Do Institutional Investors Influence Capital Structure Decisions?

The following post comes to us from Roni Michaely, Professor of Finance at Cornell University, and Christopher Vincent of the Department of Finance at Cornell University.

In the paper, Do Institutional Investors Influence Capital Structure Decisions?, which was recently made publicly available on SSRN, we analyze whether institutional holdings influence capital structure decisions, and whether firms’ financial leverage affects institutional investors’ decisions to hold their equity. Theories of capital structure imply that firms choose their leverage in response to market frictions such as agency costs and asymmetric information. Meanwhile, institutional monitoring and information-gathering affect firms’ agency costs and information environment, opening channels through which institutions may influence firms’ choices of leverage. In the agency framework, institutional investors serve as an external disciplinary mechanism for management, lessening the need for internal disciplinary mechanisms such as debt. In the asymmetric information framework, institutional investors decrease information asymmetry between outside and inside shareholders, which reduces the adverse selection costs of equity and lowers the cost of equity relative to debt, serving to decrease the amount of debt needed for a separating signaling equilibrium.

We find a robust negative relationship between leverage and institutional holdings: firms with a large percentage of their shares held by institutions, on average, have relatively low leverage ratios. We also find that changes in institutional holdings are associated with changes in leverage in the opposite direction. To establish causality, we use two instrumental variables techniques to remove the endogenous components of the relationship between institutional holdings and leverage: two-stage least squares and dynamic panel estimation. We conclude that institutional holdings negatively affect firms’ financial leverage, but firms’ leverage does not affect institutional holdings. Furthermore, our tests allow us to characterize how firms lower their leverage in response to increased institutional in-vestment. Interestingly, we find that as institutional holdings increase, firms simultaneously become more likely to issue equity and less likely to issue debt, but the effect of equity issuance is more dominant.

Our results are strongly supportive of capital structure theories that predict a substitutive relationship between leverage and institutional holdings. Using tests that differentiate between firms prone to agency costs and firms prone to asymmetric information problems, we provide evidence that institutions most strongly influence capital structure through their effect on information asymmetry. Furthermore, the preferential tax treatment of institutional investors as equity holders also suggests an increase in the portion of equity as the portion of the equity held by institutions increases. However, we find no evidence that tax considerations play a role in this relationship.

Finally, our results suggest that significantly different motives underlie the interaction between institutions and dividends (Grinstein and Michaely (2005)) and institutions and leverage (this paper). Grinstein and Michaely (2005) show that institutions do not affect firms’ payout policies, but that changes in payout policies affect institutional holdings. Moreover, they show that the interaction is most pronounced in large firms and firms that are cash cows, consistent with the monitoring role of institutions. We, on the other hand, find that institutions do affect leverage, but that changes in leverage do not unambiguously affect institutional holdings. Furthermore, we find that the interaction is most pronounced in small, growth firms, in line with the notion that institutional investors reduce asymmetric information, in turn inducing firms to reduce leverage. These contrasting findings may, perhaps, point to not only different interactions between institutional holdings and various financial policies, but also to differing roles played by dividends and leverage in resolving asymmetric information and agency conflicts between management and outside equity holders.

The full paper is available for download here.

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