Do Long-Term Investors Improve Corporate Decision Making?

Jarrad Harford

University of Washington

Ambrus Kecskes

York University – Schulich School of Business

Sattar Mansi

Virginia Polytechnic Institute & State University

Abstract:

We study the effect of investor horizons on a comprehensive set of corporate decision making. Long-term investors have the means and motive to monitor corporate managers, which generates corporate decisions that are consistent with shareholder value maximization. We find that long-term investors restrain numerous corporate misbehaviors such as earnings management and financial fraud and foster shareholder democracy. They discourage a range of investment and financing activities but encourage payouts. Shareholders benefit through higher stock returns, greater profitability, and lower risk. Firms diversify their operations. We use a popular identification strategy to establish causality of our results.

Do Long-Term Investors Improve Corporate Decision Making? – Introduction

It is well established that managers of publicly traded firms, left to their own devices, tend to maximize their private benefits of control rather than the value of their shareholders’ stake in the firm (Berle and Means (1932) and Jensen and Meckling (1976)). At the same time, imperfectly informed market participants can lead managers to make myopic investment decisions (Stein (1988)). Indeed, most managers admit that they are willing to sacrifice longterm shareholder value for short-term profits (Graham, Harvey, and Rajgopal (2005)). Numerous mechanisms have been proposed to counter this mismanagement problem. One of the most important of these is monitoring by investors with long investment horizons (Drucker (1986), Porter (1992), and Monks and Minow (1995)). By spreading both the costs and benefits of ownership over a long period of time, such investors can be very effective at monitoring managers (Gaspar, Massa, and Matos (2005) and Chen, Harford, and Li (2007)). In this paper, we ask two basic questions. First, do long-term investors in publicly traded firms improve corporate behavior? Second, does their influence on managerial decision making improve returns to shareholders of the firm? To this end, we study a wide swath of corporate behaviors.

According to theory, if long-term investors exert a positive influence on managers, we should observe a decline in corporate misbehavior (such as financial fraud). We should also observe a rise in shareholder democracy (in the form of shareholder proposals and executive turnover, for instance). However, regarding investment, financing, and payout decisions, the predictions of theory are somewhat less clear (e.g., see Bebchuk and Stole (1993) regarding managerial horizons and corporate investment).

The dominant view in the literature on manager-shareholder conflicts is that poorly monitored managers will destroy shareholder value by overinvesting (Baumol (1959) and Williamson (1964)). This empire building hypothesis has broad empirical support (e.g., Morck, Shleifer, and Vishny (1990) and Gompers, Ishii, and Metrick (2003)). Another view holds that managers will underinvest, under certain conditions, thereby also destroying shareholder value (Holmström (1979) and Grossman and Hart (1983)). This quiet life hypothesis is supported empirically as well (e.g., Bertrand and Mullainathan (2003) and Giroud and Mueller (2010)). We let the data settle this debate about whether managers invest too much or too little.

Our view of financing, like that of Stulz (1990), is that it is determined by management’s investment decisions. In other words, managers that overinvest also raise too much financing, and those that underinvest raise too little. Payouts should follow the opposite pattern to financing, but only if managers mainly pursue a residual payout policy. If instead they accumulate corporate resources in any event, then payouts should be higher with sufficient monitoring by investors. Finally, theory clearly predicts that, on the whole, greater monitoring should increase shareholder value, whether as a result of greater profitability or lower risk.

We test these predictions using a large panel of firm-years comprising an average of roughly three thousand firms annually over close to thirty years. We follow the literature (e.g., Gaspar, Massa, and Matos (2005) and Chen, Harford, and Li (2007)), and we use portfolio turnover to capture the investment horizons of investors and then group investors into short-term or long-term categories based according to their investment horizons.

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Corporate Decision Making

Corporate Decision Making