Investor Horizons and Corporate Cash Holdings

The following post comes to us from Jarrad Harford, Professor of Finance at the University of Washington; and Ambrus Kecskés and Sattar Mansi, both of the Department of Finance at Virginia Tech.

It is well known that the separation of ownership and control in public firms causes tension between investors and managers. These so-called “agency problems” are particularly pronounced in the use of corporate cash holdings because it is both easy for managers to misuse cash and hard for investors to evaluate the appropriateness of mangers’ use of cash. Moreover, cash holdings account for a substantial proportion of corporate assets (about 25% of total assets in recent years). Therefore, since firms with better internal corporate governance tend to use their cash holdings more for the benefit of their investors rather than their managers, it is not surprising that investors are willing to pay a higher price for them.

In the paper, Investor Horizons and Corporate Cash Holdings, which was recently made publicly available on SSRN, we study how the investment horizons of a firm’s institutional investors affect the agency costs of corporate cash holdings. It is widely recognized that monitoring by institutional investors of managers increases firm value. However, not all institutional investors are created equal, and, one important way in which they differ is their investment horizons. Differences in investment horizons arise, for example, because of differences in investment strategies (e.g., short-term hedge funds) and/or differences in the maturity of liabilities (e.g., long-term pension funds).

We argue that monitoring by investors of managers is an important determinant of cash holdings. Theory suggests that firms want to hold more cash to ensure that they can finance profitable projects but not so much that managers can waste cash on unprofitable projects that benefit them at the expense of investors. We argue that the costs of monitoring are lower and the benefits are higher for investors with longer horizons, so they monitor more. Moreover, long-term investors can influence managers to increase shareholder value by threatening to sell their shares (“taking the Wall Street walk”). Our argument suggests that firms with longer investor horizons should hold more cash. Moreover, firms with cash holdings in excess of what they need to finance profitable projects should invest less (i.e., in unprofitable projects) and pay out more to shareholders (i.e., return surplus funds) if they have longer investor horizons. Finally, their more profitable use of excess cash should be reflected in their stock price.

To test our predictions, we measure the investment horizons of investors as their portfolio turnover and the investor horizons of firms as the ownership of their long-term (i.e., low portfolio turnover) investors. We find that firms with longer investor horizons hold significantly more cash. Moreover, we they have excess cash (i.e., beyond their investment needs), they significantly decrease their investment in projects and significantly increase their payouts to shareholders. Finally, we find evidence consistent with the stock market understanding the value to shareholders of greater monitoring: the effects of long-term investors are impounded into stock prices years before excess cash materializes. Our results are robust to accounting for internal governance mechanisms such as antitakeover provisions and managerial ownership as well as the external governance mechanism of concentrated ownership (so-called “blockholder” investors). We are also able to establish that long-term investors cause our results (rather than the other way around) by using long-term investors that index as an instrument.

We make two significant new contributions. First, in studying the effect of horizons on corporate cash holdings, we improve our collective understanding of how investor horizons affect corporate behavior – an emerging line of research. Second, we show that a new external corporate governance mechanism – investor horizons – helps to explain the role that governance plays in determining cash holdings beyond the general role played by institutional investors and other mechanisms. Finally, our findings provide confirmation that the U.S. evidence on corporate governance and cash holdings (better governed firms hold more cash) contrasts sharply with the international evidence (better governed firms hold less cash).

The full paper is available for download here.

Post a comment or leave a trackback: Trackback URL.

One Trackback

  1. […] full article……via Investor Horizons and Corporate Cash Holdings — The Harvard Law School Forum on Corporate Governan…. Share OptionsPrintEmailMoreFacebookLinkedInStumbleUponTwitterPinterestRedditDiggTumblrLike […]

Post a Comment

Your email is never published nor shared. Required fields are marked *


You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>

  • Subscribe

  • Cosponsored By:

  • Supported By:

  • Programs Faculty & Senior Fellows

    Lucian Bebchuk
    Alon Brav
    Robert Charles Clark
    John Coates
    Alma Cohen
    Stephen M. Davis
    Allen Ferrell
    Jesse Fried
    Oliver Hart
    Ben W. Heineman, Jr.
    Scott Hirst
    Howell Jackson
    Robert J. Jackson, Jr.
    Wei Jiang
    Reinier Kraakman
    Robert Pozen
    Mark Ramseyer
    Mark Roe
    Robert Sitkoff
    Holger Spamann
    Guhan Subramanian

  • Program on Corporate Governance Advisory Board

    William Ackman
    Peter Atkins
    Joseph Bachelder
    John Bader
    Allison Bennington
    Daniel Burch
    Richard Climan
    Jesse Cohn
    Isaac Corré
    Scott Davis
    John Finley
    David Fox
    Stephen Fraidin
    Byron Georgiou
    Larry Hamdan
    Carl Icahn
    Jack B. Jacobs
    Paula Loop
    David Millstone
    Theodore Mirvis
    James Morphy
    Toby Myerson
    Morton Pierce
    Barry Rosenstein
    Paul Rowe
    Rodman Ward