Academic journal article Financial Management

Managerial Ownership, Debt Policy, and the Impact of Institutional Holdings: An Agency Perspective

Academic journal article Financial Management

Managerial Ownership, Debt Policy, and the Impact of Institutional Holdings: An Agency Perspective

Article excerpt

Recent innovations in the theoretical literature suggest that ownership structure and the distribution of financial claims can affect firm performance and value by mitigating agency costs of the firm. A considerable body of literature exists indicating that managerial stock ownership helps in aligning managerial interests with those of the external stockholders. Debt holders and the related monitoring devices are also considered to be important mechanisms for controlling managerial behavior and mitigating the agency problems in the firm. In a similar vein, the literature indicates that institutions are important monitoring agents and exercise an active role consistent with protecting their significant stake in the firm. While efforts have been expended in examining ownership structure and firm performance, Jensen and Warner (1988) note that, "The precise effects of stock holdings by managers, outside block holders, and institutions are not well understood, however, and the interrelations between ownership, firm characteristics, and corporate performance require further investigation."

This paper adds to the literature by examining the impact of institutional holdings of common stock on debt policy and managerial ownership in an agency framework. In spite of their commonalty in providing capital and their role in reducing agency costs in the firm, no prior research has examined the effect of institutional holdings on debt financing and managerial ownership. Because they represent three alternative mechanisms for mitigating agency problems, it is hypothesized that increasing institutional ownership can offset the need for debt and managerial ownership to reduce agency costs. Thus, in equilibrium higher institutional ownership should be inversely related to the proportion of debt and managerial ownership in the firm. This proposition is investigated empirically in a two-equation simultaneous equation regression framework with debt and managerial ownership as the endogenous variables. Institutional holdings are assumed to be exogenous and beyond the control of management; however, the agency literature indicates that their presence will have an inverse effect on debt and managerial ownership. The empirical evidence provided in this study is consistent with the proposition that higher levels of institutional ownership are associated with lower levels of debt ratios and managerial ownership. Results from the simultaneous equations system support the view that debt policy and managerial ownership are jointly determined. The remainder of the paper is organized as follows. Section I contains a review of the literature. Section II describes the empirical design and the data used in the study. Section III provides a discussion of the results. Finally, section IV summarizes and concludes the paper.

I. Literature Review

This section provides a brief review of the role of debt and managerial ownership in controlling agency conflicts of the firm. We then present a discussion of the significance of institutional investors as monitors of firm management. The section concludes with a discussion of the interrelationships among financial leverage, managerial ownership, and institutional investors.

A. Role of Debt and Managerial Ownership in Controlling Agency Conflicts

According to the agency model of the firm espoused by Jensen and Meckling (JM) (1976), the modern corporation is subject to agency conflicts arising from the separation of the decision-making and risk-bearing functions of the firm. In this setting, JM show that managers have a tendency to engage in excessive perquisite consumption and other opportunistic behavior since they receive the full benefit of such activity but bear less than their full share of the costs. JM refer to this as the agency cost of equity and show that it could be mitigated by increasing managerial ownership in the firm, thus forcing managers to bear the wealth consequences of their actions. …

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