A new research paper, “Institutional Investor Monitoring Motivation and the Marginal Value of Cash” by ICMA academics, Professor Charles Ward, Chao Yin, and Dr Yeqin Zeng, has recently been accepted by Journal of Corporate Finance.
This paper examines whether the monitoring motivation of institutional investors has an impact on the value of US firms’ cash holdings. Over the period 1995-2015, we observe a significant growth in the cash to total asset ratios for US public firms (Figure 1). By the end of the fiscal year 2015, the aggregate cash holdings reported by non-financial and non-utility firms listed on the New York Stock Exchange (NYSE), NASDAQ, and the American Stock Exchange (AMEX) had reached $2.3 trillion, representing 22.4% of total firm assets and equivalent to 12.5% of annual US GDP. Firms may hold more cash or other liquid assets for the precautionary motive should they face higher cash flow uncertainty, market competition, or credit constraints. However, the use of cash is mainly at the managers’ discretion. Firm managers may either directly take the cash in the form of perks or excessive salaries, or invest it in projects that do not maximize shareholders’ profits. Therefore, the managerial agency problem may reduce the value of corporate cash holdings.
Corporate governance studies support the view that institutional investors play a monitoring role in firm activities. However, the motivation of institutional investors in mitigating the managerial agency problem may vary greatly due to their limited monitoring attention. To understand the basic intuition of this idea, imagine that consumers usually do not compare all potential products when making choices, students do not allocate their time equally to prepare for their final exams, and researchers do not pay attention to every paper published in their fields. It takes institutional investors time and resources to monitor firms and improve their governance. Due to institutional investors’ limited monitoring attention, institutions rationally pay more attention to firms that are more important in their portfolios.
In contrast to the classical view that monitoring incentive varies from investor to investor, we provide evidence that even for the same institutional investors, its monitoring incentive towards different holding firm could also be different. When a firm accounts for a larger weight in an institutional investor’ portfolio, the institutional investor has a higher motivation to monitor the firm. Consequently, the stock market will give the firm’s cash holding a much higher valuation. Our results show that the presence of highly motived monitoring institutional investors would significantly mitigate the equity holders concern of cash related agency problem.
Figure 1. US corporate cash holdings
This figure plots the total cash holdings and cash to total assets ratios of US public firms in our sample, which consists of all non-financial and non-utility firm-year observations for the period 1995–2015. The bar charts represent total cash holdings, the sum of cash and marketable securities, in nominal and real terms. The line plot represents the ratios of total cash holdings to total assets.