Traditional explanations for why companies choose certain financial policies focus on firm-specific factors. For instance, all else being equal, firms with higher tax rates are likely to favor debt financing over equity financing, given the tax advantages of debt. However, growing evidence suggests that firms also take cues from their peers in selecting financial policies. Yet, it is unclear whether this approach is consistent with maximizing shareholder interests.
In a recent study, we examine the impact of firms’ external corporate governance environments on the propensity of firms to mimic their industry peers in the selection of financial policies. Managers of firms with strong corporate governance are likely to make financial policy and other decisions that are optimal for shareholders. In this case, managers might use information from the changes in the financial policies of peers to inform their own policy decisions. If doing so is consistent with shareholder interests, then the presence of these peer effects should be most apparent in firms with strong corporate governance.
On the other hand, managers in poorly governed firms may make financial policy choices which are either inconsistent with or even detrimental to shareholders’ preferences. Managers of firms operating under weak corporate governance may maximize their own benefit by minimizing the cost and effort of selecting optimal financial policies. Of course, shirking the responsibility to optimize financial policies may prompt scrutiny from financial or labor market participants. By mimicking industry peers in financial policy choice, managers may be able to avoid such scrutiny and minimize any effort to optimize financial policies. Under this argument, corporate peer effects should be more pronounced for firms operating in an environment of relatively weak governance.
To test these theories, we use accounting and equity data (from Compustat and Center for Research in Secuirty Prices, respectively) for nearly all publicly-listed, industrial companies from 1965 through 2014. External corporate governance is measured two ways. First, we use the concentration of institutional ownership from the Thomson Reuters Ownership Database as a proxy for corporate governance. Institutional owners with high ownership concentration have greater incentives to monitor the firm. Second, we use an index of the ability of a firm to be taken over (data available here). Protections from external takeover markets may entrench a manager, as there is little threat of disciplinary loss of control. We consider peer influence on the selection of firms’ leverage ratios, as this is a central financial policy decision for firms.
For both measures of corporate governance, the use of peer effects in the selection of leverage ratios is significantly more common for firms with relatively weak external corporate governance, suggesting that this is a manifestation of managers minimizing efforts to optimize financial policies. Supporting this interpretation, peer mimicking by managers in firms with weak corporate governance is concentrated in firms that operate in industries where it is most costly to identify optimal policies due to volatile cash flows.
The incentive to mimic peers to avoid the cost of optimizing financial policies may be offset by managers’ incentives to maintain high value in the labor markets, as labor market incentives may drive managers to increase firm efficiency. We also find that data bears this out. For instance, managers in weakly governed firms are more likely to mimic peers when their firm is also headquartered in a state with strong enforcement of non-competition agreements. Such enforcement promotes executive stability by increasing the cost of switching to other firms. However, this enforcement also reduces managers’ incentives to increase value in the labor market because of this stability. Further, we find that managers who seek to protect their reputation for creating efficiencies at weakly governed companies tend to engage in peer mimicking.
We also find two important implications for firms that mimic their peers in the selection of leverage. First, leverage ratios are less responsive to changes in the firms’ expected profitability, which typically has a significant influence on leverage choice. This suggests that such firms ignore firm-specific cues for an optimal policy choice.
Second, we find evidence that mimicking the leverage choices of successful peers with high leverage ratios may lead to significant and inadvertent financial risk. Mimicking firms with high leverage have a greater risk of default and, as a result, more expensive debt. These firms’ also have equity with a higher value for beta, a sign of high cost of equity financing. These findings suggest that higher financing costs can be an unintended consequence of mimicking peers. Further, these costs are especially high if the mimicking firm adopts a high leverage ratio.
In sum, we contribute to the growing literature in finance and accounting that suggests firms’ policies are influenced by observing the policies of peer firms. Peer mimicking in the selection of a firm’s leverage ratio occurs largely at firms with weak corporate governance, especially when not corrected by managers’ incentives to increase their value in the labor market. Further, this practice appears to be costly, because mimicking firms seem less sensitive to firm-specific factors that should influence leverage choice, and they adopt leverage ratios that result in greater financial risk.
This post comes to us from Professor Douglas J. Fairhurst at Washington State University and Yoonsoo Nam, a PhD candidate at the school. It is based on their recent paper, “Corporate Governance and Financial Peer Effects,” forthcoming in Financial Management magazine and available here.