Living close to the University of British Columbia comes with many benefits, one being the ability to drop in on PhDs presenting finance papers at the Sauder School of Business. For those who have never attended a PhD paper presentation, I highly recommended doing so. They are surprisingly entertaining affairs, which include vigorous debate between the presenter and the audience. The pursuit of truth is a beautiful process.
This past Thursday, I had the pleasure of attending a presentation by Professor Roni Michaely from Cornell University titled "Do Institutional Investors Influence Capital Structure Decisions?" Professor Michaely's research interests are in the area of corporate finance, capital markets and valuation, and he has received numerous awards and recognitions for his work to date, including:
- The 2007 Russell Distinguished Teaching Award, Johnson Graduate School of Management, Cornell University.
- The 2005 Jensen Prize for the best paper published in the Journal of Financial Economics in the Areas of Corporate Finance and Organizations; (for the paper: "Payout Policy in the 21st Century").
- Nominated for the 2002 Journal of Finance Smith Breeden Prize (for the paper: "The Market Making of a Dealer Market: From Entry to Equilibrium in the Trading of Nasdaq Stocks").
- The 2000 Journal of Finance Smith Breeden Prize for Distinguished Paper (for the paper: "When the Underwriter is the Market Maker: An Examination of Trading in the IPO Aftermarket").
- The 2000 Western Finance Association Award for the best paper on capital formation (for the paper: "The Making of a Dealer Market: From Entry to Equilibrium in the trading of Nasdaq Stocks").
What struck me about the Professor's work is that his subject matter is very applicable to capital markets participants. One drawback of the PhD presentations is that they can get overly theoretical and esoteric, and their findings can be difficult to apply in the "real world." This can be especially true with extremely quantitative papers. Einstein said it best:
As far as the laws of mathematics refer to reality, they are not certain, and as far as they are certain, they do not refer to reality.
After attending Professor Michaely's presentation, I left with knowledge that I could apply to my investing process immediately. In fact, I enjoyed it so much so that I followed up with an email asking for an interview, which he happily agreed to, and which follows near the end of this article.
"Do Institutional Investors Influence Capital Structure Decisions?" investigates what impacts a rising or falling percentage of institutional equity ownership has on a firm's capital structure. This is an interesting question, as when an institutional investor increases their ownership it could provide an incentive for either an increase or decrease in leverage. For instance, as institutions bought into a company, they could encourage that company's management to take on further leverage to grow returns. Conversely, once a company has attracted institutional ownership, it may be able to raise the capital required for business expansion via equity offerings, decreasing their reliance on debt and thus lowering leverage.
The paper's finding is that institutional holdings are a significant determinant of a firm's capital structure. From the paper's abstract:
Specifically, we find that a change in institutional holdings causes an opposite change in leverage. Higher leverage, on the other hand, does not unequivocally cause institutions to decrease their holdings. We also find that firms lower their leverage in response to increased institutional holdings by becoming more likely to issue equity and less likely to issue debt. These findings are consistent with both asymmetric information and agency models where institutions, who monitor and reduce information asymmetry problems, substitute for debt. However, since our findings are most pronounced for small, high-growth firms, where adverse selection and information asymmetry problems are most severe, we suggest that the evidence supports theories that imply institutional holdings substitute for debt primarily in the role of reducing asymmetric information between management and outside shareholders.
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Another important point not mentioned in the abstract is that this is a one way street. That is, it was found that the institutional investors influence capital structure decisions, but capital structure decisions do not affect institutional investor ownership. Thus, a company lowering its leverage doesn't cause institutional investors to purchase the stock.
I can think of a multitude of ways to apply this finding to the analysis of portfolios, but I'll leave that to the Professor. Without further ado, below is the question and answer period with Professor Roni Michaely on his paper "Do Institutional Investors Influence Capital Structure Decisions?"
Sean Bellamy McNulty: First off, thank you for agreeing to do this Q&A for the readers of SeekingAlpha.com, Professor Michaely. Let's start off with the question that is on the top of reader's minds: What could the retail investor take away from your findings?
Roni Michaely: There are several takeaways. First, the presence of institutions as equityholders, especially if those institutions put efforts to keep managers more "honest," is a good thing. Second, investors have to pay attention to many dimensions of what the firm does. In the context of this research, one firm may issue equity, or stop its repurchase program, and that may be the right thing to do for that firm, say, because of an increase in institutional holdings. But another company may stop its repurchase program for other reasons, which may be less "legitimate" (e.g., it needs the money to invest in some fancy project). So when it comes to investment, you must think multi-dimensional -- you must think not only about the trees, but about the big picture when it comes to valuation.
SBM: In your abstract, you refer that your findings "supports theories that imply institutional holdings substitute for debt primarily in the role of reducing asymmetric information between management and outside shareholders." In layman's terms, how do institutional shareholders reduce asymmetric information between management and other shareholders?
RM: Imagine you have $200 invested in Panera Bread Company. Now imagine you have 200 million dollars invested in Panera Bread Company. How will this change your behavior? In all likelihood in the second case (200 million dollars invested), you will follow the company more closely. You will devote much more time to investigate how the company invests and what the management is doing. You may even talk with Panera bankers, with their suppliers and customers. You will also have much better access to Panera's management team. Not only to hear what they have to say, but they will also listen to what you have to say. You will know more -- and the gap between what equity holders (you as someone who holds the $200m stake in this case) know about the company and what management knows is narrower. More than that, your trades will reveal part of this information to the market and other investors. Thus, not only you, but other equity holders will have this information (in other words, this information will be reflected in prices). That what we mean by "reducing asymmetric information." The larger the stake you have in the firm, the more incentive you have to learn about the firm and the greater incentive you have to devote more resources to it. This is the main difference between institutions and most individual investors.
The initial information gap is significantly greater for small growth companies. These are the type of firms with greater uncertainly about the outcome to begin with -- and more advantage of being "an insider." For example, these firms have higher cost of raising equity capital exactly because of this reason: outside equity holders ask themselves, what do the insiders know that I do not know? How come they are now offering a potion of their firm to outsiders? Maybe they know it is overvalued? These types of issues are more pronounced for small growth firms. So if asymmetric information is the main driver behind what we find (negative effect of institutions on the amount of debt), it should be more pronounced in these types of firms.
SBM: You note that you find that small, young, cash-strapped firms with relatively many growth opportunities see a much stronger relationship between institutional ownership and leverage. Does this lead you to suspect that this relationship between institutional ownership and leverage is largely brought on by the company's management rather than institutional investors? For example, a company that knew that it had the institutional demand for its equity would choose to issue equity rather than debt.
RM: Yes. This is a very nice insight. It is brought on by the company's management for two reasons. First, when a small firm gets an "infusion" of institutional holdings, and when these institutions reduce the degree of information asymmetry (see above), issuing equity become cheaper (i.e., reduce the cost of equity capital and increase liquidity). This is more pronounced in small firms. Second, for small firms, management is much more attuned to, and depends on, institutions. So no surprise they may have a more significant footprint on those firms' policy.
SBM: On page 38, you find that "an increase in institutional holdings is associated with a higher probability of a firm being an equity issuer in the following year, and a lower probability of a firm being an equity repurchaser in the following year." Given that equity issuance dilutes ownership, whereas debt doesn't, would you say that management may, in many cases, be acting against existing shareholders' interests?
RM: Absolutely not. What I mean is there are many cases where management acts against the interest of shareholders. And there are so many examples, from trying to build empires that serve management's egos and pockets, to [providing themselves a] quiet and comfortable life at the expense of shareholders. But equity issuance is not an example for it. Equity issuance is dilutive ONLY if management sells under-valued equity. In the presence of institutions, this is even less likely to be the case.
SBM: Along the same lines, would you say your findings support or dispute the theory of efficient markets? Wouldn't companies in an efficient market be indifferent to institutional shareholders as they sought to maximize profits?
RM: No. Companies in an efficient market should not be indifferent to institutional shareholders as they sought to maximize profits. Here is an example that is out of my paper: We know that (1) firms that want to raise capital want to lower information asymmetry, since it will lower their cost of equity capital; (2) institutions reduce asymmetric information. Hence, when a firm has more institutions at the margin, it is better off raising the money through equity capital. This is the efficient thing to do. Ignoring it is equivalent of a firm who ignores another aspect of a relative advantage it has. In other words, not ignoring the extent of institutional investing will result in a mix of debt and equity that will minimize its cost of capital and maximize it value. It is efficient.
SBM: And finally, any stock picks for the readers of Seeking Alpha?
RM: Of course! Put the significant portion of your money in ETFs. Buy and hold and do not trade. I am willing to bet most of you will make more money like that in the long run. With the rest of your money (a small portion of it), you can follow some of the sage advice you get from Seeking Alpha.