Institutional Debt Holder Governance

Investor Activism

A study at Drexel University’s LeBow College of Business shows that, at shareholder meetings, family funds that hold both corporate bonds and equity in a given company tend to vote in line with the interests of creditors when the fraction of their debt over equity holdings is high.

Key Insights

• Institutional investors own more than two thirds of equity traded on the US stock market, as well as a large fraction of US corporate bonds. This joint debt-equity holding affects the voting behavior of institutional investors and, therefore, the governance of US public corporations when debt and equity’s interests are in conflict.
• When companies are in financial distress, fund families managed by institutional investors with a long position in both corporate debt and equity of a given company are more likely to vote in line with the interests of debt holders rather than shareholders, compared with fund families with only equity positions. In contrast, there is no difference in voting behavior between the two types of fund families when companies are financially sound.
• The voting behavior of fund families with joint debt-equity holdings influences corporate decisions: A higher fraction of debt over equity holdings in a given company is associated with an increase in capital expenditures and seasoned equity offerings, but a decrease in dividend payments, share repurchases and non-core acquisitions. This suggests that higher debt-equity holdings lead to companies acting more in the interests of creditors than of shareholders.

Summary of Complete Findings

Shareholders can influence companies via a combination of public and private engagement. Public engagement involves submitting a shareholder proposal, initiating a proxy fight, or starting a “just say no” campaign, and it is centered on the power to vote at shareholder meetings. Private engagement relies on private meetings with directors and executives to influence management decisions, often using public engagement or share divestment as a threat. As shareholders, institutional investors own more than two thirds of equity traded on the US stock market and play a well-known role in the governance of public corporations. This study investigates the effect of holding bonds as well as equity on institutional investors’ engagement with a company. It shows that debt holdings change the way institutional investors vote at shareholder meetings, which in turn influence the actions taken by companies under financial distress.

The researchers constructed a dataset of 571 US fund families investing in US listed companies by combining three sources: the Morningstar Direct database, which contains information on the holdings of both debt and equity of all US-based funds; the voting data from Institutional Shareholder Services (ISS); and the balance sheet information on all publicly traded firms with a positive level of debt from Compustat. A fund family is the set of funds managed by the same institutional investor.

The first observation is that, when considering all companies, there is no significant correlation between the fraction of debt over equity holdings and the propensity to vote in line with the interests of debt holders. The reason is that, when companies are financially sound, there is limited conflict of interest between creditors and shareholders. Changes in company policy have a very small effect on the value of debt holders’ stakes. In contrast, when a company is under financial distress, its decisions are likely to have large effects on the value of its bonds as well as the value of its shares. Therefore, when holding corporate bonds in a company in financial distress, it becomes worthwhile for a fund family to coordinate the voting of its equity and debt funds and invest resources to develop their own view on the company’s strategy.

The researchers identify companies under financial distress as those companies whose probability of default is at least 75%. For this group of companies, they find that mutual fund families with a long position in both corporate debt and equity tend to vote more in line with the interests of debt holders rather than shareholders, compared with families with only equity positions. Furthermore, when they look at decisions in which there is a greater conflict between debt and equity interests, they discover that fund families with joint debt-equity holdings are more likely to vote in the interests of creditors when considering dividend policy, equity issues and share repurchases, anti-takeover provisions, executive compensation, and restructuring activities. On the contrary, for decisions that are associated with no conflict of interest, such as director elections, the fraction of debt over equity is found to have no impact on voting patterns.

These results hold across several robustness checks and when assessed against exogenous events such as a merger between fund families. In addition, while fund families rarely vote against management or ISS recommendations, they still exhibit a higher probability to do so when they have large debt holdings relative to their equity stake in companies that are under financial distress.

The research further investigates how the voting behavior affects a company’s decisions and finds that the greater the fraction of votes in the interests of creditors in a given company, the greater the extent to which the company acts in the interests of debt holders in both its investment and payout policies. In particular, the study shows that an increase in fraction of debt over equity in a family fund is associated with an increase in capital expenditure and seasoned equity offerings, and a decrease in dividend payments, in share repurchases and in the probability of making a non-core acquisition. These are all changes that favor debt holders.

Finally, the research compares the significance of the two types of company engagements (public or private) undertaken by institutional investors. It finds that corporate decisions are more affected by voting, which therefore is the main channel of influence adopted by fund families.

In conclusion, this study shows that institutional investors with both debt holdings and equity stakes in US companies exercise an important governance role through voting at shareholder meetings. Debt holdings change the way institutional investors vote and engage with companies. In doing so, they can sway management decisions closer to the interests of creditors when firms are under financial distress.

“Institutional Debt Holder Governance” by A. Keswani (City, University of London), A. Tran (City, University of London), P. Volpin (Drexel University), was published in the Journal of Financial and Quantitative Analysis, 2021.
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