The Threat of Exit with Optimal Contracting: Institutional Churning Trades and Subsequent Firm Performance

Abstract

The role of institutional investors on the register constitutes a significant puzzle. Concentrated investors could intervene (i.e., exercise 'voice') so as to improve firm governance mechanisms. Alternatively, acting as informed traders, they could effectively discipline management if they adopt the 'Wall Street rule' and engage in exit (Edmans and Manso (2009)). We derive the optimal incentive contract for a risk-averse manager in the presence of such traders. Then, utilizing unique daily institutional trading data, we show in conformity with the model: (i) a sizeable portion of institutional trading takes the form of 'stock churning'; (ii) churning is profitable, (iii) profitability diminishes in the number of investors trading simultaneously; (iv) trading activity is associated with improved pricing efficiency in the form of lower spreads and market impact costs; (v) the number of investors trading simultaneously and magnitude of churning swings due to higher noise-trader volatility significantly improve long-term firm performance; (vi) when concentrated investors do not churn there is no long-term effect; and (vii) investors appear to recognize the benefit of making stock price more sensitive to managerial action since institutional stockholdings are higher in stocks that investors churn. Thus the 'threat of exit' speaks more authoritatively than 'voice'.

Keywords: informativeness, voting with your feet, Wall Street rule, churning, governance

JEL Classification: D82, G14, G23, G32