The Influence of Governance on Investment

The following post comes to us from Matthew T. Billett, Professor of Finance at Indiana University; Jon A. Garfinkel, Associate Professor of Finance at the University of Iowa; and Yi Jiang, Assistant Professor of Finance at California State University.

The governance structure of a firm can influence any number of its policies and actions, sometimes to the benefit and sometimes to the detriment of shareholders. Among the many studies of these relationships, numerous ones investigate the link between firm governance and corporate investment; however, the findings are inconclusive. Some studies report results suggesting poor governance associates with excessive investment (over-investment or empire-building), while others suggest the opposite (poorly governed managers may prefer the “quiet life”).

In our paper, The Influence of Governance on Investment: Evidence from a Hazard Model, forthcoming in the Journal of Financial Economics, we revisit the question of how governance affects corporate investment behavior in an attempt to reconcile these conflicting findings. Unlike prior studies we use a hazard framework, wherein we study how governance influences the time between large investment expenditures. This empirical approach helps alleviate some of the concerns with the methods of prior studies and also provides an unexplored perspective. In this framework, we find that governance does influence the time between major investments (investment spikes). Poor governance associates with shorter periods between spikes than that for firms with stronger governance. We further show that this relation is due to poorly governed firms over-investing, rather than stronger governance firms under-investing.

There are several additional key results in our work. First, governance appears to interact with financial constraints to limit over-investment except among financially unconstrained poorly governed firms. This is important as it illustrates where governance is most needed as a check on potential managerial empire-building. Moreover, another check on such activities—higher CEO pay incentives (high delta)—also appears to reduce the hazards (spike frequency), below those for other firms.

We address the potential endogeneity question (wherein firms choose governance to align with other characteristics that influence investment behavior) in two ways. Sarbanes-Oxley required changes to firm behaviors designed to improve governance. Hazards (frequency of spike investments) fell for poorly governed firms after the passage; they did not change for other firms. We also study long-run firm performance following spike investments. For poorly governed financially unconstrained firms with low CEO pay incentives (i.e. those firms most likely to be over-investing), long-run operating and stock performance are significantly negative. For other firms, long-run operating and stock performance are insignificantly different from benchmarks.

Overall, our evidence suggests that poor governance, particularly among unconstrained firms with low CEO pay incentives, permits overinvestment.

The full paper is available for download here.

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