibilities as other directors

Board Diversity

  • 2020 target for half of new appointments to senior and executive management to be women. Companies should explain why they have failed to meet the target and the steps taken to address it
  • Every existing FRC reference to gender diversity should also add a reference to ethnic diversity


  • Firms to report on their people policy in the Annual Report, i.e. approach to investing in people and how they ensure that their pay and working conditions are reasonable
  • Investors to disclose voting records; FRC to name those who don’t vote
  • Firms to provide full information on advisors engaged in transactions

A Note on the Use of Evidence

  • The Report writes “The TUC states that “There is clear academic evidence that high wage disparities within companies harm productivity and company performance“.” This statement is actually false. The TUC (potentially inadvertently) quoted an unpublished 2010 paper by which found that high pay ratios are negatively correlated with firm performance. However, the final version of the paper was published in 2013 (i.e. 4 years ago). After going through peer review, it found the opposite result. In the authors’ own words, “We find that employees do not perceive higher pay ratios as an inequitable outcome. We do not find a negative relation between relative pay and employee productivity. We find that firm value and operating performance both increase with relative pay.”
    • This highlights the potential issue of “confirmation bias”. You can always find some academic paper to support any viewpoint (some studies support vaccination, others oppose it). So, just having “evidence” to support a viewpoint means little – what matters is the quality of evidence. One cannot just hand-pick an unpublished draft that shows what you would like it to show, particularly when the published version shows the opposite.
    • Claiming to be unaware of the published paper is not an acceptable defense. It is incumbent upon a witness, who chooses to quote an unpublished paper, to check whether it has since been published. Confirmation bias is not only misinterpreting evidence once you have received it, but the failure to search for new evidence. One cannot just stop at finding a half-finished paper because it shows what one would like it to show, and not bother to see if there is a finished version
    • I highlighted in my supplementary testimony that the result was overturned (and the US evidence was independently confirmed using UK data in a paper forthcoming in a top journal). Thus, while the bulk of the Report is balanced and well evidenced, it is surprising that it contains a statement known to be wrong. The Oxford Dictionaries word of 2016 is “post-truth”, which has led to a widespread, and very welcome, acknowledgment of the importance of correcting untruths. Thus, when such corrections are made, they should not be ignored.
    • As stated in my supplementary testimony, “The goal of the above is absolutely not to discredit the TUC, which is an organisation I respect, and whose goal of encouraging ethical treatment of workers I very much share. [Indeed, I expect that we both share strong support for the Committee’s recommendation for firms to disclose their people policy.] This is simply intended to be one example of how important it is to be critical with evidence.”
    • Moreover, that the paper finds that pay ratios are positively correlated with future performance is far from the final word. Academic evidence is only one input into a decision. My concern is only that, when evidence is quoted, it should be quoted accurately.
    • I will discuss best practices for the use of evidence in my upcoming TEDx talk, “From Post-Truth to Pro-Truth”, on 12 May in London. See here for details of the event and excellent other speakers.