Entrenched Management, Capital Structure Changes and Firm Value
Lundstrum, Leonard L., Journal of Economics and Finance
Abstract The relationship between managerial share ownership and the firm's change in leverage around a security issuance is examined. We find that entrenched managers are not more likely to issue equity, however they do affect lower leverage by choosing debt issuances which are smaller and equity issuances that are larger than those chosen by managers that are not entrenched. The magnitude of the decline in leverage that occurs from before the issuance to after the issuance is positively related to managerial share ownership. In addition, this relationship is confined to only the "entrenchment" range of managerial share ownership. The market reacts negatively to an issuance announcement when managerial share ownership is high.
Keywords Ownership Structure * Capital Structure * Security Issue * Agency Theory
JEL classifications G30 * G32 * G34
A number of investigators, including Berger et al. (1997) and Garvey and Hanka (1999) report that managerial entrenchment affects the firm's choice of leverage. Theory implies that debt constrains management discretion by either reducing the manager's bargaining power (Noe and Rebello 1996) or by reducing discretion over spending (Stulz 1990). Zwiebel (1996) argues that entrenched managers use their influence to lower debt levels to the point that capital structure maximizes empire building subject to sufficient efficiency to prevent a takeover. Agency costs will be incurred at the time of security issuance if the manager makes a sub-optimal security issuance choice.
Jensen and Meckling (1976) find that agency costs are decreasing in managerial share ownership. Yet Stulz (1988) argues that agency costs are not necessarily monotonically decreasing in managerial share ownership as there exists an "entrenchment" range over which the manager's ability to deter takeovers dominates the "incentive" effect of managerial share ownership. We examine the relation between managerial share ownership and the likelihood, magnitude, and information content of security issues.
When negotiating debt covenants, creditors appear to respond to the fraction of shares held by the CEO. Begley and Feltham (1999) find that the number of covenants in debt contracts is increasing in the fraction of the firm's shares held by the CEO. This evidence suggests that managerial share ownership may be important to understanding the agency problems associated with security issuance. The evidence that creditors demand more covenants for firms with high managerial share ownership suggests that the creditor's concerns about agency conflicts are heightened when managerial share ownership is high. Share ownership appears to not only affect creditor demands but also the leverage choice. Friend and Lang (1988), Moh'd et al. (1998) and Nam et al. (2003) all conclude that leverage is decreasing in managerial share ownership.
We examine two important extensions of these lines of inquiry. First, while theory implies that managerial share ownership affects the agency costs associated with issuance, security issuance announcement returns have yet to be tied empirically to managerial share ownership, with the limited exception of Limpaphayom and Ngamwutikul (2004) in the case of seasoned equity offerings. Friend and Lang (1988), Nam et al. (2003), and Moh'd et al. (1998) all argue that their results indicate that agency problems are an important determinant of capital structure. While none of these investigators examine the valuation effects of these agency problems while controlling for outside blockholder share ownership, we do.
Second, none of the aforementioned papers reports whether the relationship between managerial share ownership and leverage change is monotonie over the range of managerial share ownership. These two gaps in the literature are addressed.
Over an intermediate range of managerial share ownership, firms issue significantly less debt than when managerial ownership is extreme. …