Why Are Firms with More Managerial Ownership Worth Less?

Rüdiger Fahlenbrach is Associate Professor at the Swiss Finance Institute at Ecole Polytechnique Fédérale de Lausanne (EPFL), Switzerland. This post is based on a recent paper by Professor Fahlenbrach; Kornelia Fabisik, Swiss Finance Institute doctoral student at EPFL; René M. Stulz, Everett D. Reese Chair of Banking and Monetary Economics at the Fisher College of Business at The Ohio State University; and Jérôme P. Taillard, Associate Professor of Finance at Babson College.

In our paper Why Are Firms With More Managerial Ownership Worth Less?, we provide new evidence on the relationship between firm value and managerial ownership.

An important and well-documented result in corporate finance is that firm value is positively correlated with managerial ownership over some range of ownership and then, beyond that range, becomes negatively correlated. Several theory papers model the tension between managerial ownership and incentives and predict such a concave relation: It is good when managers have some skin in the game, but if they own too many shares, they become entrenched.

We build a new database of managerial ownership information by parsing original SEC documents. While the samples in existing studies are tilted towards large firms and have data for few years, we have much broader coverage from 1988 to 2015 as we have data for more than 1,800 firms per year on average (even after excluding utilities, financial firms, and dual class firms). We show using our large database that the relationship between firm value and ownership is more complicated than previously thought. With our sample, we find strong and robust evidence that the relation between firm value and managerial ownership is negative rather than positive and thus opposite to theoretical predictions and prior empirical findings. Yet, when we restrict our sample to the subset of larger firms similar to the samples used by earlier work, we recover their findings of a positive relationship between value and managerial ownership over some range of ownership.

We show that the consistently negative relation between firm value and managerial ownership uncovered in our sample has a straightforward explanation. Insiders own more shares at the IPO than they typically want to own over time. As a result, they want to decrease their ownership, but face frictions in doing so. If a firm’s stock is illiquid, it takes time and it is expensive to sell large stakes. Managers may not even be able to sell under conditions that are acceptable to them. The level of managerial ownership of a firm therefore depends on its past history. If the firm’s stock is highly liquid quickly after the IPO, managers decrease their ownership, and the firm eventually has low managerial ownership. The firms whose stock is liquid are typically successful firms, which means firms with a high Tobin’s q. Hence high q firms tend to have low managerial ownership. Conversely, firms with high managerial ownership are firms whose stock has lacked liquidity. Such firms are firms that have not been consistently successful, and therefore end up with high managerial ownership and low q.

With our theory, the relation between managerial ownership and Tobin’s q is the outcome of the past history of the firm. The mechanism also explains why the results in the literature hold for highly liquid large firms, but not for other firms: it is because frictions in the adjustment of managerial ownership are not relevant for large liquid firms.

Our theory predicts that the relation between managerial ownership and Tobin’s q depends on the evolution of stock liquidity. We indeed find strong evidence that the firms with high past liquidity have a relation between Tobin’s q and managerial ownership that is consistent with the earlier literature, while firms with low past liquidity exhibit a strong negative relation between firm value and managerial ownership.

A direct test of our theory that the relation between Tobin’s q and managerial ownership reflects past history is to regress Tobin’s q on the change in managerial ownership since the IPO or first available ownership observation. Our prediction is that firms whose managerial ownership fell more have a higher Tobin’s q. These firms are successful firms whose managers were able to sell shares easily because their stock had been liquid for a number of years. We find strong evidence that Tobin’s q is positively related to the drop in managerial ownership since the IPO.

With our theory, managerial ownership should be decreasing in past stock liquidity. We find strong evidence that a firm’s current managerial ownership is a decreasing function of the number of years the firm has had with high stock liquidity, which are years in which managers could have decreased their ownership at lower cost. We go further towards a causal interpretation of the relation between managerial ownership and liquidity by using two exogenous shocks that improved liquidity. Such shocks should lead to a decrease in managerial ownership if our explanation for the negative relation is correct. We first use the major Nasdaq reforms in the late 1990s as a shock to liquidity. Although the reforms also had an impact on NYSE and Amex, Nasdaq experienced a greater improvement in execution costs. We estimate a difference-in-differences regression around the Nasdaq reforms to study the impact of liquidity on managerial ownership and find clear evidence that managerial ownership decreases as a result of the shock to liquidity. The introduction of decimalization, which affected large firms with small bid-ask spreads but not smaller listed companies, provides a second shock to liquidity. We again find that firms whose liquidity increased relatively more experienced greater drops in their managerial ownership.

Our explanation for the negative relation between managerial ownership and Tobin’s q is that higher liquidity decreases managerial ownership and that some of the forces that lead to higher liquidity increase Tobin’s q as well. In particular, better operating performance generally improves both liquidity and Tobin’s q. We find strong support for the hypothesis that a stock is more liquid if its cumulative past performance is better. We then show that Tobin’s q is also higher for firms with greater past performance.

Overall, our evidence suggests that theories of firm value and managerial ownership should take into account frictions that impede adjustments in managerial ownership.

The complete paper is available here.

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