Governance by Constraint: The Corporate Governance Implications of an Anomaly

Abstract

We study the corporate governance implications of the anomaly, generated by the fact that major equity investors overweight their portfolios toward high-beta stocks because of leverage constraints. We hypothesize that the resulting higher portfolio concentration will increase the monitoring incentives of investors and reduce the agency costs of the firms they own. We test this hypothesis by quantifying a measure of leverage constraint of mutual funds and relating it to their monitoring behavior and the portfolio firms' governance quality. We find that leverage-constrained funds monitor more actively – vote more often against management in contentious proposals and are more likely to induce CEO turnovers. Consequently, the portfolio firms have a higher value of cash holdings, lower need to alleviate agency problems through payouts, and higher investment efficiency. These effects are more pronounced as the beta anomaly becomes more acute, i.e., when the security market line gets flattened. We identify a causal effect using extreme fund outflows and the number of nearby banks as instruments for fund leverage constraints.