Shareholder governance in an intermediated world

Well-functioning equity markets both spread risk across investors and create incentives for owners to keep management honest. The classical academic view of these twin functions — risk sharing and monitoring — visualizes a world of proprietary ownership in which an investor buys shares with her own money, bears the risk, and monitors because she profits when the firm improves. The link between the two is mechanical: more equity, more skin in the game, more monitoring. This is elegant and tractable, but is a description of a world that no longer exists.

Today most equity is held by professional asset managers — mutual funds, hedge funds and the like — on behalf of clients. Such delegation breaks the mechanical link: the entity that trades and monitors (the fund) is not the entity that bears the consequences (the clients), and the relationship between them is governed by a contract someone had to design. In Delegated Blocks, presented at the ECGI's GCGC conference in Singapore this June, we ask a foundational question: how does the delegation of equity ownership reshape the link between risk sharing and monitoring?

The separation principle

Our headline answer: optimal delegation contracts separate risk sharing from monitoring. The key force is the free-riding logic of Grossman and Hart (1980), applied through two distinct lenses depending on who — clients or managers — has bargaining power and thus can dictate terms.

A client with bargaining power wants the fund to buy equity for risk-sharing reasons, yet values monitoring only at the level justified by her initial endowment: extra monitoring on newly bought shares is reflected in the price she pays, since other traders free-ride on it. So, the optimal fund is designed so that managers buy enough equity to give their clients risk exposure, while simultaneously giving those managers just enough skin in the game to monitor at a level reflecting their clients’ preferences. 

A manager with bargaining power would love to charge for monitoring but cannot because monitoring is a public good: all shareholders enjoy a better-governed firm whether or not they join the fund. So, the manager strips out monitoring by taking no skin in the game and charges only for risk sharing.

Our contracts are minimal. They specify just three things: how many managers the fund has, their skin in the game, and an upfront fee. There are no performance fees, no monitoring covenants, and no commitment: once the fund is formed, managers trade and monitor purely in their own interest, and the contract works indirectly, shaping managerial incentives.

Two key types of asset managers, in one model

While we set out to address a fundamental question about monitoring and risk sharing, the model delivers more: the same formal framework generates, under plausible conditions, two key types of real-world asset management.

When clients are wealthy and have bargaining power, the optimal fund gives managers substantial skin in the game so that they undertake meaningful monitoring. These are precisely the characteristics of an activist hedge fund. The data agree: hedge fund clients are, by law, accredited investors and qualified purchasers, hedge fund managers co-invest between 7 and 20 per cent of fund assets, and hedge funds are by far the most active institutional monitors.

Flip either client wealth or bargaining power and hedge funds don’t form. Give managers the bargaining power and they will refuse to take skin in the game, designing funds that provide risk sharing but do not monitor. Take away the clients' wealth so that they don’t want any monitoring, and the contract converges to the same point even with client bargaining power. Either way, the optimal fund offers vanishing skin in the game, zero monitoring, and diversification as the sole client benefit. These are precisely the characteristics of a mutual fund. The data agree: 57 per cent of mutual fund managers invest nothing in their own fund — the rest hold a trivial amount — and mutual funds are famously muted in firm-level engagement.

If you draw the 2×2 matrix — client bargaining power on one axis, client wealth on the other — the hedge fund occupies just one corner: wealthy clients and client bargaining power. The other three are all mutual funds. In effect, our model says that hedge-fund governance is fragile, while mutual-fund outcomes are overdetermined. This explains a fact so familiar we may forget it needs explaining: mutual funds vastly outweigh hedge funds in number and assets. 

Two other practical implications

Our model says that block size is a poor predictor of monitoring: what matters is a fund's internal structure, not its ownership. Mutual funds can hold enormous blocks and never monitor. This is relevant to empiricists using blockholdings as a governance proxy. Further, if active funds endogenously under-monitor, the governance role of passive funds becomes more important, not less.

Amil Dasgupta is Professor of Finance and Director of the Financial Markets Group at the LSE, and an ECGI Research Member.

Richmond Mathews is an Associate Professor of Finance at University of Maryland.

This blog is based on a paper presented at the the twelfth annual Global Corporate Governance Colloquia (GCGC), hosted by the National University of Singapore and ECGI. Visit the event page to explore more conference-related blogs.

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