Local Ownership as Private Information: Evidence on the Monitoring-Liquidity Trade-Off

Abstract

This Paper investigates the impact of ownership patterns on the way the firm is monitored, on the liquidity of its shares, and on its stock price. Building on the literature showing that local mutual funds (funds holding geographically close firms) enjoy superior returns due to private information, we use local ownership as a proxy for the amount of informed investment. Since location is reasonably exogenous, local ownership provides an identifying restriction that is used to address endogeneity concerns that have been raised in the literature (Demsetz and Lehn, 1985). Using data on a broad panel of US firms, we show that informed ownership improves the quality of governance of the firm and induces value-enhancing decisions (less over-investment and fewer but better acquisitions). At the same time, its presence in the firm increases the adverse selection discount required by less informed investors to trade, reducing the firm's liquidity. Both effects are properly impounded in the firm's stock price. Our results provide an economic interpretation of why ownership seems to be unrelated to performance. Informed investors affect prices indirectly, and in opposite directions: their monitoring activity tends to raise prices, but the lower liquidity induced by their presence tends to reduce prices.

Keywords: Local ownership, corporate governance, liquidity, monitoring, mutual funds, private ownership

JEL Classification: G23, G30, G32