Tag: Cash reserves

The Effect of Managers’ Professional Experience on Corporate Cash Holdings

The following post comes to us from Amy Dittmar of the Department of Finance at the University of Michigan and Ran Duchin of the Department of Finance at the University of Washington.

In our paper, Looking in the Rear View Mirror: The Effect of Managers’ Professional Experience on Corporate Cash Holdings, which was recently made publicly available on SSRN, we study the role of managers’ professional experience in financial decision making, focusing on one of the most debated corporate policies in recent years – cash savings.

We focus our analysis on corporate cash policies because firms hold unprecedented, increasing levels of cash. In 1980, firms held $234.6 billion (in 2011 dollars) in cash, amounting to 12% of assets. By 2011, the amount of cash grew to $1,500 billion, or 22% of assets. The predominant approach to understanding corporate cash holdings is the precautionary savings motive. According to this motive, firms hold liquid assets to hedge against future states of nature in which adverse cash flow shocks, coupled with external finance frictions, may lead to underinvestment or default. While prior research shows that the precautionary savings motive explains much of the cash policy of firms, some suggest that managers are overly conservative in their decision to hold high levels of cash.

Motivated by psychological evidence, which shows that past experience affects individual decision-making, we argue that managers may behave conservatively because they experienced financial difficulties in their professional career. To test this hypothesis, we collect detailed data on managers’ employment histories and construct four measures of experience at firms that faced financial difficulties. These measures capture financial constraints and adverse shocks to cash flows and stock returns. To separate firm and CEO effects, the measures are based on prior employment at other firms.


The Sensitivity of Corporate Cash Holdings to Corporate Governance

Katherine Schipper is a Professor of Accounting at Duke University.

In the paper, The Sensitivity of Corporate Cash Holdings to Corporate Governance, forthcoming in the Review of Financial Studies, my co-authors (Qi Chen, Xiao Chen, Yongxin Xu, and Jian Xue) and I analyze the change in cash holdings of a large sample of Chinese-listed firms associated with the split share structure reform that required nontradable shares held by controlling shareholders to be converted to tradable shares, subject to shareholder approval and adequate compensation to tradable shareholders. The reform removed a substantial market friction and gave controlling shareholders a clear incentive to care about share prices, because they could benefit from share value increases by selling some of their shares for cash.

We predict and find that this governance improvement led to reduced cash holdings of affected firms, and that the effect is more pronounced for private firms than for state-owned enterprises (SOEs), for firms with more agency conflicts, and for firms for which financial constraints are most binding. We interpret these results as consistent with both a direct free cash flow channel and an indirect financial constraint channel. These results are robust to several alternative specifications that address concerns about endogeneity and concomitant effects. They provide strong evidence that governance arrangements affect firms’ cash holdings and cash management behaviors. To the extent that cash management is a key operational decision that affects firm value, our findings suggest an important mechanism for corporate governance to affect firm value.


Multinationals and the High Cash Holdings Puzzle

The following post comes to us from Lee Pinkowitz of the Department of Finance at Georgetown University; René Stulz, Professor of Finance at Ohio State University; and Rohan Williamson, Professor of Finance at Georgetown University.

In the paper, Multinationals and the High Cash Holdings Puzzle, which was recently made publicly available on SSRN, we investigate whether the cash holdings of American companies are abnormally high after the financial crisis and whether these cash holdings can be explained by the theories summarized in the previous paragraph. We show that the extent to which cash holdings are unusually high after the crisis depends critically on the measure used. We would expect larger firms to hold more cash. Since corporate assets tend to grow over time, the dollar amount of cash holdings would grow even if the ratio of cash to assets stays constant. Consequently, at the very least, cash holdings should be measured relative to a firm’s assets. Using all non-financial and non-regulated public firms with assets and market capitalization greater than $5 million per year, the average cash/assets ratio is 20.18% in 2009-2010 compared to 20.50% in the 2004-2006 pre-crisis period. However, when we consider the median ratio, it is higher by 0.87% in 2009-2010 than in 2004-2006. Similarly, the asset-weighted ratio is higher by 0.74% in the recent period. The larger increase in the asset-weighted ratio than in the equally-weighted ratio suggests that large firms increased their holdings more and we show that this is the case. However, the changes in cash holdings from 2004-2006 to 2009-2010 are dwarfed by the changes in cash holdings from 1998-2000 to 2004-2006. Over that latter period, the average cash/assets ratio increases by 3.77%, the median by 6.39%, and the asset-weighted average by 3.62%. When we distinguish between private and public firms, we show that there is no evidence of an increase in the cash/assets ratio for private firms.


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).


The Corporate Governance, Cash Holdings, and Economic Performance of Japanese Companies

The following post comes to us from Meng Li and Douglas Skinner, both of the Booth School of Business at the University of Chicago, and Kazuo Kato of the Osaka University of Economics.

In our paper, Is Japan Really a “Buy”? The Corporate Governance, Cash Holdings, and Economic Performance of Japanese Companies, which was recently made publicly available on SSRN, we investigate whether the governance practices of Japanese companies, as manifested in their holdings of cash, have improved over the past two decades, and whether any such improvements translate into improved economic performance. We find that, in general, some of the differences between Japanese and U.S. companies that were evident during the 1990s have become less pronounced over the past 10 years but that important differences remain. While overall levels of cash holdings are now roughly the same for U.S. and Japanese companies, when we condition on firm characteristics we find that Japanese firms still hold substantially more cash than U.S. firms. We do find, however, that regressions of the determinants of firms’ cash holdings developed using U.S. data (e.g., Opler et al., 1999; Bates et al., 2009) fit Japanese firms better in the 2000s than in the 1990s, suggesting that Japanese managers now pay more attention to the economic determinants of their firms’ cash holdings, consistent with improved governance.


SEC Staff Focus on Offshore Cash Holdings

The following post comes to us from Brian V. Breheny, partner at Skadden, Arps, Slate, Meagher & Flom LLP, and is based on a Skadden memorandum by Mr. Breheny, Andrew J. Brady, and Derek B. Swanson.

As reported recently in the press, the SEC staff has, with greater regularity, been issuing comments to companies seeking disclosure of the extent of offshore cash holdings and the impact of such offshore holdings on the company’s liquidity position.  In general, the staff appears to be concerned about the U.S. federal income tax consequences of repatriation of offshore holdings, especially where it appears those holdings serve as a key source of liquidity for the company on a consolidated basis.

Consistent with the SEC’s recent interpretive guidance on the presentation of liquidity and capital resources disclosures in Management’s Discussion and Analysis, the staff appears to be focusing its attention on companies that have significant offshore cash (and cash equivalents) holdings to enhance disclosures in respect of those cash holdings.  In particular, the staff has asked companies to, among other things:

Agency Costs in the Era of Economic Crisis

The following post comes to us from Mira Ganor of The University of Texas School of Law.

In the paper, Agency Costs in the Era of Economic Crisis – The Enhanced Connection between CEO Compensation and Corporate Cash Holdings, which was recently made publicly available on SSRN, I examine the evolution of the practice of cash hoarding following the Great Recession. The results suggest that managerial behavior, as evidenced by the elasticity of cash holdings as a function of total director compensation, has changed significantly in 2008 with economically meaningful implications. The effect was somewhat diminished the following year, which may be attributed to the growth and stimulus of the second half of 2009, but peaked again in 2010. In particular, I find that following the Great Recession managerial compensation has become positively correlated with the level of corporate cash holdings, suggesting that agency costs contribute to cash retention in times of financial distress.

It is possible that high managerial compensation influences the managers to be more risk averse and thus affects the managers’ decision to retain cash. Since diversified shareholders are likely to be less risk averse than the managers at times of financial crisis, when it is harder to find a comparable alternative job and the probability of complete failure increases, it may well be that the cash hoarding practice is at a suboptimal level and comes at the expense of shareholder value. Thus, the influence of the size of the managerial compensation on the manager’s risk tolerance should be taken into account when evaluating managerial pay.


The SEC and Banks’ Loan Loss Reserve Policies

The following post comes to us from Paul Beck and Ganapathi Narayanamoorthy, both of the Department of Accountancy at the University of Illinois at Urbana-Champaign.

In our paper, Did the SEC Impact Banks’ Loan Loss Reserve Policies and Their Informativeness?, which was recently made publicly available on SSRN, we study the joint impact of the SEC’s intervention in bank regulation during the late 1990’s and earnings management. In contrast with traditional bank regulators who focused on understatement (adequacy) of banks’ loan loss reserves, the SEC was concerned with overstatement of loan loss reserves to manage reported income. The SEC’s intervention in banking regulation involved several initiatives. These included investigations of banks that were alleged to have overstated loan loss allowances, the issuance of loan loss guidance in Staff Accounting Bulletin (SAB) 102, and pressuring traditional bank regulators belonging to the Federal Financial Institutions Examination Council (FFIEC 2001) to issue a policy statement affirming SAB 102 guidance. The SAB 102 loan loss guidance requires bank holding companies to use a consistent methodology that can be justified vis-à-vis actual loan loss (charge-off) rates and also imposes responsibility on bank examiners and financial statement auditors to evaluate controls over the loan loss estimation process.


Second Circuit Clarifies Materiality Requirement in Securities Fraud Cases

Brad Karp is chairman and partner at Paul, Weiss, Rifkind, Wharton & Garrison LLP. This post is based on a Paul Weiss client memorandum.

Recently, the Second Circuit decided Fait v. Regions Financial Corp., No. 10-2311-cv (2d Cir. Aug. 23, 2011), in which the Court affirmed the dismissal of a putative class action alleging violations of Sections 11(a), 12(a)(2), and 15 of the Securities Act of 1933 (the “Securities Act”). The Second Circuit held that defendants’ alleged failures to write down goodwill in a timely manner and to increase loan loss reserves sufficiently during the financial crisis were not actionable, because defendants’ challenged statements were matters of opinion rather than fact. Thus, plaintiffs had to allege that defendants did not believe the statements were true at the time they were made, something the complaint failed to do. Fait promises to be a useful tool in defending claims under the Securities Act, as well as claims that a defendant otherwise misstated financial figures, when those figures depend on the judgment of management rather than strictly objective criteria. The decision may be particularly important with respect to claims against accounting firms, whose conclusions based on their audits of financial statements and internal control regularly take the form of an expression of opinion.


The New Face of M&A: How a Trillion Dollars Will Change the Strategic Landscape

James Woolery is Co-Head of North American Mergers & Acquisitions at JPMorgan. This post is based on a JPMorgan report.

1. The Trillion Dollar Question

How would a trillion dollars affect the strategic M&A landscape? By now, virtually everybody who reads the financial press is aware that corporate cash balances are massive. In fact, the largest U.S. firms collectively have in excess of $1 trillion on their balance sheets. These firms have accumulated liquidity during the crisis by cutting back on shareholder distributions, capital expenditures, R&D and acquisitions. Since the crisis, these same firms have delevered by paying down debt and growing their earnings, further enhancing their liquidity positions. As one can see in Figure 1 below, cash balances surged from 5.9% to 10.7% of total assets and from $410bn to $1.1trn, while leverage declined from 3.0x to 2.0x.

As we discussed in several recent reports, the cash-rich environment is ripe for a significant increase in shareholder distributions. [1] Albeit resurging from crisis lows, existing dividend and buyback levels are not nearly enough to consume these firms’ cash flows, let alone put a dent into the record high cash balances. Moreover, distributions do not address the major issue facing large firms today: declining growth rates. The scarcity of organic growth opportunities is perhaps more concerning than any other current corporate issue. Over the last decade, large-cap long-term EPS growth rates declined from 13.2% to 11.2% currently.