Getting on Board: The Monitoring Effect of Institutional Directors

Abstract

We identify a sample of firms with directors employed by institutional investors and examine the effect of a direct channel of institutional monitoring. Using difference-in-differences tests, we find weak evidence that institutional directors have a positive effect on informational efficiency. More importantly, institutional directors have a significantly positive impact on stock returns over the long run. Further analysis shows that the presence of institutional directors leads to a slight increase of managerial entrenchment. Consistent with the notion that entrenched managers reduce risk-taking, we also find significant decreases in R&D investments and financial leverage, and significant increases in payouts for firms with institutional directors. The findings suggest that aligning with the interest of long-term investors, institutional directors deter firms from pursuing potentially value-decreasing investment projects and influence firms to return value to investors through lower debts and higher payouts, mainly share repurchases.

Keywords: Institutional Investors, Board of Directors, Institutional Monitoring, Informational Efficiency, Firm Performance, Corporate Policies

JEL Classification: G30, G34, G20, G23, G14