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.
Our analyses of post-reform firm behaviors find that private firms increased cash payouts but not external debt financing or capital expenditures; we interpret this finding as consistent with a relatively more pronounced free cash flow channel effect that reduced the incentives of private firm controlling shareholders to hoard the listed firm’s cash as a reservoir for their personal cash needs and a relatively less pronounced financial constraints channel. In contrast, the SOEs increased both external debt financing and capital expenditures, consistent with the operation of the financial constraints channel; SOEs also increased dividend payouts but not by as much as did private firms.
We draw two important implications from our results. The first is that the liquidity of large shareholders matters, in that our results are based on a natural experiment that improves corporate governance arrangements by relaxing trading constraints imposed on large shareholders. The second implication from our analyses of the relative effects on private firms and SOEs is that ownership matters, in that the free cash flow channel appears more descriptive of the governance path taken by the share reform in private firms and the financial constraint channel appears more descriptive for the SOEs. We attribute this difference in effects to important differences in the two types of owners. Specifically, controlling shareholders of private firms—persons and families—have both the ability and the incentive to use corporate cash for personal needs while controlling shareholders of SOEs—government agencies—are themselves organizations whose employees are subject to organizational controls. The nature of the agency conflict, and therefore its partial resolution by the share reform, differs for the two types of firms because their owners differ.
The full paper is available for download here.