The “Wall Street Walk” and Shareholder Activism: Exit as a Form of Voice

Abstract

We examine whether a large shareholder can alleviate conflicts of interest between managers and shareholders through the credible threat of exit on the basis of private information. In our model, the threat of exit often reduces agency costs, but additional private information need not enhance the effectiveness of the mechanism. Moreover, the threat of exit can produce quite different effects depending on whether the agency problem involves desirable or undesirable actions from shareholders’ perspective. Our results are consistent with empirical findings on the interaction between managers and minority large shareholders and have further empirical implications. (JEL D53, D82, G10, G30, G34) The role of active large shareholders in improving corporate performance has been discussed extensively in the last two decades. Although large shareholders (including pension funds, mutual funds, hedge funds, and other investors) hold a substantial and increasing fraction of shares in public companies in the United States, most large shareholders play a limited role in overt forms of shareholder activism such as takeovers, proxy fights, strategic voting, shareholders’ proposals, etc. One likely reason for this is that active shareholders only realize a relatively small fraction of the benefits from their monitoring while bearing the full cost, which can be substantial. In other words, we have a classic “free rider” problem. In addition, legal barriers, agency problems affecting the incentives of the large shareholder, and the fact that many large shareholders are committed to being passive and not investing resources to monitor their portfolio firms