Abstract: An important recent theoretical literature argues that the threat of exit can be an effective form of governance when the block-holder is a principal. However, delegated portfolio managers hold a significant fraction of equity blocks. How do agency frictions arising from such delegation affect the ability of block-holders to govern via the threat of exit? An important source of agency frictions in fund management stems from the well-documented fact that funds are often subject to short-term flow-performance relationships. Different types of funds differ in the extent to which they care about flows. Some, like mutual funds, are typically exclusively flow-motivated because they receive un-contingent assets-under-management fees. Others, like hedge funds, receive a degree of explicit profit-linked compensation, and thus have higher-powered incentives. We show that when block-holding funds are sufficiently flow-sensitive, exit will fail as a disciplining device. Our result generates testable implications across different classes of funds: only funds with relatively high-powered incentives will be effective in using exit as a governance mechanism. We also show that the threat of exit can complement shareholder voice. This implies that those funds that cannot effectively use exit will also be inclined not to use voice. We thus provide a potential explanation for the empirically documented variation across different types of portfolio managers’ use of voice.
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