Ever since the 1930s, scholars have discussed the “agency problem” built into the structure of publicly owned corporations. This was a theme of Ronald Coase’s landmark article, “The nature of the firm” in 1937.
Shareholders presumably want a company managed in a way that maximizes their – the shareholders’ – utility, as reflected in stock price and dividends. But managers may have their own agendas. As a simple example: it may be both more lucrative and more prestigious to be the CEO of a large company than of a small one, and this fact may make a CEO averse to proposals to spin off divisions of a corporation, even where such spin offs do maximize shareholder value.
If the shareholders lose a potential gain because the spin off doesn’t happen, then the loss of that opportunity is an agency cost.
Thus, the agency problem: how might agency costs best be reduced? One common hypothesis is that the presence of large institutional investors in the mix is a boon to the corporation’s value and thus to other investors, including the retail stock buyers. After all, the large investors (emphatically including sovereign wealth funds) have the resources and the inclination to monitor their portfolio stocks carefully, and can credibly threaten management with unwelcome consequences if they do not act so as to maximize shareholder value. The small investors can in effect piggyback, benefitting from the monitoring role of the large institutional investors. That’s one hypothesis.
Do SWFs Help or Hurt the Bottom Line?
On the other hand, there is a contrary hypothesis in the literature that SWFs in particular have a distortive behavior on the behavior of their portfolio companies, because they may be motivated by their sovereign’s political considerations rather than by wealth maximization. This distortive effect may make them worthless (or worse) as monitors for the other investors in those same companies.
A new study by two scholars at the University of Goettingen, in Germany seeks to shed some empirical light upon this theoretical dispute. Nico Lehmann and Almasa Sarabi ask: does the presence of an SWF mitigate or does it increase agency costs?, and thus does it improve or does it harm the interests of other investors in the same companies to be found in the SWF’s portfolio?
Lehmann and Sarabi employ as a case study the Norwegian Government Pension Fund Global. In 2007, the NGPF changed its investment strategy. It adopted a 60% equity and 40% fixed income rule for its portfolio (a much greater reliance upon equity than it had previously employed) and it added small-cap firms to its investible mix.
The year before the NGPF announced this change, it already had the stocks of 892 U.S. based companies in its portfolio. Soon after the announcement, though, the corresponding number was 2,308. This amounts, the authors contend, to a “natural experiment” combining “exogenous variation in fund-level NGPF data with a large-scale U.S. empirical setting” allowing for “insights into the long-term economic consequences of institutional ownership, and SWF investments in particular.”
The two scholars study the U.S. firms in which NGPF became an investor subsequent to this change in strategy, and they draw three conclusions: first, the performance of these firms did generally improve over a three year period beginning with their addition to its portfolio. Second, target firms with governance and monitoring deficiencies were among those that benefitted from the NGPF’s presence among their investors. Finally, the first and second findings did not result from “superior stock picking quality” compared with a passive strategy once invested.
Their study, in short, provides evidence that directly supports the first hypothesis above: that SWFs can serve a valuable monitoring function.
As Lehmann and Sarabi acknowledge, their data can at best establish that this monitoring function prevailed for “one particular SWF, for one particular market, and for a specific time period.” Much more work remains to be done before this becomes a settled generalization.
At the least, though, the findings are consistent with the idea that the suspicions generated by SWFs and their allegedly political/market distortive consequences are overblown, and that a “constructive and differentiated discussion on the promise and perils of SWF investments” is called for.