Online Coloring Co-interval Graphs

 
INSTITUTIONAL INVESTMENT HORIZON AND CORPORATE 
FINANCING DECISIONS  
 
Ligang Zhong (Queen’s University) 
 
 
 
Paper presented at the 
th9  International Paris Finance Meeting 
December 20, 2011 
www.eurofidai.org/december2011.html 
 
 
Organization: Eurofidai & AFFI 
 
 
 
 
 Institutional Investment Horizon and Corporate Financing Decisions

*
Ligang Zhong
Queen’s University

Abstract
Traditional literatures document that the longer-term institutional investor serves as a
better monitoring mechanism and is associated with better corporate policy. In this paper,
I exam its impact on corporate financing decisions and find an entrenchment effect of
long-term institutional holdings for the first time. I find that institutional investment
horizon is negatively associated with firms’ likelihood of issuing equity and debt and is
also negatively associated with the amount of the security issuance; in addition, firms
with a longer institutional investment horizon adjust their capital structure at a slower
pace, issuing more debt when over-levered and issuing less debt when under-levered,
ceteris paribus. Firms’ management department seems aware of the entrenchment cost
and issue shorter-term debt to counteract the effect. It seems that long-term institutional
investors act as the friction in the corporate financing process due to their higher portfolio
rebalancing cost compared with short-term institutional investors.
Key Words: Institutional investment horizon, capital structure, institutional monitoring




*The Author can be reached at Queen’s School of Business, Queen’s University, 143 Union Street,
Kingston, Ontario, Canada, K7L3N6. Tel: 001-613-449-7049. Email: LZhong@business.queensu.ca.
Acknowledgements: I am grateful for comments made by Lew Johnson and Yang Ni.

Introduction
In the past 30 years, institutional investors have been playing an increasingly important
role in the US equity market. The median proportion of institutional ownership of US
common stocks rose from less than 5% in the 1980’s to more than 55% by 2008; in
addition, the percentage of firms without institutional ownership was around 30% during
the early years of 1980’s, whereas, by 2008, almost all common stocks have at least one
13F institution filing their ownership report (Glushkov, Moussawi, and Palacios (2009)).
Such a trend causes a tremendous amount of research on the role of institutional investors
on corporate policies and firms’ investment decisions. However, the majority of the
research is concentrated on the ownership levels. The effect of institutional holding
length on corporate policies does not attract as much attention as the holding level in the
current literature. Exceptional efforts for such an effect have been made on corporate
payout policy (Gasper et al (2005b)), earnings management (Bushee (2001)), executive
compensations (Shin (2009)), mergers and acquisitions (Gasper et al (2005a)), and
corporate investment (Cella(2010)). However, none of these studies look at the effect of
institutional holding length on financing decisions. I am filling the void in this study.
After controlling for various predetermined factors and endogenous issues, I document a
strong and robust effect of institutional ownership length on firms’ financing decisions.
I study the effect of investment horizon on corporate financing decisions in the
framework of the pecking order theory and the trade-off theory, both of which are of the
most influential models for corporate financing decisions. According to the pecking order
theory (Myers (1984), Myers and Majluf(1984)), due to adverse selection, firms first look
to retained earnings, then to debt, and only in extreme circumstances to equity for
2 financing. In the same paper, Myers called the other model in which firms balance the tax
savings against the deadweight bankruptcy cost of debt financing the trade-off model.
There are two key implications for these two models. The key implication for the trade-
off theory is that firms have an optimal target leverage ratio. Once deviate, firms will
adjust their leverage gradually to eliminate the deviation. The key implication for the
pecking order theory is the strict ordering of financing and only those factors which can
affect the information environment of a firm can change such ordering. Based on these
two models, institutional investment length can affect firms financing decisions in the
following four aspects.
First, Institutional investment length can affect the equity issuing firms’ information
environment directly by signalling effect. Papers show that institutional investors are
smarter than retail investors, have better private information on firm fundamentals, and
move prices in the correct direction (Nofsinger and Sias (1999), Sias (2004), and
Wermers (1999, 2000)). Therefore, their holding length can serve as credible information
on the quality of the firm to the market, i.e., longer holding length suggests a higher
quality of the firm and shorter holding length indicates the lack of confidence from these
smart investors. When it comes to the financing decisions, firms with better information
environment (signalled from longer institutional investment length) will face less adverse
selection and their equity issuing will be discounted less in the market. Consequently,
they can shift their financing decisions to rely more on equity financing when face
external financing needs.
Second, the long-term holding of institutional investors has monitoring advantages.
Existing literatures document that institutional investors are monitoring firms to improve
3 corporate governance so that they can reap the benefit in the future (Shleifer and Vishny
(1986), Hartzell and Starks (2003)). Through long-term holdings, institutional investors
can have less cost to gather the information related to firms’ status and have better
knowledge about firms’ history. For example, compared with short-term institutional
investors, long-term institutional investors are at better position to monitor the firm to
operate well. Such monitoring effect from long-term holding can have effect on firms’
debt issuing activity. Elyasiani, Jia and Mao (2010) find that the cost of debt is robust and
negatively associated with firms’ institutional investment stability. In this vein, one can
predict that firms with longer institutional investment horizon issue more debt, ceteris
paribus.
Even though signalling effect and monitoring effect of long-term holdings can increase
the issuing activity of both debt and equity, I predict that firms will issue more equity
relative to debt. The rational is following: due to the asset-substitution effect or agency
cost of debt, as advocated by Jensen and Meckling (1976), firms have the tendency to
issue equity when external financing is needed and the information asymmetry problem is
less severe, so as to reduce the conflict between equity holders and debtholders. In
addition, the monitoring and signalling advantage arising from longer-institutional
investors can also reduce firms’ deviation from their optimal leverage ratio. Once deviate,
firms with longer institutional investment horizon will make the adjustment faster.
The above rationale assumed that the incentive of long-term institutional investors is
aligned with other stakeholders in the firm. However, it is also possible that long-term
institutional investors, after gaining more power in the firm, will act on their own interest
and add another lay of agency cost to the firm. Such agency cost of equity holders can be
4 found in Jensen and Meckling (1976). One can also trace the malign role played by
institutional investors back to the trading behaviour of institutional investors during the
bubble period. As modelled by Delong et al. (1990) and Abreu and Brunnermeier (2003),
and further proved by the empirical evidence from Brunnermeier and Nagel (2004),
institutional investors are far from correcting the mispricing, instead, they ride the bubble
and push the price further from firm fundamentals. Here, long-term institutional investors
might not be interested in pocketing the short-term trading profit; but they use their
higher bargaining power to influence firms’ corporate financing decisions for their own
interest. Because long-term institutional investors have different trading strategies
compared with short-term ones due to different liability maturities, prudent man rules,
long-term institutional investors is less willing to rebalance their portfolios. Therefore,
they are less likely to appreciate firm’s capital structure change. For example, a new
equity/debt issuing will change the risk of a firm, causing long-term institutional investor
to re-adjust their holdings because of the risk hedging purpose; a new equity issue will
also dilute institutional investors’ voting power. Long-term Institutional investors are
more concerned with such dilution effect since they are more interest in cor