Institutional Investor Activism and Financial Market Structure

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This article investigates investor activism when a number of investors are capable of expending resources to exercise a role in corporate governance rather than the single large monitoring shareholder featured in most of the extant literature. Managers choose a level of perk consumption based on their conjectures regarding investor monitoring strategies. Institutional investors make monitoring decisions and engage in strategic trade in anonymous financial markets with other agents whose trades are motivated either by liquidity or by portfolio- balancing considerations. In this setting, it is shown that a core group of monitoring institutions emerges endogenously to curtail managerial opportunism. These core institutions pursue activist policies and engage in heavy trading on both the buy and sell side of the market. In addition a fringe group of monitoring institutions, which are somewhat active and trade only on the buy side, may emerge. Although the smallest institutions are passive, there is no monotonic relationship between shareholdings and activism. In fact, among those institutions that choose to monitor with positive probability, those with smaller holdings are the most active. In addition to characterizing the emergence of monitoring activity in the presence of numerous potential activist investors, comparative statics are also developed. Some these comparative statics are counterintuitive from the perspective of models that fail to endogenize both security market structure and shareholder activism: For example, it is shown that, despite the attendant exacerbation of the free-rider problem, some dispersion of institutional holdings can actually increase monitoring efficiency, and that increasing the size of the shareholdings controlled by informed institutional investors may lower bid-ask spreads.