Public firms are increasingly connected through institutional investors’ stock ownership, largely due to individual investors who invest excess cash and retirement savings through financial institutions. Firms with institutional cross-ownership have institutional stockholders with significant stakes in other firms within the same industry. Cross-ownership presents interesting and important dynamics, because an investor, the cross-owner, has an incentive to maximize welfare through joint ownership of the different firms. The investor also has access to private information about the firm’s peers. In a new paper, we examine how cross-owners affect a firm’s ability to raise capital for investment.
Investment opportunities are vital for generating shareholder value. After such an opportunity arises, a firm typically goes through a cycle: financing, making the investments with that financing, and engaging in operations to produce and sell the resulting product. Not surprisingly, investors care about adverse selection and post-financing concerns such as agency, information asymmetry among investors, and product market competition. Existing theories and empirical evidence provide contrasting predictions about how cross-ownership can affect corporate financing in the face of investment opportunities.
Some findings suggest that capital providers can benefit from the presence of institutional investors with cross-ownership, which should facilitate the financing of investment opportunities. In particular, there is evidence that these institutional investors can use their information advantage from multiple shareholdings to generate positive post-financing effects. First, adverse selection and post-financing agency problems are important considerations when a firm tries to obtain financing. There is evidence that institutional cross-ownership is associated with better shareholder monitoring. That evidence includes more frequent firings of poorly performing CEOs, greater likelihood that cross-owners will vote against management on shareholder-sponsored governance proposals, and improved financial reporting. There is also evidence that institutional cross-ownership facilitates product market coordination, perhaps as a result of cross-owners’ knowledge about different firms. Firms with cross-owners benefit from product market collaboration such as within-industry joint ventures and experience greater innovation and operating profitability. From the perspective of its capital providers, greater product market coordination can reduce financial risk.
On the other hand, cross-owners can make investors more concerned about losses from adverse trades and self-dealing, thus hindering the financing of investment opportunities. First, potential capital providers might be concerned that institutional cross-owners use their information advantage to engage in trades that are adverse to other shareholders. For example, using information gleaned from other firms, cross-owners could sell (buy) shares after gaining knowledge of news that is good (bad) for the firm. Concerns about the potential for adverse trades by existing cross-owners are akin to investors’ concerns about insider trading. Further, institutional cross-owners might induce firms to engage in self-dealing that expropriates the wealth of other capital providers. An institutional investor with cross-ownership has the incentive to trade-off the interest of one firm against another cross-held firm in order to maximize the benefits of jointly owning multiple firms. Self-dealing can take many forms, such as intercorporate loans and transfer pricing.
Ultimately, it is an empirical question whether institutional cross-ownership facilitates or hinders the corporate financing of investment opportunities. Improved monitoring of agency problems and better product market coordination predict a positive association between institutional cross-ownership and corporate financing, whereas concerns about losses from adverse trades and self-dealing predict a negative association.
Using a large sample of U.S. firms from 1981 to 2016, we find that firms with institutional cross-ownership obtain more external financing when they have investment opportunities, consistent with investors expecting better post-financing outcomes when institutional stockholders are present. When investment opportunities are available, firms with cross-ownership are able to obtain more than double the external financing compared with those without it.
Further, we find that the effect of institutional cross-ownership on corporate financing is stronger when there is less publicly available information about the firm. This finding suggests that, when providing additional capital to fund a firm’s investment opportunities, capital providers take into account the role of institutional cross-owners by using their private information to monitor opaque firms. Nevertheless, we do not find that product market competition results in a stronger (or weaker) effect of cross-ownership on the financing of investment opportunities.
Finally, we document that the effect of institutional investors with cross-ownership on the corporate financing of investment opportunities is stronger when the investors have a longer investment horizon. This result further indicates the advantage of having private information in the hands of long-term investors, who are more attentive to monitoring. Consistent with cross-ownership facilitating the financing of investment opportunities, we also find that firms with institutional cross-ownership make more capital and R&D investments.
Our paper contributes to the literature on the factors that influence providers of capital. Our paper contrasts with and complements this literature by investigating how cross-owners can facilitate a firm’s financing of investment opportunities Consistent with prior literature, we find evidence that suggests capital providers take into account how effectively cross-owners monitor agency problems.
This post comes to us from Professor Yangyang Chen at Hong Kong Polytechnic University, Professor Qingyuan Li at Wuhan University, and Professor Jeffrey Ng at Hong Kong Polytechnic University. It is based on their recent paper, “Institutional Cross-Ownership and Corporate Financing of Investment Opportunities,” available here.