Introduction

A crucial development in the market for corporate control in the 1990’s has been increased activism by large institutional shareholders such as the California Public Employees Retirement System (CalPERS), the Florida State Board of Administration, TIAA-CREF and the State of Wisconsin Investment Board. These institutions have pressured board members and managers of many leading corporations to improve performance and to remove anti-takeover obstacles. Publicly, institutional investors have frequently joined dissident shareholders in voting against management on proxy proposals. Privately, they have engaged management in discussions about ways of improving performance. Institutional investors have been successful in forcing divestitures, CEO turnover and change in governance structure in a number of prominent corporations including Eastman Kodak, General Motors, IBM and Sears [Pound (1992)].

The institutional shareholder activism movement of the 1990s has been accompanied by relaxed regulatory oversight of corporate governance activities by shareholders [Hawthorne (1993)]. Until 1992, shareholders were required to file and distribute a proxy statement with the SEC when communicating in writing or orally with ten or more shareholders. That policy was eliminated in 1992 allowing major shareholders to both communicate and coordinate their activities without laborious regulatory oversight. In addition, the SEC eliminated its requirement that materials such as ads and letters distributed to shareholders be reviewed in advance. From a regulatory perspective, a key question is whether these reforms have been effective in enhancing the corporate governance process [Sharara and Hoke-Witherspoon (1993)].

The institutional activism movement has not lacked for skeptics. Business leaders and politicians have argued that large pension funds lack the expertise and ability to serve as effective monitors in the market for corporate control [e.g. Business Week (1991), Cordtz (1993), and Wohlstetter (1993)]. Others have noted that state pension funds are subject to pressures to avoid activism and instead aid the objectives of state and local politicians [Romano (1993)]. A lack of accountability, an absence of appropriate incentives and free-rider problems may also hinder institutional activism efforts. See Admati, Pfleiderer and Zechner (1994); Monks (1995) and Murphy and Van Nuys (1994).

One way for institutions to reduce free-rider problems among themselves and to sidestep political pressure is to create an organized third party monitoring organization. Such an organization can serve as a focal point for diffuse investors and can enhance credibility when challenging management. In principle, organized institutional shareholders can exercise significant clout at a fairly low cost because of economies of scale in activism [Black (1990)].

The best known institutional investor organization is the Council of Institutional Investors. The Council consists of over 100 public and private pension funds that collectively own more than $1 trillion in financial assets. The Council was founded in 1985 to provide a voice for institutional shareholder interests. Today, the Council provides a forum for funds to share information and to jointly monitor corporate performance, executive pay and governance related issues. By joining forces through the Council, institutional investors can represent themselves as jointly owning a substantial block of shares of virtually any large public firm.

This study focuses on the activities of the Council of Institutional Investors because of its high profile in the 1990’s. Beginning in 1991 the Council has circulated a focus list of firms identified as having poor operating performance. Some of the companies listed in early years were included because they were perceived to have governance structures that entrenched management. While the Council's staff is responsible for compiling and distributing the list, the organization itself does not engage the management of these firms to change policy. However, the Council encourages members to coordinate activities related to focus list firms. As mentioned earlier, such activity became far less costly in the early 1990s due to liberalization of proxy solicitation rules. The publication of a focus list by the Council of Institutional Investors is intended to affect the performance of listed companies by encouraging members to pursue coordinated activism programs. In addition, negative publicity associated with appearance on the list may add urgency to corporate efforts to achieve a turnaround and catalyze efforts of independent directors to push for change.

We investigate whether the approach to shareholder activism taken by the Council of Institutional Investors is associated with improvements in corporate performance. We document the operating performance and share returns of firms that appeared on focus lists for a period of four years before listing to two years afterwards. Evidence that firms experience improvements in operating and share price performance after focus list appearance would be consistent with the view that the Council’s brand of coordinated institutional monitoring and ‘quiet’ governance activism by institutional investors is effective.

We find that firms placed on Council focus lists subsequently experienced statistically and economically significant improvements in operating profitability and share returns. This is consistent with the view that activism undertaken by members of the Council of Institutional Investors is effective. It might also be that the observed performance improvements are actually associated with industry co-movements and risk factors associated with superior stock returns. Thus, we compare performance of focus list firms to portfolios matched on the basis of previous performance, size, book-to-market ratio, and industry. We find that focus list firms experienced statistically significant improvements in share price and operating performance in the post-listing period, even when compared to benchmark firms.

Our conclusions differ from those in several studies that have found a negligible effect of institutional activism, particularly when pursued through proxy proposals. See Del Guercio and Hawkins (1997), Gillan and Starks (1995), John and Klein (1994), Karpoff, Malatesta and Walkling (1996) and Wahal (1996). There are several potential explanation for the difference in conclusions. First, we examine coordinated activism of many shareholders rather than the efforts of a single pension fund. With the credibility lent by collective action and the associated economies of scale, we would expect that efforts carried out by a group of investors would be more effective than those of a single party acting alone. This is particularly likely in the case of large, public U.S. companies where the largest institutional investor typically owns less than two percent of outstanding shares. Second, we focus on a more recent time period than most previous studies. To the extent that institutional activism has become more effective over time, particularly after the 1992 proxy solicitation reforms, we have a greater chance of detecting any effects. Third, we look at a sample of firms that is free of selection bias based upon firm’s reaction to being targeted. Most companies that are targeted in vigorously contested proxy votes have declined to make changes suggested in initial private meetings with investors. Thus, past studies of the effect of proxy proposals may have focused on companies that were atypically recalcitrant. It may very well be that management teams are most responsive to activism efforts which are private and carried out quietly in the context of a long-term relationship. For example, Carleton, Nelson and Weisbach (1997) find that TIAA-CREF is successful in achieving desired governance changes in over 95% of cases where it privately contacts companies. Because firms are not consulted before they are included on Council focus lists, our sample may include more firms that are responsive to quiet pressure than do previous studies.

The Sample and Benchmark Comparisons

Data

We examine all but two firms that appeared on focus lists issued by the Council of Institutional Investors in 1991, 1992, 1993 and 1994. In total, we examine 117 separate listings in the 1991-94 period. There are fewer firms than listings because some firms were listed in consecutive periods.

Information on corporate operating profitability was constructed using the Standard and Poors COMPUSTAT II Research, Extended and Primary, Secondary, Tertiary tapes. Data on operating and leadership changes taking place around focus list release were obtained from the Wall Street Journal Index and Lexis/Nexis searches of the New York Times. Stock price performance data were obtained from the CRSP tapes issued by the University of Chicago. Returns are compounded monthly and adjusted for splits and dividends.

The Sample and the Council Selection Process

Table 1 describes the Council of Institutional Investors focus list sample with respect to market capitalization and age. The mean market capitalization of firms in the sample is $14.9 billion (the median is $2.6 billion) making our sample firms among the largest in the U.S. economy. The firms are also mature with an average of 41 years on the CRSP tapes. The large size of sample firms also suggests that they exhibit risk characteristics similar to the market as a whole; in fact, the mean and median Beta estimates for our sample are 1.06 and 1.04 respectively.

As an aside we can infer from Table 1 that the focus list selection procedure changed somewhat over time. In 1993, more NASDAQ firms appeared on the list and the median firm size and age fell somewhat. In 1994, all firms were chosen from the S&P 500 Index. The staff of the Council of Institutional Investors has confirmed that the procedure for choosing focus list firms changed across time. In 1991 and 1992 firms were chosen based on prior stock price performance, by governance characteristics and by whether executives appeared to be overcompensated based on Graef Crystal's "black hat" list. In 1993 firms were selected from a larger universe by Institutional Shareholder Services. The strategy for list inclusion weighed market underperformance more heavily than in prior years. In 1994 firms were selected purely based on past stock price performance over a five-year window. Specifically, firms were selected based on an average of past industry-adjusted one year and five year share price performance from the S&P 500 universe. The dynamic nature of the firm selection process may make it more difficult to capture the relation between coordinated institutional activism and increased performance. It also provides us with a natural robustness check. Were our results to hold across time, it would it would be hard to argue that they could be attributed to a special risk characteristic identified by any one screening method.

Comparison Group Portfolios

The goal of this study is to document the performance of firms included in the Council of Institutional Investors’ annual focus list. Any long-run measure of performance must be benchmarked appropriately. We create comparison group portfolios on the following dimensions: size, market risk, short-run past performance, long run past performance, the book-to-market ratio, and industry performance. We required that all firms in the benchmark portfolio trade for a full year after selection.

The first logical comparison group is a large capitalization market portfolio. We report stock market performance for the portfolio of firms in the Standard and Poors 500. The S&P 500 Index portfolio is a reasonable benchmark given that over 80 percent of the firms in our sample are included in the index itself.

We also employ a benchmark portfolio of firms that were matched to those in our sample by their return in the year before appearing on a Council list and by market capitalization decile. This is the short-run match portfolio. This portfolio was constructed by sorting firms into market capitalization deciles and into one-year prior share return deciles. Firms were selected into the short-run match benchmark portfolio by prior one-year performance deciles, conditional on their size decile. This follows the bivariate matching approach suggested by Barber and Lyon (1997). This benchmark portfolio allows us to control for the possibility that firms on Council lists perform differently than the S&P 500 because a prior downturn in market value which is reversed or extended in the post-listing year.

Another benchmark portfolio controls for past long-run movements in the share price of firms on Council lists. This portfolio was constructed by sorting firms into market capitalization deciles and into four-year prior share return deciles. Firms were selected into the long-run match benchmark portfolio by prior share performance conditional on their size decile. We employ this benchmark to allow ourselves to check whether any abnormal performance of firms on Council lists reflects the long-run share price reversal effect noted by DeBondt and Thaler (1987) and Loughran and Ritter (1996). Each firm in our sample was matched with a portfolio of NYSE/AMEX firms that were in the same prior four-year market return decile.

To control for industry effects, we match each firm in our sample to all firms on the CRSP NYSE/AMEX tape with the same four-digit SIC code. In all cases, the industry-matched portfolio had a minimum of four firms for each company on the Council of Institutional Investors focus lists.

Finally, we employ a book-to-market benchmark. This portfolio was constructed by sorting NYSE firms into market capitalization deciles and into book-to-market deciles. Firms are matched to the decile with the closest book-to-market ratio in the fiscal year ended prior to the focus list release date that is also in their size decile. We define the book-to-market ratio in the same way as do Fama and French (1990). Controlling for the book-to-market effect allows us to remove any risk/anomalous behavior associated with distress that is reflected in the book-to-market ratio.

Statistical Inference With Long Horizon Stock Returns

Our efforts to statistically compare the long-run share price performance of focus list firms against the performance of benchmark firms is fraught with difficulty because standard parametric inference methods do not perform well with long-horizon stock returns. Barber and Lyon (1997), Kothari and Warner (1997) and Lyon, Barber and Tsai (1998) have highlighted inference problems owing to the lack of normality and statistical independence of long-horizon returns. We employ two strategies to minimize mis-specification of test statistics. The first is to match sample firms to control firms selected on both size and the relevant control factor (e.g. short-run past return or market-to-book). Barber and Lyon (1997) find that this strategy significantly reduces mis-specification of long-horizon returns in a Monte Carlo study. The second strategy is to use non-parametric bootstrap tests to compute p-values. Ikenberry, Lakonishok, and Vermaelen (1995), Kothari and Warner (1997) and Lyon, Barber and Tsai (1988) argue that this approach reduces inferential error in long-horizon event studies.

We compute compound buy-and-hold returns for the focus list firms over 12-month and 24-month post-event horizons on an equal-weighted basis without portfolio rebalancing. For each of the four listing years in the 1991-1994 time period, we bootstrap an empirical distribution of the relevant long-horizon return by repeatedly drawing a same-sized sample with replacement from the benchmark group (e.g. short-run return match or S&P 500). We compare the empirical distribution generated from the benchmark data to the buy-and-hold return for our sample to identify an empirical p-value. Because the benchmark includes our sample firms under the null that the groups are not distinct, the p-values are likely to understate the statistical significance of the results when the groups are distinct and the pool of reference firms is small.

Share Price Performance Performance Before List Release

Table 2 documents total holding period returns in the period preceding focus list release. The Council of Institutional Investors carefully considers stock price performance when selecting firms for its focus list. Not surprisingly, focus list firms exhibit average four-year pre-listing share price performance that was substantially below that of the S&P 500 firms. The focus list firms underperformed the S&P 500 by 72.9% in 48 months before listing and by 22.4% in the 12 months before listing. Similarly, the focus firms underperformed others in their industry group by 42.6% over the prior 48 months and others in their book-to-market/size benchmark by 85.3%. As expected, the portfolio based on matching long-run performance has average 48-month returns of the same magnitude as the focus list sample.

Table 2 illustrates our earlier point that the selection process used by the Council of Institutional Investors has evolved to place more weight on prior share price performance over time. The mean prior holding period return for the 1991 and 1992 focus list companies was similar to that of other firms in the same industry and not much less than those of the market as a whole. But in 1993 and 1994 the returns were much lower than those for the market as a whole.

Performance After List Release

In this section we report evidence consistent with the effectiveness of coordinated ‘quiet’ activism. The ‘behind-the-scenes’ nature of institutional activism makes it difficult to pinpoint a single event that represents a shift in management policy. Further, we do not expect to observe immediate action to meet or contact focus list firms. It may take several months before Council members react to release of the focus list. Thus, to avoid difficulties from attempting to date activism, we measure holding period returns for two full years after the Council’s focus list is made public.

Table 3 reports the average stock market return of firms on the Council lists relative to the benchmark firms in the 12-month and 24-month post-listing periods. These returns are compounded monthly starting from October 1 of each year until September 30 of the following year. Council listed firms significantly outperform all benchmark portfolios. For each sample year, these firms generated mean returns that were substantially above those of other firms in the S&P 500 Index. Taken together, the portfolio of focus list firms exhibits a mean return of 25.8% in the 12 months after listing which exceeded the S&P by 5.9%. Over 24 months, the performance gap widened to 9.2%. While not reported the gap in median returns is similar in magnitude. The difference in returns between the focus list group and the S&P 500 group is statistically significant at the five percent level over 12 months. While economically significant, the return relative to the S&P 500 portfolio is not statistically significant over the 24-month horizon. Recall, however, our earlier point that the benchmark portfolio also contains our sample.

Comparing the focus list sample with the other reference portfolios yields similar inferences. In all comparisons, the Council listed firms performed better than the benchmark portfolios. For example, the performance of the short-run prior share price comparison portfolio in the twelve-month post-listing period was roughly 10 percentage points less than that of the focus list firm portfolio.

Overall, the evidence indicates that firms on Council of Institutional Investors focus lists outperformed the market and comparison group firms in the 1991-94 period. These results are consistent with the view that coordinated institutional shareholder activism is effective. In an effort to better understand the source of these share price gains we now document the subsequent operating performance and operating policies of focus list firms.

Operating Performance

Table 4 describes the operating profitability of firms before and after their appearance on Council of Institutional Investors focus lists. We measure operating profitability as earnings before interest, taxes and depreciation divided by the book value of assets (EBITDA/Assets) in the appropriate fiscal year. Because of data constraints, operating profitability from year minus-3 to year plus-3 is only available for the 1991 - 1993 focus list companies.

Not surprisingly, the results in Table 7 indicate that firms on the Council of Institutional Investors lists generally exhibit profitability below that of other firms in the S&P 500 Index. On the other hand, the performance of these firms is similar to that of their industry counterparts suggesting that industry trends tended to drive the poor performance.

In the two years after listing, focus list firms experience substantial improvements in profitability. The median EBITDA/assets ratio of focus list firms is 13.3 percent in year +2 vs. 10.9 percent in year 0. This represents a substantial profitability improvement and is statistically significant at the one percent level. The statistical and economic significance of the observed performance improvement largely remains after making adjustments for both industry and S&P 500 firm performance. This suggests that the abnormal share price returns accompanying appearance on a focus list reported in the last section are due to real changes in firm operations.

Income as a fraction of assets can be decomposed into income as a fraction of sales (profit margin) times the ratio of sales to assets (asset turnover). This useful decomposition has been widely used to gain insight into the sources of change in profitability (e.g. Healy, Palepu and Ruback (1992)). Changes in profit margin typically imply reductions in cost while changes in asset turnover typically imply scale economies due to changing volumes.

Tables 5 and 6 report profit margin and asset turnover for focus list companies. Table 5 indicates that most of the observed improvement in asset productivity is attributable to changes in profit margin. For example, the median focus list firm sees over a two percentage point improvement in profit margin in the two years after appearance. On the other hand, changes in asset turnover are relatively modest and essentially zero after adjustment for industry. These results suggest that focus list firms improvements in asset productivity by cutting costs and by shifting into more profitable activities.

We have also examined a wide variety of other performance indicators to find that focus list firms did not grow faster than comparison companies and did not raise the rate of dividend payouts and share repurchases relative to comparison companies. Table 7, Panel A reports evidence that focus list companies did lower financial leverage measured as debt/assets at book in the post-listing period. This change is consistent with pecking-order behavior where companies use internally-generated funds to pay down debt.

Panel B of Table 7 reports changes in capital expenditures of focus list firms. Interestingly, firms in the sample cut back capital expenditures rather dramatically, but typically the cuts began before appearance on a focus list. This is consistent with the relationship between cash flow and capital expenditures observed elsewhere. It is noteworthy, however, that sample firms do not later increase capital expenditures even though profitability improves. To the extent that earlier capital expenditures were wasteful, this result would suggest that intervention by institutional shareholders tends to reduce free cash flow problems in the Jensen (1986) sense.

Divestitures, Acquisitions and CEO Turnover

Thus far, we have reported substantial share price and profitability improvements, on average, after firms appear on Council of Institutional Investors focus lists. If the share price and profitability changes observed to this point are due to shareholder pressure, we might also observe other real changes taking place in focus list firms. For example, past studies have found that operating and leadership changes frequently follow other forms of corporate governance activity including blockholder activism, hostile takeovers and leveraged buyouts. [See Bethel, Liebeskind and Opler (1998), Bhagat, Shleifer and Vishny (1990) and Muscarella and Vetsuypens (1988)]. In addition, Huson (1997) finds that CalPERS interventions in the early 1990s were associated with an increase in the rate divestitures.

Table 8 reports the frequency of divestitures, acquisitions and CEO turnover in the year before and after firms appear on a focus list. There was a statistically and economically significant increase in the frequency of asset divestitures. Specifically, in year before being listed, 39 percent of sample firms reported one or more divestitures. In the year after being listed, 51.7 percent of the sample reported at least one divestiture. There was also a decline in the frequency of mergers and acquisitions, although the decline was not statistically significant. There was relatively little change in the rate of CEO turnover following appearance on a focus list. One-year CEO turnover rates were abnormally high both before and after appearance on a focus list. We observe an 18.6% CEO turnover rate before list release and a 17.8% turnover rate afterward. This compares to average turnover rates of 8 to 14% observed by Warner, Watts and Wruck (1988).

Table 9 provides additional insight into the sources of abnormal returns observed after firms are placed on Council focus lists. The table reports cumulative abnormal returns in the year after appearing on a focus list by whether divestiture, acquisition or CEO change took place (both before and after listing). Interestingly, there is a disproportionate improvement in share price for firms that undertake a divestiture. The median abnormal share appreciation of firms that announce a divestiture in the year after listing is 33.8% (vs. 16.7% if no divestiture takes place). Insofar as these divestitures can be traced back to institutional investor pressure, this result is consistent with the argument that institutional investors catalyze real, value increasing changes in focus list firms.

Table 9 also stratifies abnormal stock returns by whether firms announced acquisitions and by whether there was a change in CEO. Here we observe less of a performance differential. Firms that announced an acquisition after being listed, experienced smaller returns, but the difference was not statistically significant.

Conclusion

We document the performance of firms that appeared on focus lists distributed by the Council of Institutional Investors between 1991 and 1994. Our main result is that focus list firms experienced share price performance that outpaced the S&P 500 by a substantial margin in the two years after being listed. This improvement is robust to a variety of benchmark adjustments. Matching portfolios created on the basis of long- and short-term returns prior to inclusion on the focus list, book-to-market ratio and industry experienced significantly lower mean and median returns in the post-listing period. We also find that operating profitability improves substantially after firms are placed on focus lists. This result is consistent with the view that observed post-listing share price improvements anticipate real efficiency gains.

In order to broaden our understanding of the efficacy of coordinated institutional activism, we also searched for observable indications that management is changing its course. Examples of these activities include, but are not limited to, divestitures, a slowdown in acquisitions and management turnover. The results show that the rate of asset divestitures rises substantially after firms are placed on a Council focus list. This finding is consistent with the view that real changes underlie much of the performance improvement observed among listed firms. In fact, we find that post-listing share price improvements taking place after listing are highest among firms that announced divestitures.

The results of this study are broadly consistent with the view that coordinated institutional governance activism is effective. At the same time, we emphasize that the results are subject to several important caveats. The first, of course, is that it is difficult under any context to show that observed improvements are explicitly linked to shareholder activism. The second is that the improvements observed here may be specific to the time period studied. It is also possible that the improvements observed here are sample-specific or a statistical aberration. It is also possible that internal pressures led to the changes observed in this study. Yet were this a primary factor, we would have also expected to find performance improvements among other poorly performing firms that were not targeted by the Council. We did not find this. It is also plausible that shareholder pressure that preceded release of Council focus lists might have also played an important role in share price improvements observed in this study. CEO turnover, for example, was abnormally high in both the year before and the year after firms were placed on Council focus lists. We encourage future researchers to attempt to better disentangle the precise sources of the apparent performance improvements that accompany institutional investor activism.

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