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.