An institutional investor is an organization that buys and sells securities in sufficiently large volume to qualify for lower commissions and other forms of preferential treatment, such as pension funds.
Institutional investors are always looking for profitable new investments in which they can generate a return on their cash, and so are continually being pursued by public companies. However, their sheer heft makes them unlikely investors in micro cap and smaller businesses, since there are not enough available shares for them to move easily in and out of ownership positions. If they were to do so, their initial purchases would drive up the stock price, while any subsequent stock sales would depress the stock price. In addition, most institutional investors have adopted internal investment rules that constrain them from buying the stocks of smaller companies. Thus, this type of investor is not available to smaller public companies.
In cases where an institutional investor has elected to purchase a company’s stock, the extent of its investment may soak up the majority of available shares, which restricts the ability of other investors to buy the stock. Most investor relations officers (IROs) are willing to put up with this inconvenience, for two reasons:
- Stock placements. Institutional investors are usually quite willing to buy stock when a business has an initial public offering or secondary offering, if the initial purchase price is low enough to increase the odds that the investor can eventually sell the shares for a profit.
- Stock transfers. If an investor wants to sell a large block of shares, the IRO may be able to convince a single institutional investor to acquire the entire block.
There are also several risks associated with institutional investors, which are:
- Stock price. When an institutional investor eventually sells its shares, the volume of shares being sold can trigger a significant decline in the stock price. Some investors attempt to mitigate this effect by liquidating their positions over a relatively long period of time.
- Votes. An institutional investor may own so many shares that it can influence the voting for directors at the annual meeting, as well as votes on other issues.
It is difficult to determine whether institutional investors as a group tend to be longer-term or shorter-term investors. It is obviously preferable from a public company’s perspective for an institutional investor to retain its stock position for as long as possible, if only to avoid any downward pressure on the stock price. However, institutional investors (like any investors) must continually review the fundamentals of the companies and industries in which they invest, and liquidate positions where the long-term outlook is not good. Some investors are quicker to move their holdings than others; one company may experience considerable annual churn in its institutional shareholders, while another sees little change from year to year.
The IRO may decide to pursue institutional investors, with the objective of increasing the proportion of shares held by this type of investor. If so, be aware that the investment strategies of only a small number of these investors may even allow them to invest in the company. For example, they may only invest in certain countries, industries, or companies having a certain market capitalization. Others may only invest in companies having a certain growth profile, or perhaps only those that pay dividends, or only those listed in certain stock indices. There may also be rules about never investing below a certain stock price, or where the result will be an excessive amount of ownership in a business. A few base their decisions on the ethical or social responsibility profile of a company. Further, their rules may not allow them to invest more than a certain percentage of total funds in any one industry. In short, the investment rules of an institutional investor can constrain it from making an investment.
Investment decisions within institutional investment firms are usually made by a small number of fund managers. These managers typically rely upon the advice of their own in-house analysts, or the reports of one or more outside analysts to make investment decisions. The IRO can draw the attention of these managers to the company by requesting a meeting between the fund manager, the in-house analyst, and the company’s CEO or CFO. If the fund manager is interested, this may lead to a series of additional meetings. The fund manager and analyst will be particularly interested in the dynamics of the business and the industry in which it operates, as well as barriers to entry, competitors, and expected future growth rates. They will also want to learn about the backgrounds and accomplishments of the senior management team. The analyst will be particularly interested in drilling down into the operational results and cash flows of the business, to ascertain whether the company’s products and services can continue to grow in a profitable manner.
An investment by a high-quality institutional investor may result in a flurry of additional investments from other investors who follow the holdings of that institutional investor. Thus, it may be particularly worthwhile for the IRO to maintain relations with a select group of fund managers on an ongoing basis.