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E-MailJoan Farre-Mensa is Assistant Professor of Business Management in the Entrepreneurial Unit at Harvard Business School. This post is based on the article, Financing Payouts, authored by Mr. Farre-Mensa, Roni Michaely, Professor of Finance at Cornell University, and Martin Schmalz, Assistant Professor of Finance at the University of Michigan.
The established conventional wisdom in the finance literature is that firms rely on free cash flow to fund their payouts, whether these payouts are motivated by agency, signaling, or other considerations. In a popular finance textbook, Ross, Westfield, and Jaffe (2013) conclude that “a firm should begin making distributions when it generates sufficient internal cash flow to fund its investment needs now and into the foreseeable future.” Accordingly, they recommend managers to set their level of payouts “low enough to avoid expensive future external financing.” While it is a theoretical possibility that firms could also raise external funds to finance their payouts, such behavior is costly and thus often considered an “extreme payout policy” (DeAngelo, DeAngelo, and Skinner, 2008) that is “uneconomic as well as pointless” (Miller and Rock, 1985)—which likely explains why this possibility has gone unexamined until now.
The results in our paper Financing Payouts, which was recently made publicly available on SSRN, counter this conventional thinking. We find that 42% of industrial public U.S. firms with positive payout initiate an equity or a net debt issue during the same year. The vast majority of them, 36% of all payers, could not have funded their payout without the proceeds of these issues. In addition to being widespread, such “financed payouts” are also substantial in dollar magnitude: 32% of the aggregate capital paid out by public U.S. firms is raised by the same payers during the same year via net debt or firm-initiated equity issues. If we include as a source of payout financing the proceeds of equity issues initiated via employee stock option exercises, the percentage of financed payouts increases by nine percentage points: 41% of the aggregate capital paid out by public firms is simultaneously raised by the same payers either actively from the capital markets or passively from their employees. Clearly, thus, a big portion of payouts is not funded by free cash flow.
Critically, firms’ reliance on the capital markets to finance their payouts is not a transitory phenomenon: The gap between firms’ payouts and their internally generated funds persists if we aggregate firms’ sources and uses of cash flows over four-year intervals. This finding indicates that the use of external capital to finance payouts is persistent and is not the result of payout smoothing or, more generally, of timing mismatches between free cash flow and payouts.
The frequency, magnitude, and persistence of financed payouts are unexpected, particularly in light of the obvious costs associated with this behavior. In addition to underwriting and other direct issuance expenses, these costs include asymmetric information discounts on newly issued securities and passing up profitable investment opportunities as a result of prioritizing payouts over investment. In fact, most firms that finance their payouts do not have an investment-grade credit rating or are in the top public-firm size quartile, which suggests that the cost of financing payouts can be substantial for them.
Our finding that over 40% of all payers finance their payouts with external funds implies that there must be benefits that offset these costs. In order to explore what these benefits are, we first examine the form of payouts that firms finance. We find that firms are as likely to finance their dividends as their share repurchases. Thus, actively financed payouts cannot simply be explained by firms’ desire to avoid the well-known costs associated with dividend cuts.
We next analyze the extent to which firms choose debt or equity issues to finance their payouts, a choice that has direct capital structure implications. Our analysis shows that net debt is by far the most important source of payout financing: up to 30% of aggregate payouts are financed via simultaneous net debt issues. Conversely, 39% of the proceeds of net debt issues—$135 billion of the $350 billion of net debt issued by public U.S. firms in the average sample year—are paid out during the same year by the same issuers. Given that SEOs and private placements are relatively rare, it is not surprising that only 3% of aggregate payouts are financed via firm-initiated equity issues. Yet we find that, when firms do initiate equity issues, they pay out a striking 19% of the proceeds during the same year.
To shed further light on the motives behind financed payouts, we analyze the characteristics of firms that finance their payouts in the capital markets. The results of this cross-sectional analysis point to four key drivers of financed payouts. First, financing payouts allows firms to jointly manage their capital structure and cash holdings in a way that cannot be replicated by relying on either payouts or security issues alone. Second, as suggested by Easterbrook (1984), financed payouts can be the result of a monitoring strategy according to which investors force managers to set such high payout levels that firms are frequently forced to raise external capital to finance investments. By subjecting investment decisions to the scrutiny of the capital markets, this strategy minimizes the risk that managers invest sub optimally.
Third, we find that equity-financed payouts are most prevalent among firms with high idiosyncratic volatility of stock returns, which have more opportunities to engage in market timing. Finally, the desire to increase earnings-per-share appears to be an important driver of debt-financed repurchases, particularly in industries where short-termist pressures to meet or beat analysts’ forecasts are higher. By contrast, we find little support for the notion that signaling considerations are a first-order driver of financed payouts.
While none of the above motivations is qualitatively new to the literature, the pervasiveness, economic magnitude, and persistence of payout-financing behavior indicate that the benefits associated with financed payouts are much more important than prior work has recognized. At the same time, our findings suggest that, relative to these benefits, the external financing costs of financed payouts might be less important than it is assumed in the literature.
At a more fundamental level, a key implication of our paper is that payout and issuance decisions are often closely related, and thus much can be gained by studying them jointly as interdependent elements of the financial ecosystem.
The full paper is available for download here.
