Governance Mechanisms and Equity...

Governance Mechanisms and Equity Prices1

K. J. Martijn Cremers2

International Center for Finance

Yale School of Management

&

Vinay B Nair3

Stern School of Business

New York University

Keywords: Corporate Governance, Anti-Takeover Mechanisms,

Monitoring, Size, Equity price

First draft: Feb. 2003

This draft: March 2003

1We thank Arturo Bris, Robert Daines, Robert Engle, Kose John, Florencio Lopez-de-Silanesand Ivo Welch for helpful discussions and Lily Xiaoli Qiu for help with data. Nair thanks theCenter for Law and Business at New York University for financial support.

2Cremers is at the International Center for Finance at the Yale School of Management, 135Prospect Street, New Haven, CT 06520. Ph: (203) 436 0649. Email : [email protected]

3Nair is at the Department of Finance, Stern School of Business, New York University, 44 W.4th Street, New York, NY 10012. Ph: (212) 998 0344. E-mail: [email protected]

Abstract

Effective corporate governance relies on both internal and external mechanisms.

We investigate if these mechanisms are substitutes or complements by looking at

equity prices from 1990 to 2001. We find that these mechanisms are strong com-

plements, together producing annualized abnormal returns of 10-15% depending

on the proxy for internal governance. Internal governance is measured using

data on block-holder and public pension fund holdings. External governance

is measured using a governance index developed by Gompers, Ishi & Metrick

(2003), which is used as a measure of takeover protection. Further, we show

that firm size is also shown to play an important role on how these mechanisms

interact. We confirm our results using a more parsimonious measure of anti

takeover protection.

Governance Mechanisms and Equity Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

1 Introduction

Effective corporate governance combines both internal and external mechanisms.1 Block-

holders and the board of directors are often seen as the primary internal monitoring mecha-

nisms.2 In the United States, takeovers are the primary mechanism for external governance.3

How these mechanisms interact is of great interest, to practitioners and academics alike, and

important for the design of corporate governance. The importance of corporate governance

is highlighted in a recent paper by Gompers, Ishi and Metrick (2003), hereafter GIM. They

create a governance index using firm-specific data on takeover defenses and shareholder vot-

ing rights. Defining governance categories based on their index, they find that a portfolio

that buys firms in the best governance category and sells firms in the poorest governance

category generates an annualized abnormal return of 8.5%.

Their study indicates that the value of good corporate governance is reflected in equity

prices. As a result, equity prices provide a handy tool to detect the effectiveness and the

interaction of the various governance mechanisms. In this paper, we consider how internal

and external governance mechanisms interact. In the process we also present evidence to

extend the results presented in GIM.

Recent empirical work to investigate this interaction includes Hadlock and Lumer (1997),

Mikkelson and Partch (1997), Dennis and Kruse (2000) and Huson, Parrino and Starks

1For a survey on corporate governance, see Shleifer and Vishny (1997).2For evidence on the monitoring role of large shareholders, See Franks and Mayer (1994), Gorton and

Schmid (1999) , Kaplan and Minton (1994) and Kang and Shivdasani (1995).3See Easterbrook and Fishel (1991) and Jensen (1993).


(2001). Section 2 presents their results and discusses the two main reasons for concern

- the use of top management turnover to detect the interaction between the governance

mechanisms and the use of overall takeover activity as an index for external control that is

common to all firms.

For the proxy of external governance, we employ the firm-specific defense mechanisms in

place by way of using the index developed by GIM as an anti-takeover index.4 We corroborate

our findings by constructing an alternative index of takeover protection, which focuses on

only 4 key anti-takeover provisions - staggered boards, preferred blank check, restrictions to

call special meetings or act through written consent.

We consider two different proxies for internal governance - the percentage equity own-

ership of institutional blockholders, defined to be an institutional shareholder with equity

ownership greater than 5%, and percentage of share ownership by public pension fund hold-

ings.5

Our conclusions are easily summarized. We find that internal governance is effective

only in the presence of good external governance. Similarly, we also find that external

governance is effective only in the presence of good internal governance, especially for larger

firms. Arguments on why firm size alters the effectiveness of external governance can be

found in Section 2. For smaller firms external governance by itself is effective, though to a

4The GIM data is compiled from Rosenbaum, Virginia, ’Corporate Takeover Defenses’, IRRC Inc.

(1990,1993,1995,1998)5We have also used institutional ownership rather than just institutional blockholders. The results, which

are omitted here, are consistent with reduced significance, arguably due the noisiness in the proxy.


lesser degree than when combined with good internal governance. We find that a portfolio

that is long in firms with high internal and high external governance and is short in firms

with high external but poor internal governance generates an annualized abnormal return

of 10-14.5%, depending on which proxy is used for internal governance. Thus, we infer that

the GIM results seem particular to only those large firms that have high internal governance

and by smaller firms in general. The results presented in GIM are strengthened when only

these firms are considered.

Moreover, we find that extending the sample to 2001 somewhat reduces the magnitude

of abnormal returns reported in GIM, which are also found sensitive to the precise definition

of bad governance.6 The evidence suggests that the larger abnormal returns in 1998 and

1999 in the GIM paper are partly due to the addition of smaller firms in the sample.

Section 2 places this paper in the context of prior research, develops the firm size hy-

pothesis and outlines our contributions. Section 3 discusses the data. In section 4, we

present some preliminary analysis that is followed, in section 5, by the results using a two

stage weighted least squares method. Section 6 checks for robustness in the takeover defense

measure. Section 7 discusses the implications. The conclusion follows.

2 Prior Research and Contributions

This section discusses related prior literature and our contributions. This paper investigates

the interaction between internal governance mechanisms and external governance mecha-

6GIM term this portfolio ’dictatorship’ firms.


nisms. As mentioned earlier, Hadlock and Lumer (1997), Mikkelson and Partch (1997),

Dennis and Kruse (2000) and Huson, Parrino and Starks (2001) attempt a similar investi-

gation. While we rely on equity prices, these papers examine the frequency of top executive

and CEO turnover for evidence on whether internal and external monitoring mechanisms are

substitutes or complements. The results have been mixed. Hadlock and Lumer (1997) and

Mikkelson and Partch (1997) suggest that the effectiveness of internal mechanisms depend

on external control where as Dennis and Kruse (2001) and Huson, Parrino and Starks (2001)

suggest that effectiveness of internal monitoring is independent of external control.

The level of market wide takeover activity is assumed to be indicative of external control,

leading to the same level of external control for all firms. This does not account for an

important aspect - the takeover protection provisions each individual firm has in place.7 High

takeover activity does not necessarily entail good external governance for firms that have a

high degree of takeover protection. We incorporate the firm-specific defense mechanisms in

place by using the index developed by GIM as an anti-takeover index.8 We corroborate our

findings by constructing an alternative index of takeover protection, which focuses on only 3

key anti-takeover provisions - staggered boards, preferred blank check and restrictions to call

7Moreover Huson, Parrino and Starks (2001), the more extensive of the aforementioned papers, also come

to their conclusion by noting that (words in brackets inserted) ”..despite the decline in takeover activity

during the late 1980’s, the frequencies of forced turnover and outside succession (of CEO’s) increases in the

1990s (till 1994).”In another paper documenting the merger and takeover activity in US, Holmstrom and

Kaplan (2001) note the following: ”After a steep, but brief, drop in merger activity around 1990, takeovers

rebounded to the levels to the 1980s. Leverage and hostility, however, declined substantially.”8Note that the GIM data is compiled from Rosenbaum, Virginia, ’Corporate Takeover Defenses’, IRRC

Inc. (1990,1993,1995,1998)


special meetings or act through written consent. We postpone a discussion of the relevance

of these provision for Section 6, where we present these results.

Further, the choice of executive turnover to detect the interplay between internal and ex-

ternal mechanisms raises concerns that are illustrated by considering the following scenario.

The dismissal of executives might only be a last resort for the monitoring shareholders and

the corporate board. If this is the case, using CEO turnover does not allow for continuous

effective governance that might remove the possibility of extreme bad performances, which

in turn might preclude the need for dismissing top management. The use of management

turnover will emphasize only those governance mechanisms that function through manage-

ment dismissal, creating a bias in the study. More generally, effective governance provides a

higher ex-ante threat of dismissal whereas using top management turnover detects only those

scenarios where the threat is ex-post exercised. Another problem is the fact that internal

and external governance are continuous where as executive turnover is discrete. Focusing on

equity prices to detect the interaction solves both these problems. However a focus on equity

prices for an event study creates another concern - that contemporaneous firm conditions

might obscure inferences made by focusing at stock returns.

As in GIM, we avoid this problem by taking a long horizon approach. Our sample of

firms also is bigger than the samples considered in the aforementioned papers. Further we

extend the time period investigated in GIM (1990-1999) by two years, investigating equity

returns from 1990 till 2001. This extension is non-trivial and merits some comment. The

latter part of last decade saw a phenomenal surge in the stock markets. This was followed by


a severe and dramatic drop in equity prices, starting in 2000. Our extension can determine

to what extent any of the results are sensitive to these events and the period considered. By

examining both a bull and a bear stock market, we show that our results are robust to these

changes in stock market conditions.

In addition, we also contribute to the GIM results by investigating the variation in

equity returns within each category that they form. We show that firms with a similar

GIM index contribute very differently to the documented abnormal return. We show that

the contribution to the abnormal returns documented by GIM are strongly related to both

our proxies of internal governance and firm size. This evidence equips us with a better

understanding of how governance enhances value.

Our investigation of firm size is driven by prior research that suggests that the effective-

ness of external control is different for small and large firms. Small firms can be more prone

to takeovers9, primarily due to financing reasons. If the bidder faces financial constraints,

as is likely in real world scenarios, it is easier to takeover small firms than large firms. Even

if the bidder does not face any direct financial constraint but the cost of raising finance is

increasing in the amount raised, a takeover of a large firm will be less attractive.

Size is important for another reason. Informational asymmetry between shareholders and

the management or the bidder varies with firm size.10 Moreover, in the US large deals are

9See Ambrose and Megginson (1992), who extend Palepu (1986) to investigate the role of size in the

probability of being a takeover target.10As an indication of reduced information asymmetry, note that large firms have more extensive analyst

coverage (Kasznik et al, 1999).


bound to receive substantial media attention, that can considerably reduce informational

asymmetry. Since the shareholders of large firms have a better idea of the true value, they

will demand a higher premia. This will cause the free rider problem to be more severe

in large firms as pointed out in Grossman and Hart(1980) and deter takeovers. Toeholds,

provided by part ownership of the target, are then likely to be more vital in large firms for

a successful takeover. A bidder bids aggressively in the presence of toeholds, both due to

direct and indirect reasons.11 A large blockholder in a firm can play such a role. Since our

analysis seeks to detect interactions between monitoring by blockholders and market control,

it is insightful to see how size factors in the analysis.

We use a two stage weighted least squares regression approach to investigate the role of

firm size. Our methodology to detect the role of firm characteristics in the interaction of

external and internal governance mechanisms is new and can conceivably be used in other

contexts as well.

To summarize our contributions, we detect the interaction between internal and external

governance using equity prices in a large sample, use firm-specific measures of external and

internal control, consider the period from 1990 to 2001, investigate the role of firm size,

create a new measure for takeover protection and develop a new methodology.

3 Data and Construction

The main data used for the study can be classified in the following three categories.

11See Shleifer and Vishny (1986) and Bulow, Huang and Klemperer (1996).


3.1 Internal Governance

To construct proxies for internal governance, we use data on institutional share holdings.

The data source is CDA Spectrum which collects information on institutional sharehold-

ings from the SEC 13f filings.12 Holdings are reported quarterly. For the holdings in the

months between the quarter-ending months, we assume that the holdings remain unchanged.

Institutions fall into five distinct categories : banks, insurance companies, mutual funds, in-

dependent investment advisors and others.

The first proxy is the percentage of stock held in each firm by its largest blockholder.

Blockholders are institutions with an ownership greater than 5% of the firm’s outstanding

shares. To ensure robustness we perform our test using a variant of this measure as well.

The results using total percentage share ownership by all blockholders is consistent with the

results documented here and is not presented in the paper. 13

By using blockholding rather than institutional holdings, we mitigate the problem that

institutions with minor stakes may have little incentive to monitor. A blockholder also

has substantial voting control to pressurize the management (Shleifer and Vishny (1986)).

However, there remains another issue. Institutions have different objectives and different

incentives to monitor. It has been argued that hedge funds, for example, avoid any direct

management interaction to steer clear of any insider trading violations. Institutions such as

12The 1978 amendment to the Security and Exchange Act of 1934 requires all institutional investors with

more than $100 under management to report their shareholdings to the SEC.13This might be a more relevant proxy if there is no free riding amongst blockholders and they collectively

monitor the firm.


corporate pension funds and bank trust departments are written off as strong advocates of

shareholder interests because they suffer from strong conflicts of interest due to the commer-

cial network of firms in which they own stock and debt.

Public pension funds are free from this corporate pressure but might be politically in-

fluenced.14 They are known to be aggressive shareholder activists.15 Therefore our second

proxy for internal governance is constructed by the percentage of shares held by the 18

largest public pension funds (PP).16

There are two general concerns related to the use of this data. Using blockholder data

may bias results towards finding better internal governance in smaller firms, since it is easier

to hold 5% of a small firm than of a large firm. Since we also investigate the importance

of firm size in this interaction, this effect, if existent, should show up there and the results

can be interpreted accordingly. If this bias was significant we would expect to find different

results for the effectiveness of internal governance in small and large firms. As we show

later, differrent results for small and large firms are obtained only for the effectiveness of the

external governance mechanisms.

Second, public pension funds and institutions tend to hold stocks in larger firms.17 This

reduces the concern discussed earlier and would only imply that internal governance is typ-

14See Romano (1993).15See Guercio and Hawkins (1999) for the impact of pension fund activism. See Gillan and Starks (2000)

for a discussion on the role of institutions in shareholder activism.16We thank Lily Xiaoli Qiu for the list of the public pension funds, that are reported in the appendix, as

well as for her help in accessing the CDA Spectrum database.17See Karpoff et al. (1996).

Governance Mechanisms and Equity Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10

ically weaker in smaller firms. A goal of our investigation is to see if this means weaker

overall governance, or if market control is sufficient to govern these firms.

3.2 External Governance

Takeovers are the primary source of external governance. A great deal of theory and evidence

suggests that takeovers address governance problems (Jensen (1988), Scharfstein (1988)).

Takeovers also typically increase the combined value of the target and the acquiring firm,

indicating that firm performance is expected to improve afterwards (Jensen and Ruback

(1983)). Moreover, it is mostly poorly performing firms that are targeted (Morck, Shleifer

and Vishny (1988a, 1989)). However, a poorly performing firm can resist a takeover through

takeover defense provisions in its charter. For our proxy of external governance, the main

interest is in measuring the protection a firm has against market control. This protection

can take the form of direct anti-takeover provisions as well as other devices that provide

managerial protection and that restrict shareholder power to change charter provisions, to

meet and to overrule the management during takeover attempt periods.

We use the measure compiled by GIM from the IRRC publications as our measure of

anti takeover protection.18 They consider 24 different provisions in 5 categories - tactics for

delaying hostile bidders, voting rights, director/officer protection, other takeover defenses

and state laws. The index is formed by adding one point if the firm has a specific defensive

provision in place and zero otherwise, leading to values between 0 and 24.

18Note that GIM use this index as a measure of governance in their paper.


Firms where shareholders do not have significant voting rights are unable to change anti-

takeover clauses, or reduce delay in case of a value increasing takeover attempt. Voting rights

therefore indirectly affects takeover defense. State laws significantly affect the effectiveness

of market control as well. Daines (2002), for instance shows how delaware law can make

firms more prone to takeovers. Further discussion of state laws can be found in Allen and

Kraakman (2003). Importance of delay tactics, especially in takeovers that require a proxy

fight, have been acknowledged as crucial by some legal scholars. For striking results on the

power of staggered boards as a takeover defense mechanisms, see Bebchuk et al. (2002).

19 High levels of protection can make takeovers prohibitively expensive and reduce the

effectiveness of market control as well.

As a result, the measure used by GIM can be used as a measure for the extent to which

a firm is vulnerable to takeovers. An analysis of which of the 24 provisions are effective and

how they interact is beyond the scope of this paper. For now, we continue with this takeover

index, which we call EXT. For a detailed description of EXT, we refer the reader to GIM.20

In order to ensure that our results are not driven by any alternative interpretation of this

index, we create a new anti-takeover measure that accounts for only 3 components known to

be critical to takeovers. These 3 provisions are the existence of classified boards, blank check

preferred and restrictions on calling special meeting or acting through written consent. we

again simply sum these 3 provisions to create a value between 0 and 3. Further discussion

19Also see Daines and Klausner (2001) and Coates (2000).20What we call EXT is the same as the ’G’ index used in their paper.


of these provisions can be found in section 6. Our results are robust to using either the GIM

index or our alternative measure of takeover protection.

3.3 Sample and Equity Prices

Our sample is restricted by the firms for which we have the takeover index available.21 IRRC

data, which is used to create the takeover index, are available only during the years 1990,

1993, 1995 and 1998. Among these firms we eliminate firms that have dual class common

stock.22 IRRC does not update every company in each new edition, so some changes may

be missed. Also some provisions are inferred from proxy statements and other filings. In

quarters between the updates and after the last update, the previous available data is used.

Thus the data is noisy. However, as GIM point out, there is no reason to suspect any

systematic bias in the measure. We start our analysis in 1990.23 The period analyzed is

from Septemeber 1990 to December 2002, giving us 136 monthly observations.

Stock price data is obtained from CRSP. To compute the effect on equity prices we

calculate abnormal returns. This is the value of the intercept in an asset pricing model.

If the portfolio generate no abnormal return the intercept is zero. Of course, the return

is ’abnormal’ relative to the asset pricing model. We return to this point later. For now

note that we use the Carhart (1997) four factor model that includes the market portfolio,

21We thank Andrew Metrick for providing us with perm numbers for this sample.22The number of firms eliminated is less than 10% of the total.23The 1990’s were relatively more stable than the 80’s in terms of the legal framework as well as takeover

defense mechanisms. See GIM for how the index changed through the period.


SMB and HML from Fama & French (1993) and the momentum factor, UMD.24 and the

momentum factor. This also enables comparison with the GIM results.

4 Analysis

Our sample includes an average of 1600 firms per year from September 1990 to December

2001, with 136 time series data points. Table 1 reports some summary statistics: the number

of firms in portfolios sorted on external-governance, and the 25, 50 and 75 percentiles both

of the percentage of shares held by the largest blockholder and of the percentage of shares

held by the group of public pension funds. Note that there is an increase of firm in Feb-

98. IRRC added firms at this date that were mostly small in size. Also the blockholder

ownership is increasing from 1990 to 1998, changing from 9.3% to 11.2% for the 75 percentile

category, consistent with documented evidence on increasing institutional ownership. It is

also interesting to note that public pension fund holding appear to be more evenly distributed

with time with the difference between the 75 percentile and the 50 percentile ownership levels

reducing from 1.85% (4.25%− 2.40%) in 1990 to 0.71% (2.87%− 2.16%) in 1998.

We start by initially categorizing external governance into 4 groups. Following GIM, those

with EXT ≤ 5 are firms prone to takeovers. This is the category they term as ’democracy’

firms. Those with EXT ≥ 14 are those with greater takeover defense, thus making external

governance weak. In GIM, these firms are called ’dictatorship’ firms. Firms with 6 ≤ EXT ≤

9 and those with 10 ≤ EXT ≤ 13 are the other two categories. Therefore firms with high

24The Fama-French factors are from Fama’s website.


EXT have weaker external governance. Similarly, we also divide firms into 4 quartiles based

on the proxy for internal governance. Those with high blockholder ownership or high public

pension fund holdings are defined to have stronger internal governance. Combining both

measures, we sort all firms into 4×4 portfolios using independent sorts of these internal and

external governance proxies.25 Subsequently, we create three dimensional sorts by creating

quartiles of size as well, resulting in 64 portfolios.

Correlations for EXT with various proxies for internal governance and firm size are docu-

mented in Table 2.26 We find that EXT is correlated with size (11%), confirming the finding

by GIM that large S&P firms tend to be firms with high degree of takeover protection. We

also find that EXT is correlated with public pension fund holding. This is not surprising by

noting that public pension funds tend to own shares in large firms, evidenced by a correlation

of 35% between public pension fund holding and firm size. This confirms the findings in vari-

ous papers on public pension fund holdings.27 We find no relation between blockholdings and

EXT. The correlation coefficient for the two proxies using blockholder data and EXT is 0.3%

and 1%. Consistent with this finding is the observation in GIM that changes in institutional

ownership are not related to the EXT. This reduces the possibility that internal monitoring

changes as firms are less prone to takeovers. Instead it suggests that any interaction we

find should be the result of a change in effectiveness of governance mechanisms, and not a

change in the percentage ownerships of the blockholders and the public pension funds. The

25We also create 5*5 and 3*3 matrices. Splitting these two governance mechanisms into three to 5 categoriesdid not affect the results.

26For a detailed documentation of EXT, we refer the reader to GIM.27See, for example, Guercio and Hawkins (1999).


two measures of blockholdings ownership - the percentage of share ownership by the largest

blockholder and the percentage of share ownership by all blockholders - are negatively cor-

related with size and highly correlated with each other. The negative correlation of these

measures with size is as expected - lesser capital is required to own 5% of a small firm than

of a large firm. The high correlation(88%) between the two measures suggests that firms

where there exists one large blockholder are also characterized by high total blockholding,

suggesting free riding, herding or information sharing between the institutions. We report

results only for the case of the share ownership of the largest blockholder.28

Therefore, on average large firms tend to have high public pension fund holdings, low

amount of blockholder ownership and a higher degree of takeover protection.

Interestingly, our proxies for internal governance (PP and BLOCK) have the opposite

correlations with size, and while one is correlated with EXT the other is not. Thus the tests

are not biased towards producing similar results for both the proxies.

4.1 Returns

In this section, we proceed to investigate the equity returns for the various portfolios. To

ensure that differences in riskiness or ’style’ do not drive our results we calculate abnormal

returns using the four factor model of Carhart (1997).29 The estimated abnormal return is

28The results when the proxy for internal governance is total ownership by blockholders are very similarand are omitted.

29For the effects of size and book to market, see Fama French (1993). For the momentum effect, see

Jegadeesh and Titman (1993).


the constant α in the model

Rt = α + β1 ×MKTt + β2 × SMBt + β3 ×HMLt + β4 × UMDt + εt (4.1.1)

where Rt is the excess return to some asset in month t. MKTt, SMBt, HMLt and UMDt

are the returns on the factor mimicking portfolios designed to capture the market, size, book

to market and momentum effects.

We start by replicating the main GIM results. Our results are very similar and are not

presented.30 However once extended from 1999 to 2001, the GIM result slightly diminishes

, now producing abnormal returns of 7.5% to the democracy minus dictatorship portfolio

instead of the 8.5% reported in the GIM paper.

Table 3 documents the abnormal returns for the 11 years. Note that in the years of

heightened stock market activity, the abnormal returns are very high. This shows why ex-

tending the data is important. There could also be an alternative reason for this pattern

that is unrelated to the stock market conditions. In 1998, IRRC added a number of firms,

increasing the sample by 25%. These were mostly smaller firms and firms with high institu-

tional ownership. Therefore, if the abnormal return generating effect of the GIM index was

more pronounced for small firms, this would induce a greater abnormal return post 1998.

As shown later, we find support for this view. Since we form portfolios by sorting firms on

up to three dimensions (external governance, internal governance and size), we reduce the

cutoff for poor external governance firms from EXT ≥ 14 to EXT ≥ 13. This ensures that

we have sufficient number of firms in the low external governance category in each of the 3

30They are not identical because we ignore stocks with ADRs and use quarterly data.


dimensional sorts.

A surprising result emerges. Once extended till 2001, changing the cutoff of the low

external governance firms to ≥ 13, removes any abnormal return accruing to better exter-

nal governance firms (Table 4). We find that a vale weighted portfolio that holds the high

external governance firms and shorts the low external governance firms generates an annu-

alized abnormal return of 7.5%, significant at 1%, by using the definition in GIM. With this

alteration (EXT ≥ 13), a similar portfolio generates an annualized abnormal return of only

2.6% that is statistically insignificant. Significance remains for the equally weighted portfolio

though, generating an abnormal return of 7%. This difference between value-weighted and

equally-weighted portfolios indicates that smaller firms added in 1998 might be affected by

takeover defense differently.

We interpret this as lack of robustness for the GIM results once the sample is extended

to 2001. To alleviate concerns about the robustness of our results, we hereafter report all

results using this altered definition of poor external governance. None of our results are

contingent on this categorization. The two stage weighted least squares method described

in the next section provides another robustness check.

We estimate the abnormal returns for the 16 portfolios sorted along external and internal

governance measures. Keeping the level of internal governance fixed, we estimate the ab-

normal returns accruing to a portfolio that buys high external governance firms and shorts

low external governance firms. We have four such portfolios, one for each level of internal


governance considered. If the effectiveness of external governance is independent of internal

governance, one should find similar abnormal returns for all the four portfolios. However

if they are complements, the abnormal return would be significant only for the portfolio

where internal governance is high as well. Similarly, we also estimate the abnormal returns

accruing to high internal governance firms relative to the low internal governance firms, for

various levels of external governance. Results are presented in Table 5.

We find that an increase in the proxy for external governance generates annualized ab-

normal returns relative to the poor external governance portfolio of 10.8% when internal

governance, as measured by the share ownership of the largest blockholder, is high. This

shows that even though external governance for the whole sample does not generate any

abnormal returns, it produces significant and large abnormal returns in combination with

internal governance. In all other scenarios, the abnormal returns are insignificant. Therefore,

the GIM results appear due to a subset of the firms that have high internal governance.

The effectiveness of internal governance is manifested by the returns accruing to a portfo-

lio longing high internal governance firms and shorting low internal governance firms. Such a

portfolio generates significant abnormal returns only when external governance is good. The

abnormal return in this case is 7.9%. This, again, suggests strong complementarity between

internal and external governance.

The results using public pension fund ownership as proxy are similar as well. With

percentage of shares owned by public pension funds as a proxy, the abnormal returns for


high external governance relative to poor external governance are significant only for the

case with high internal governance - generating 9.5%. However, abnormal returns accruing

to a portfolio that longs high internal governance firms and shorts low internal governance

firms is no longer statistically different from zero, though the trend remains the same. This

is supportive of evidence that suggest that monitoring by public pension funds does not

increase shareholder wealth. See Wahal (1996), Gillan and Starks (2000) and Karpoff et al.

(1996).

The value weighted returns discussed above are indicative of large firms, suggesting that

internal and external governance mechanisms are complements. Since firm size is one of

the factors we are interested in, for reasons mentioned in the introduction, we also compute

equally weighted returns (Table 6). Equally weighted returns emphasize small firm returns

as well.

Indicative of a size effect, in the equally weighted case, external governance generates

significant returns even for a lower internal governance level. The abnormal returns are

statistically significant for two highest internal governance groups. In fact, for the case when

internal governance - measured by blockholder ownership - is the highest, the annualized

abnormal returns accruing to portfolio that longs good external governance firms and shorts

low external governance firms is a striking and significant 14.9%. Internal governance by itself

produces results similar to the value weighted returns, being significant only when external

governance is high. When the percentage of shares owned by public pension funds is used

as a proxy, the returns to external governance are more striking, with significance even for


the lowest level of internal governance. Internal governance by itself remains insignificant at

all levels of external governance.

One could view the value weighted results representative of large firms and equally

weighted results representative of the smaller firms. It appears that external governance

by itself is effective in terms of stock returns in small firms while a combination of internal

and external mechanisms is required for effective governance in large firms. However, we

caution against inferring too much from the comparison between equally weighted and value

weighted results. The precise role of firm size is investigated later. For now, note that firm

size appears to be a factor influencing how external and internal governance mechanisms

interact. In regressions that follow we present the results using equally weighted portfolios.

Since our sample is biased towards large firms, value weighted returns would prevent us from

finding any interaction based on size.

5 Two Step Weighted Least Squares

In order to determine how internal and external governance mechanisms interact, we imple-

ment to a two stage weighted least squares method. This method circumvents the use of

noisy panel data. There is another important advantage of this method. By creating sorts

on an additional dimension, namely firm size, we are able to detect interactions better by

creating better controls. However, this results in a lower number of firms in each portfolio

as compared to two dimensional sorts. Note that we now have 64 portfolios that are formed

by three dimensional sorts on external governance, internal governance and firm size. The


second stage in our methodology overcomes these accompanying problems of low significance.

5.1 Methodology

We now proceed to develop a test to detect the precise nature of the interaction between

external and internal governance, conditional on firm size. Our empirical methodology to

detect any interaction between the two mechanisms and their relation to firm size consists

of two steps. The description of the method follows.

Estimating Alpha :

We first estimate the abnormal return accruing to the various portfolios formed as de-

scribe earlier. To this end we estimate αk×N in the ordinary least squares regression

RT×N = DT×k.αk×N + FF4T×4.β4×N + εT×N , (5.1.1)

where T is the number of months (T=136), N is the number of portfolios and DT×k is a

dummy matrix. For example, when we divide the various firms into 4× 4× 4 buckets using

independent sorts on our proxies for internal and external governance as well as on firm size,

N is 64. For the dummy matrix, k=1 implies that the dummy matrix is a constant and k=11

refers to the case of yearly dummies - from 1991 to 2001.31 These are the year fixed effects.

FF4 denotes the return factors for market, size, book to market and momentum.

Regressing Alphas on Portfolio Characteristics :

31The last months of 1990 only fall under the 1991 dummy.


We now use the kN estimated abnormal returns as the dependent variable in the regres-

sion

αkN×1 = XkN×m.γm×1 + hkN×1. (5.1.2)

The coefficients are estimated using weighted least squares, with var(αkN×1) = Σα as the

weighting matrix. Instead of the OLS assumption

var(h) = σ2I, (5.1.3)

we now assume that

var(h) = s2V (α), (5.1.4)

where V (α) comes from the first step.32

Here, X is a (kN ×m) matrix of m dummies. We consider dummies for the effectiveness

of external governance, internal governance and firm size. The specific form of the second

stage regression will be presented alongside the results in the following subsections. For the

sake of illustration, consider the case when we categorize firms into 4 × 4 buckets based on

internal and external governance and use year dummies. In this case, the first step regression

produces 11×16 α’s. These are then used as dependent variables in the second step regression

where the dummies capture the interaction for external and internal governance. From the

coefficients on these dummies, we can infer whether the two governance mechanisms are

substitutes or complements.

32The alpha’s are assumed to be time independent.


Note that we know the variance covariance matrix of the dependent variable from the

first step regression, which we use for heteroscedasticity corrections. A detailed explanation

of the correction can be found in the appendix. In the results that follow we present only

the second stage estimates and regressions.33

5.2 Results

Our goal is to detect the interaction between internal and external governance and the

role of firm size in this interaction using the weighted least squares regressions. In all

the regressions that follow the level of external governance is given by a dummy variable

DEXT = 5 − EXT . EXT takes values from 1 to 4, based on the firm’s anti-takeover

provisions, with 4 being high takeover defense in place. Consequently, DEXT ranges from 1

to 4 as well. However EXT=4 now corresponds to DEXT=5-4=1. Therefore, higher values

of DEXT indicate better external governance. The dummy for internal governance is DINT,

which takes values 1 to 4 as well, with a higher number representing a higher percentage of

shares owned by largest blockholder(or public pension fund). The size dummy ranges from

1 to 4 as well, with 4 representing large firms. Each dummy is generated from independent

first stage 4×4×4 sorts on the three dimensions of internal governance, external governance

and size. Table 7 reports the results of the various regressions that are discussed below.34

33For each set of proxies, the first stage results are the same.34These are for the case when internal governance is given by the measure created using public pension

funds share ownership. Results, which are omitted, are similar with blockholders.


5.2.1 Regression I: Substitutes, Complements and Firm Size

The first regression, based on the 3-dimensional 4× 4× 4 sort, is

αi = K + γ0max{DEXT,DINT}ISIZE≤2 + γ1max{DEXT, DINT}ISIZE≥3+

γ2min{DEXT, DINT}ISIZE≤2 + γ3min{DEXT, DINT}ISIZE≥3 + εt (5.2.1)

Here, ISIZE≥3 and ISIZE≤2 is a dummy variable that takes the value 1 for portfolios including

the 50% of the largest and smallest firms, respectively.

The min() function captures the fact that any one mechanism is not effective if the other

is poor. The max() function captures the fact that if one of the mechanisms is high, the

other does not matter. This reflects independence of the two mechanisms. Therefore,if these

mechanisms are substitutes, we would expect the coefficient on max(DEXT,DINT) to be

significant and if they are complements we would expect to see a significant coefficient on

min(DEXT,DINT).

For example, consider a portfolio with low internal governance (DINT=1) and high exter-

nal governance (DEXT=4). If this portfolio has high abnormal returns one would conclude

that they are substitutes. The max() function would be high in this case (4) and the min

function would be low (1). If the abnormal returns are high only when both DEXT and

DINT are high, we could conclude that internal and external governance mechanisms are

complements.

The results from the regression (5.2.1) are consistent with our previous findings. Refer


to Table 7, panel A. The estimates indicate that the mechanisms are substitutes for small

firms and complements for large firms. Among the fours estimated coefficients only two

are statistically significant. The significance of the variable max{DEXT, DINT}ISIZE≤2

shows that the mechanisms are independent for small firms and that a high value of DEXT

can produce high abnormal returns irrespective of DINT. The other significant variable is

γ3min{DEXT,DINT}ISIZE≥3, with a coefficient of 2.3 significant at the 1% level. We

also find that for value weighted returns35 the substitution effect is missing, confirming our

concerns that the value-weighted portfolios are heavily biased towards large firms.

5.2.2 Regression 2: Substitutes and Complements

We now look at the interaction in the absence of any size effects, to give an idea of the

relevance of size. Results are presented in the first column of Panel B in table 7. We now

estimate the following second stage regression.

αi = K + γ0max{DEXT, DINT}+ γ1min{DEXT,DINT}+ εt (5.2.2)

We find that the mechanisms are complements but the coefficient for max{DEXT,DINT}

is no longer significant. This shows the importance of controlling for size. Another aspect the

regression brings forth is that external and internal governance combined together produce

significant abnormal returns, as noted by a coefficient of 1.74. This suggests that when both

DINT and DEXT are high and equal to 4, the abnormal return for the portfolio is 6.96%.

From the previous regression we know that the abnormal return for specifically large firms

35Results are omitted in the interests of space.


is 9.2% (4 × 2.3%).

5.2.3 Regression 3: Substitution and Firm Size

We now see if the substitution effect is by itself significant, estimating

αi = K + γ0max{DEXT, DINT}+ εt. (5.2.3)

Results are presented in the second column of Panel A in Table 7. Consistent with the

size effect we find significance in the regression that uses equally weighted portfolios but no

significance in the regression that use value weighted portfolios. Confirming the importance

of size further, we find that the significance is higher for smaller firms than for larger firms.

To detect this we estimate

αi = K +γ0max{DEXT, DINT}ISIZE≤2 +γ1max{DEXT, DINT}ISIZE≥3 + εt (5.2.4)

In combination with the results presented in the previous section, these results suggest

that for smaller firms, external governance is effective by itself and is relatively independent

of internal governance mechanisms. In larger firms, a combination of both external and

internal governance is required.

5.2.4 Regression 4: Complements and Firm Size

We proceed to investigate further the complement effect in isolation, by estimating

αi = K + γ0min{DEXT,DINT}+ εt (5.2.5)


and

αi = K + γ0min{DEXT,DINT}ISIZE≤2 + γ1min{DEXT, DINT}ISIZE≥3 + εt (5.2.6)

We find that, in isolation, the complement effect is robust to size. Significance remains in

both equally weighted and value weighted regressions, as well as for large and small firms.

5.2.5 Regression 5: Extreme Portfolios

Finally, we create a dummy variable to indicate the extreme portfolios. The extreme port-

folios are the portfolios that have the highest or the lowest quartile of internal governance

or external governance. Combining these there are four possible combinations. If the two

governance mechanisms are complements, we would expect a positive coefficient for those

poertfolios with firms that belong to the highest internal governance quartile and the highest

external governance quartile. On the other hand, if they are substitutes we would expect to

see a positive coefficient on all dummies except the case where a firm has both low external

governance and internal governance. The regression to be estimates is as follows:

αi = K + γ0I(DINT=1) ∩ (DEXT=1) + γ1I(DINT=4) ∩ (DEXT=1) +

γ2I(DINT=1) ∩ (DEXT=4) + γ3I(DINT=4) ∩ (DEXT=4) + εt (5.2.7)

We reconfirm our previous findings by noting that the coefficient on the extreme portfolio

that has both high internal and external governance is positive while the others are either

negative or insignificant.


Together these regressions indicate that the two mechanisms of governance are comple-

ments. There is also evidence that in smaller firms, external governance by itself is effective.

5.3 Discussion

Combining the results using the 2-stage method presented here with our initial analysis, we

find clear evidence that external governance is effective by itself for small firms. For large

firms variation in takeover defense does not account for any variation in equity returns. It

is only a subset of large firms with low takeover defense that generate abnormal returns.

These are the firms with high internal governance as well. With reference to the substitution

effect, note a significant coefficient on the max() variable only signifies that one mechanism

is independent of another. It might be the case that only one of the governance mechanisms

is effective and is independent of the other or it might be the case that both mechanisms

are effective and independent of each other. The construction cannot distinguish between

these two possibilities. Our initial analysis provides that answer, leading us to conclude that

external governance is effective and independent of internal governance in small firms.

Our initial analysis also showed that firms with high internal governance generate ab-

normal returns only in the presence of good external governance. This result however was

obtained only when the proxy used was percentage share ownership by blockholders. Using

percentage share ownership by public pension funds, we do not find any evidence of abnormal

returns accruing to firms with high internal governance.

When interacting the external and internal governance mechanisms without considering


size, a robust complementary effect emerges. The striking abnormal returns emphasize the

importance of effective corporate governance. With this knowledge, it appears that returns

documented in GIM are strengthened if one considers only those firms with high internal

governance as well as external governance.

There remains one concern. We could be missing out on an internal governance variable

that is specifically active for small firms. If this was the case, our conclusion that external

governance is effective by itself for small firms would be incorrect. Infact, one such vari-

able could be non-institutional outside blockholders. Small firms are more likely to have

such blockholders, and including them would strengthen our complementarity effect, while

dimishing the substitution effect of small firms . If this was the case, one should view the

results presented here as the interaction of institutional internal governance mechanisms and

external governance mechanisms.

6 Robustness

6.1 An alternative measure for takeover defense

As discussed earlier, the GIM index that we have used so far may capture more than just

takeover defense, since it comprises of many provisions in the firm charter. As GIM them-

selves argue, the index is representative of shareholder rights in general, some of which might

not have a direct and large impact on takeover defense.

In order to isolate takeover protection from the other effects that might be active, we


use only three components to produce an index of external governance that varies from 0 to

3. These components are 1. staggered boards, 2. preferred blank check and 3. restrictions

on calling special meetings and action through written consent. We add a point for each of

these provisions.

Staggered boards can be a powerful anti-takeover device. Infact, some legal scholars have

pointed to staggered boards as the single most important factor in takeover defense due to the

long delay it causes. In the sample analyzed by Bebchuk et al.(2002), an effective staggered

board doubled the odds of remaining independent for an average target. A preferred blank

check gives the management the ability to issue new classes of stock without shareholder

approval and is often used a defensive measure. Ambrose and Megginson (1992) find that

a preferred blank check significantly reduces takeover probability. Finally, shareholders find

it difficult to act if there are restrictions to calling special meetings or shareholder action

through written consent is prohibited. These shareholder rights can play a very important

role in the outcome of a takeover attempt, as they would allow an aggressive pursuer to

easily remove current directors and stack the board of directors in their favor. It would give

them the ability to call a special meeting of shareholders to vote on issues they could use

to their advantage in a takeover, or it could ask the shareholders to vote on those issues by

written consent without ever calling a meeting. If these are both prohibited, the firms is

more protected to takeovers. The wait for the annual shareholder meeting is now a deterrent

as well.

Therefore our new proxy varies from 0 to 3. Using this we have four categories of external


governance, one for each point. Firms with EXT = 3 have poor external governance and

those with EXT = 0 have good external governance. Table 8 shows some summary statistics.

Note that most firms are have a EXT of either 1 or 2. The number of firms with good

internal and external governance is only 131 out of a total sample of approximately 6300

firm counts.36 Using this proxy for external governance we find that the total number of

firms with good external governance is now lower than when the GIM proxy was used to

measure external governance. This would bias us from finding significant results.

The results are presented in Table 9. As an encouraging sign, the complement effect is

confirmed in regressions 1-5, now using our parsimonious proxy for takeover defense. Using

the regression 1 model, we find that the complement effect is stronger for larger firms as well.

Interestingly the magnitude and significance (2.37 with a t-stat of 4.2) of the complement

effect for firms is stronger using this proxy for regressions that do not control for size.

However we fail to detect any substitution effect for small firms. Part of the reason could be

a low number of small firms in the high external governance category.

7 Implications

Our findings of the relation between the two mechanisms are robust, as indicated by three

alternative proxies for internal governance, two for external governance and various econo-

metric methods. It also suggests that the existence of a large blockholder is a more effective

internal governance mechanism from the viewpoint of shareholder wealth than public pen-

36A firm repeated in the four different publications is counted again.


sion fund monitoring. This confirms previous findings on public pension fund activism. See,

for example, Wahal (1996), Gillan and Starks (2000) and Karpoff et al. (1996).

The paper documents that there exists a strong interaction between internal and external

governance mechanisms. It however does not explain why these abnormal returns exist. GIM

present some evidence that investors did not properly price the agency costs associated with

poor governance. GIM investigate other alternative hypothesis on why well governed firms

have abnormal returns as well.

We looked at firm specific factors that could vary the effectiveness of external governance

- takeover defense. External market conditions may also be important. In an environment

where there are no mergers and takeovers, a firm with high takeover defense has similar

external governance as that of a firm with no takeover defense, and they both have little

threat of external control. In such an environment the abnormal returns accruing to low

takeover defense firms will be low. The pattern of yearly abnormal returns and yearly

merger activity appears generally consistent of this. However, with only 11 data points, it

is not possible to come to any robust conclusions.

Of course, it could be that we are missing out on a factor in the asset pricing model

that is related to governance. However, to justify the existence of such a factor we need

a theory of why governance should affect a firm’s systematic risk.37 Even if governance is

priced, creating a mimicking portfolio is not straightforward. Effective governance combines

various mechanisms, as we have shown in this paper. The functional form on how all these

37Almeida et al. (2003) document how firms with powerful CEO’s are more risky.


mechanisms interact will be essential before a mimicking portfolio is constructed. Also the

fact that interpretable data for takeover defense exists only post 1989 makes such an attempt

difficult. This is a task left for future research, equipped with more data.

Finally, note that the takeover index appears to be important for small firms and there is

an indication that the GIM results were strengthened by the smaller firms that were added

in 1998 by IRRC. This motivates the need for building such an index for the entire sample

of firms. Currently, our data is biased towards the large firms in the market, which captures

more than 90% of the value weighted market.

8 Conclusion

This paper presents evidence that external and internal governance mechanisms interact.

Using a sample of about 1600 firms per year from 1990 to 2001, we show that the effectiveness

of internal governance crucially depends on external governance. We also find for large firms,

internal and external governance mechanisms are strong complements while for small firms,

external governance is independent of internal governance, and that its effectiveness increases

with better internal governance. Proxies for internal governance used are percentage of share

ownership by public pension funds, percentage of share ownership by the largest blockholder

and percentage of share ownership by all blockholders. Proxies for external governance used

include index built by Gompers, Ishi and Metrick (2003) and an anti-takeover defense index

built using only three anti-takeover defense provisions. Several important empirical findings

are documented.


First, we discover that the value weighted results in Gompers, Ishi and Metrick (2003)

results reduce in magnitude, and in some cases disappear, once the sample is extended from

1999 to 2001. Surprisingly, the equally weighted results remain and are now stronger. One

reason, for which we find some evidence, is the addition of smaller firms in the sample in

1998. This also suggests that the reason value weighted results were significant in the first

place could have been due to the stock market conditions in the late 1990’s.

Second, in the case where the GIM results no longer appear to hold, we still find that

annualized abnormal returns accruing to firms with good external governance relative to poor

external governance varies between 10-15% when internal governance is good. The specific

magnitude of the abnormal return depends on the proxy used for internal governance.

An important message is that any future attempt to explain the abnormal returns accru-

ing to better corporate governance should incorporate the interaction between the internal

and external governance mechanisms and market conditions. Given the striking numbers for

the abnormal returns generated, the paper also has policy implications for takeover protec-

tion in small firms. The results in this paper suggest that in the absence of any monitoring,

anti-takeover defense has a greater negative impact for shareholders of small firms than of

large firms. Specifically, firm specific characteristics influences the interaction of the various

governance mechanisms.


Appendix

List of Public Pension Funds

California Public Employees Retirement System

California State Teachers Retirement

Colorado Public Employees Retirement Association

Florida State Board of Administration

Illinois State Universities Retirement System

Kentucky Teachers Retirement System

Maryland State Retirement and Pension System

Michigan State Treasury

Montana Board of Investment New Mexico

Educational Retirement Board

New York State Common Retirement Fund

New York State Teachers Retirement System

Ohio Public Employees Retirement System

Ohio School Employees Retirement System

Ohio State Teachers Retirement System

Texas Teachers Retirement System

Virginia Retirement System

State of Wisconsin Investment Board


Details of the 2 stage W.L.S regression

First note that the variance covariance matrix of α is

var(αkN×1) = Σα = Σε × (D′T×(k+4).DT×(k+4))

−1[1:k,1:k]

where

Σε = var(εT×N) =ε′T×N .εT×N

(T − 1)

and (D′T×(k+4).DT×(k+4))

−1[1:k,1:k] denotes the upper k×k block of the matrix (D′

T×(k+4).DT×(k+4))−1

Assumption of known heteroskedasticity: var(hkN×1) = σ2Σα. Therefore

γm = (X ′Σ−1α X)−1X ′Σ−1

α αkN×1

and

var(γm) = σ2.(X ′Σ−1α X)−1

where σ2 is estimated by

σ2 =h′kN×1.Σ

−1α .hkN×1

(kN − 1)


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Table 1: Time Variation

For each of the four dates for which Gompers, Ishi and Metrick’s (2003) proxy of external governance

(’EXT’) changes, this table reports some summary statistics of our sample of firms. The top panel reports

the number of firms that are classified as having low and high EXT, using two different cutoff levels for

these classifications. Further, we report the 25%, 50% and the 75% percentiles of the proportion of the total

shares outstanding of our sample of firms that is held by the largest blockholder (middle panel) and by the

group of public pension funds (lower panel).

Sep-90 Jul-93 Jul-95 Feb-98Number of Firms EXT < 6 148 131 112 195Number of Firms EXT > 13 83 89 84 77Number of firms EXT < 7 262 212 215 346Number of firms EXT > 12 167 186 187 171

25% percentile of % largest block 0% 0% 0% 0%50% percentile of % largest block 6.21% 6.92% 7.45% 8.11%75% percentile of % largest block 9.32% 9.91% 10.26% 11.22%

25% percentile of % public pension 0.66% 1.30% 1.58% 1.28%50% percentile of % public pension 2.40% 2.88% 2.70% 2.16%75% percentile of % public pension 4.25% 4.61% 3.86% 2.87%


Table 2: Correlation Matrix

The matrix below gives the pairwise correlations between quartile-dummies of EXT, SIZE, BLOCK, TOT-BLOCK and PP. Here, ’EXT’ denotes the proxy of external governance as given by the index developed by

Gompers, Ishi and Metrick (2003), ’SIZE’ is given by each firm’s total market capitalization of outstanding

stocks, ’BLOCK’ is the percentage of stocks held by the largest blockholder (at least 5%), ’TOTBLOCK’ is

the percentage of stocks held by all blockholders combined, and finally ’PP’ is the percentage of stocks held

by the group of public pension funds (see the Appendix). For each quarter, we calculate the quartile-dummy,

ranging in value from 1 to 4, for all firms that have all data available in that quarter.

EXT SIZE BLOCK TOTBLOCKSIZE 11%

BLOCK 0.3% -15%TOTBLOCK 1% -19% 88%

PP 14% 36% 6% 6%


Table 3: Yearly Abnormal Returns

This table report the yearly abnormal returns (alpha’s) of a portfolio that goes long firms classified as having

low EXT (or good external governance) and short firms classified as having high EXT (or weak external

governance). Here, EXT refers to the index developed by Gompers, Ishi and Metrick (2003). The abnormal

returns are the regression coefficients on yearly (1991 - 2001) dummies in combination with the four-factor

Carhart (1997) model. All abnormal returns are annualized. We report the results for both value-weighted

as well as equally-weighted portfolios, using EXT >= 14 as the definition for poor governance and EXT <=

5 as the definition for good governance (similar to Gompers, Ishi and Metrick (2003)).

Panel A: Value weighted returns.

Year EXT >= 14Abnormal Returns t-statistic

1991 0.15 (0.02)1992 16.39 (1.63)1993 3.20 (0.32)1994 7.25 (0.75)1995 -2.13 (-0.21)1996 -0.76 (-0.08)1997 5.64 (0.57)1998 20.23 (2.02)1999 30.58 (3.06)2000 -6.17 (-0.60)2001 4.82 (0.48)

Panel A: Equally weighted returns.

Year EXT >= 14Abnormal Returns t-statistic

1991 -1.64 (-0.24)1992 24.61 (3.03)1993 5.93 (0.73)1994 5.99 (0.77)1995 -1.95 (-0.24)1996 1.35 (0.17)1997 -3.46 (-0.43)1998 10.07 (1.24)1999 8.93 (1.11)2000 14.58 (1.75)2001 10.40 (1.29)


Table 4: Means and Abnormal Returns : External Governance

We report the annualized abnormal returns for the portfolios that are created by sorting all firms in our

sample into 5 (in panel A) or 4 (in panel B) groups according to their external governance (’EXT’) as

measured by the index developed by Gompers, Ishi and Metrick (2003). We also report the annualized

abnormal return and its t-statistic of a portfolio that is long in the firms in the best category of external

governance (low EXT) and short in the firms in the worst category of external governance (high EXT). The

time period is 1990 to 2001, and the abnormal returns are relative to the four-factor Carhart (1997) model.

’VW’ and ’EW’ signify the value weighted and the equally weighted portfolios.

Panel A: Sorted in 5 groups

VW EW

EXT <= 5 0.08 0.10EXT=6,7 0.07 0.12

EXT=8,9,10 0.08 0.09EXT=11,12 0.07 0.08EXT >= 14 0.02 0.07

Abnormal return 7.58 6.51t-statistic (2.32) (2.48)

Panel B: Sorted into 4 groups

EXT <= 6 0.07 0.12EXT=7,8,9 0.08 0.10

EXT=10,11,12 0.07 0.09EXT >= 13 0.06 0.08

Abnormal Return 2.64 7.08t-statistic (1.24) (3.57)


Table 5: Abnormal Returns for long-short portfolios: Value weighted

In panel A, we report the annualized mean, the annualized abnormal return and its t-statistic of a portfoliothat is long in the firms in the best category and short in the worst category of external governance, fora given category of internal governance. We consider two different proxies for internal governance: theproportion of stocks held by the largest blockholder and by group of public pension funds. In panel B, wereport the annualized mean, the annualized abnormal return and its t-statistic of a portfolio that is long inthe firms in the best category and short in the worst category of internal governance, for a given categoryof external governance. The time period used is 1990 to 2001, and the abnormal returns are relative to the

four-factor Carhart (1997) model.

Quartile Index of Internal Governance

Panel A: Public Pension Fund.

1 2 3 4Mean 0.37% -1.84% 2.93% 6.79%

Abnormal Return 1.94% -0.95% 3.43% 9.46%t-statistic (0.34) (-0.24) (0.96) (2.11)

Panel A: Largest Blockholder.Mean -0.24% 3.09% 2.36% 8.94%

Abnormal Return -0.51% 5.67% 2.46% 10.83%t-statistic (-0.15) (1.40) (0.54) (3.13)

Quartile Index of Public Pension funds Largest Blockholderexternal governance

Mean Abnormal Return Mean Abnormal Return1 2.14% 2.06% 10.08% 7.94%

(0.42) (2.00)2 1.75% -0.20% 3.09% -2.53%

(-0.04) (-0.82)3 -1.28% -0.93% 0.54% -3.94%

(-0.25) (-1.10)4 -4.28% -5.47% 0.90% -3.41%

(-1.05) (-0.74)


Table 6: Abnormal Returns for long-short portfolios: Equally weighted

See table 5 for a description, here for equally weighted portfolios.

Quartile Index of Internal Governance

Panel A: Public Pension Fund.

1 2 3 4Mean 5.40% 4.16% 3.25% 7.26%

Abnormal Return 10.18% 4.02% 6.17% 10.84%t-statistic (2.09) (1.19) (2.39) (3.08)

Panel A: Largest Blockholder.Mean 4.90% 0.73% 5.59% 8.50%

Abnormal return 5.55% 2.97% 7.35% 14.98%t-statistic (1.55) (0.80) (2.36) (4.80)

Quartile Index of Public Pension funds Largest Blockholderexternal governance

Means Abnormal Return Mean Abnormal Return1 -0.52% 2.24% 5.57% 7.48%

(0.45) (2.04)2 2.26% 0.07% 5.09% 2.21%

(0.02) (0.86)3 -3.30% -1.39% 3.09% 1.90%

(-0.52) (0.79)4 -2.39% 1.59% 1.97% -1.95%

(0.44) (-0.62)


Table 7: 2 Stage WLS : Results

Weighted-least-squares (WLS, see the text for a description) results for the 64 equally weighted portfolios

created from 4x4x4 sorts on PP, G and SIZE (see also table 2). DEXT1, DEXT4, PP1 and PP4 are dummies

for the lowest quartile of external governance, the highest quartile of external governance, the lowest quartileof internal governance and the highest quartile of internal governance, respectively. PP, the percentage ofshare ownership of public pension funds, is the proxy for internal governance. The dummy for the smallest

50% of the firms is ’Small’ and for the largest 50% is ’Large’. The dependent variables are the annualized

abnormal returns from the Carhart (1997) model in the first step. ’Max’ denotes the higher of the two

internal and external governance quartile indices. ’Min’ denotes the lower of the two internal and externalgovernance quartile indices.

Panel A: With size interaction

Constant -8.34 -6.22 -7.19(-4.14) (-2.99) (-7.19)

Max*Small 1.33 1.68(2.03) (2.58)

Min*Small 1.55 2.82(1.62) (3.72)

Max*Large 0.12 1.22(0.18) (2.17)

Min*Large 2.30 2.01(3.76) (2.01)

Panel B: Without size interaction

Constant -8.00 -6.09 -6.82(-3.89) (-2.89) (-4.17)

Max 0.54 1.25(0.93) (2.19)

Min 1.74 1.95(3.12) (3.76)

Panel C: Extreme Portfolios

Constant -2.27(-2.01)

DEXT1*PP1 -5.16(-1.96)

DEXT1*PP4 -2.72(-1.27)

DEXT4*PP1 5.04(2.10)

DEXT4*PP4 5.35(2.47)


Table 8: Descriptive Statistics : Alternative Measure for Takeover Defense

The table reports the number of firms in the four portfolios that are sorted according to our alternative

proxy of external governance, ’EXT’ (see section 5). With the alternative measure, firms with EXT equal

to 3 as classified as having poor external governance, and firms with EXT = 0 are classified as having goodexternal governance.

Number of Firms

Sep-90 Jul-93 Jul-95 Feb-98EXT = 0 145 129 99 92EXT = 1 446 381 344 428EXT = 2 410 427 459 563EXT = 3 328 378 412 482


Table 9: 2 Stage WLS : Results With New Proxy For Takeover Defense.

Reported results are the WLS results for the equally weighted portfolios and the new proxy for takeoverdefense, that varies from 0 to 3. DEXT1, DEXT4, PP1 and PP4 are dummies for the lowest quartile ofexternal governance, the highest quartile of external governance, the lowest quartile of internal governanceand the highest quartile of internal governance respectively. PP is the percentage share ownership of public

pension funds. The dummies for the smallest 50% of the firms is small and the largest 50% is large. The

dependent variables are the annualized abnormal returns from the Carhart (1997) model. ’Max’ denotes

the higher of the two internal and external governance quartile indices. ’Min’ denotes the lower of the twointernal and external governance quartile indices.

Panel A: With size interactionConstant -2.85 0.10 -4.63

(-1.80) (0.07) (-3.56)Max*Small -0.05 0.21

(-0.08) (0.36)Min*Small 1.91 3.00

(2.18) (4.91)Max*Large -1.04 -0.86

(-2.24) (-1.82)Min*Large 2.11 1.62

(3.62) (2.88)Panel B: Without size interaction

Constant -2.80 0.55 -5.08(-1.66) (0.33) (-3.73)

Max -0.97 -0.80(-2.17) (-1.58)

Min 2.26 2.15(4.20) (3.88)

Panel C: Extreme PortfoliosConstant -2.03

(-1.91)DEXT1*PP1 0.19

(0.08)DEXT1*PP4 -4.84

(-2.98)DEXT4*PP1 6.10

(1.91)DEXT4*PP4 1.04

(0.39)

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