Firm owners do not run the firm. Instead, they delegate the job to managers with expertise. Such delegation inevitably gives rise to the misalignment of interests between the firm owners and managers, as the latter do not share the benefits of the firm’s success as much. Shareholders, who are the firm owners, thus need to monitor firm managers to keep the managers in check. Large shareholders, or “blockholders,” have more incentives to monitor, as the free-riding problem is mitigated by the large stakes they hold. In one sample of U.S. public firms, 96% firms have at least one blockholder, and that a firm’s largest blockholder holds 26% of the firm on average. Two general mechanisms through which blockholders can monitor and engage in governance (referred to as “blockholder monitoring” for the remainder of the article), have been postulated in the literature: direct intervention (“voice”) and the threat of exit. The former refers to a spectrum of actions whereby blockholders involve themselves directly, e.g., negotiating with firm managers privately, voting at shareholder meetings, submitting shareholder proposals and initiating takeovers. On the other hand, the threat of exit by a blockholder also pressures firm managers to consider shareholders’ interests. When a dissatisfied blockholder sells, the market will view the sale as a negative signal about the firm’s prospect and decreases the firm’s share price. The potential of a share price decline is an ex ante threat to managers whose compensation is linked to the share price.
Equity takes up a large portion of CEO compensation to incentivize the CEO to maximize shareholder value. CEO incentives provided by equity-based compensation ( “CEO incentives”) can affect blockholder monitoring in two ways. First, higher CEO incentives could indicate that the agency issue in the firm is less severe, as the CEO is more like a shareholder of the firm, hence less need for blockholder monitoring. In this sense, CEO incentives substitute blockholder monitoring in general, no matter the blockholder uses voice or the threat of exit to monitor. On the other hand, the blockholder’s exit is more powerful if the CEO’s wealth is more linked to the share price. In this sense, CEO incentives complement blockholder monitoring through the threat of exit.
How do CEO incentives influence the presence of blockholders who are in the firm to monitor? The answer depends on the mechanism the blockholder uses to monitor. For blockholders who rely on voice to monitor, it is predicted that they are less likely to be in a firm with higher CEO incentives, which reduce the need for voice. For blockholders who monitor through the threat of exit, since CEO incentives can both substitute and complement the threat of exit as discussed above, how CEO incentives influence their presence depends on whether the substitution or the complementary effect dominates. It is predicted that, as CEO incentives increase, the monitor-by-exit blockholders are more likely to be in the firm if the complementary effect dominates, and less likely to be in the firm if the substitution effect dominates.
In my recent study, I extend the threat of exit model and show that the substitution effect outweighs the complementary effect of managerial incentives on the threat of exit. Therefore, no matter a blockholder uses voice or the threat of exit to monitor, it is predicted that the blockholder is less likely to be in the firm and monitor firm activity as CEO incentives increase. In practice, large investors use both mechanisms in concert to monitor. Therefore, in the empirical part of my study, I look at blockholder monitoring in general without distinguishing the monitoring mechanisms and obtain results that corroborate the predicted negative effect of CEO incentives on the presence of blockholders who monitor.
A Sketch of the Model
The extended threat of exit model is a 3-stage sequential game with perfect information between a firm manager and a blockholder, both of whom are risk-neutral. There are 3 prices of the firm: P0, P1, and P2 realized at the 3 stages of the game, respectively. At stage 0, the blockholder moves first in the game and decides whether to enter the firm at P0. At stage 1, The manager then decides whether to exert effort to add value to the firm. After observing the manager’s action, the blockholder decides whether to exit the firm at P1. The market sets P1 incorporating the blockholder’s trade. At stage 2, the firm’s intrinsic value is realized and equal to P2 and both players’ payoffs are also realized. The manger’s payoff is expressed as −β + w1P1 + w2P2, where β is the manger’s cost of effort and is positive; w1 and w2 are the managerial incentives, expressed as the manager’s sensitivities to share prices, and are both positive. The blockholder’s payoff depends on the price obtained by the blockholder. There is also a non-negative probability θ, with which the blockholder experiences a liquidity shock and exits the firm, regardless of the manager’s action.
It can be derived that the manager will exert the effort to increase firm value if and only if the value added δ ̃ is above a certain threshold: xNo B without blockholder in the firm; xB with blockholder in the firm. Without the liquidity shock, the blockholder exits if and only if the manager does not exert effort. Since xB is non-greater than xNo B, the presence of blockholder essentially adds value by lowering the manager’s working threshold. At the beginning of the game, the blockholder enters if and only if the blockholder’s incremental payoff for monitoring ∆pB is positive. ∆pB changes with the managerial incentives due to two effects:
- as the managerial incentives increase, xB decreases, meaning the blockholder’s presence is more effective in inducing the manager’s effort (complementary effect);
- as the managerial incentives increase, xNo B also decreases, meaning the manager is more likely to work even without the blockholder’s presence (substitution effect).
Figure 1 is a graphical illustration of what happens when the substitution effect dominates: though the manager’s thresholds of working, both with and without blockholder in the firm, decrease as managerial incentives increase, the decrease in xNo B, from xNo B to xNo B is larger than that in xB. As a result, the value added by the blockholder’s presence, which is represented the distance between xNo B and xB actually shrinks (from the green line to the blue line). Since the blockholder’s incremental payoff for monitoring is positively related to the value added, the blockholder is less likely to be in the firm and monitor as managerial incentives increase.
In the empirical analysis, I have 2 proxies for blockholder’s presence in a firm (“blockholding”): its blockholder number and total blockholder ownership, calculated based on professional investors’ 13F filings with the Securities and Exchange Commission (“SEC”).
Figure 1: Monitoring Payoff and Managerial Incentives
I use 5% ownership of a firm, which is the SEC threshold for investors to file Schedule 13D or 13G, to define a blockholder. In the baseline correlational analysis, I look at all blockholders, irrespective of their intensity of monitoring. I proxy for a firm’s CEO incentives with its CEO wealth-performance sensitivity (“WPS”). There are 3 forms of CEO WPS depending on the utility and production functions of the CEO: Percent−Percent, Dollar−Dollar, and Dollar−Percent WPS. I adopt all 3 for robustness. Regressions of blockholding on lagged CEO WPS show that the correlation between blockholding and CEO WPS is significantly negative and is robust to different proxies for blockholding and different forms of CEO WPS. In terms of economic magnitude, a one-standard-deviation increase in CEO WPS is associated with at most a 0.076 (0.8%) decrease in blockholder number (total blockholder ownership). This lends support to the substitution effect of CEO incentives on blockholder monitoring.
There is heterogeneity across blockholders in terms of their intensity and capacity of monitoring. Rather than to monitor, some blockholders might be in the firm to match an index or to capture predicted stock returns. Pure indexing is unlikely to drive the negative relation between CEO incentives and blockholding. First of all, average investors are unlikely to become blockholders of a public firm by indexing in the first place. To illustrate the point, the total market capitalization of S&P 500 is 21.03 trillion USD at the end of 2018. The portfolio value of an S&P 500 indexer would have to exceed 1.05 trillion USD to hold more than 5% ownership of an S&P 500 firm, which is unlikely for average investors. Second, due to the nature of indexing, an indexer’s stake in an index constituent firm is unlikely to change with CEO incentives significantly. Lastly, I have also tried to exclude BlackRock, Vanguard, and State Street, which are the “Big Three” asset managers in the passive investment industry from the sample firms’ shareholder bases. The negative correlation between blockholding and CEO WPS is still significant. In addition, the difference-in-differences (“DiD”) results discussed later on are also not affected materially by the exclusion of the Big Three.
I cannot rule out the possibility that blockholders are in the firm to capture predicted stock returns. However, to the extent that CEO incentive alignment helps secure the predicted returns, such blockholders would prefer higher CEO incentives. Thus, the existence of such blockholders in the sample firms should work against me finding any negative relation between blockholding and CEO WPS.
To further support that the negative relation between CEO incentives and blockholding is driven by blockholder monitoring, I examine whether the negative relation is stronger where blockholder monitoring is more likely. I assume blockholder monitoring is more likely 1) if the payoff for monitoring is higher and 2) if a blockholder has a track record of explicitly stating the intention to influence firm control by filing Schedule 13D with the SEC (a “frequent 13D filer”). I find the negative relation is indeed stronger 1) when the firm’s past performance is worse, which indicates higher monitoring payoff, and 2) when the firm has blockholders who are frequent 13D filers. 
To mitigate the endogeneity concern about the effect of CEO incentives on blockholding, I exploit a DiD design and utilize two regulation changes in 2006: 1) FAS 123(R) by the Financial Accounting Standards Board (“FASB”) that requires firms to expense the Black-Scholes value of option compensation paid to employees; 2) the SEC reform that requires firms to disclose the Black-Scholes value of option compensation paid to each top executive on the proxy statement. After the two regulation changes, the use of option grants is significantly reduced in incentive contracts. Firms replaced option grants with restricted stock grants. Such replacement helps maintain CEO incentives. However, considering the accounting and disclosure impacts, there is still likely to be a variation in CEO incentives, especially for firms that heavily depended on option grants before the regulation changes. The resultant variation in CEO incentives is likely due to a firm’s accounting and disclosure concerns rather than other economic considerations. In contrast to Hayes, Lemmon, and Qiu (2012), whose sample period extends to 2008 only, I find that average CEO incentives are lower after the regulation changes. On the other hand, blockholding is less likely to be affected by a firm’s accounting and disclosure concerns. This motivates me to examine how the variation in CEO incentives around the regulation changes affected blockholding.
With the two regulation changes defined as the “event,” I calculate the 3-year pre-event average CEO WPS and 3-year post-event average CEO WPS for each firm. I then calculate the difference to proxy for the change in CEO WPS around the event. I define the “treated” group as those with negative changes in CEO WPS around the event. The “control” group are those with non-negative changes in CEO WPS around the event. To see the event’s effect on blockholding, I first calculate the 3-year pre-event average blockholding and 3-year post-event average blockholding for each firm. I then calculate the difference to proxy for the change in blockholding around the event. Consistent with the negative effect of CEO incentives on blockholding, the treated group on average had significant increases in blockholding after the event, while the control group did not have any significant change in blockholding. The baseline DiD regression results show that being in the treated group after the event is associated with at most 0.152 more blockholders and 1.4% higher blockholder ownership. To support the validity of the DiD analysis, I first check the common trend assumption by running an augmented DiD regression. I do not find any evidence that the common trend assumption is violated. As shown in Figure 2, being in the treated group does not have any significant effect on a firm’s blockholding until after the event (Year 0 in Figure 2). I then match the treated and control groups in the baseline DiD regression using the propensity score of treatment, calculated based on the first-order and second-order terms of the control variables included in the baseline DiD regression. I run the DiD regression using the matched sample and find similar results as in the baseline.
Figure 2: Common Trend of Blockholding
Is there any anecdotal evidence suggesting that blockholders indeed factor CEO incentives into investment decisions in real life? First, CEO pay is an important piece of information to shareholders as evidenced by the disclosure requirements of regulatory bodies such as the SEC.3 Second, shareholders pay close attention to CEO pay. It is commonly reported in the media that (large) shareholders boycott 1) when the amount of CEO pay is not justified based on the firm’s performance, and 2) when the pay package does not sufficiently align the interest of the CEO and those of shareholders. Last but not least, activist shareholders are commonly seen buying into a firm at times of serious interest misalignment between the firm’s managers and shareholders. For example, Toshiba, the Japanese conglomerate, has been in a fight with its shareholders for years due to its underperformance and poor governance. Effissimo Capital Management, a Singapore-based activist fund, bought into the firm amid the fight in efforts to reshape the firm’s management.
Blockholders have been increasing in terms of their presence and importance in firms, especially nowadays when environmental, social, and governance issues are put in the
spotlight and large investors are expected to make a difference in these issues. The present study illustrates that blockholders are more likely to be in a firm and monitor when the CEO’s interests are, or are perceived to be, insufficiently aligned with those of shareholders. This has implications on a firm’s CEO compensation and ownership structure. For example, a firm might not need to worry about not having high-powered CEO compensation, as blockholders are likely to be in the firm as monitors. A firm with high-powered CEO compensation but unrealized potential might not get much help from blockholders, who could perceive the firm as correctly valued. The firm should consider replacing the CEO to improve performance and/or moderating the incentive contracts to attract blockholders to the firm as monitors. On the other hand, if a firm thinks that it is already on the right track and does not want to constantly deal with blockholders’ requests, which could be distracting, a firm should make good use of incentive contracts.
Sheng Huang is a PhD candidate in the Department of Finance at the University of Melbourne.
This paper was adapted from his paper, “Blockholder and CEO Wealth-Performance Sensitivity,” available on SSRN.