How Do Financing Constraints Affect Firms’ Equity Volatility?: How Do Financing Constraints Affect Firms’ Equity Volatility?

Higher firm equity volatility is often associated with non-fundamental trading by investors or constraints on firms’ ability to insulate their value from economic risks. This paper provides evidence that an important determinant of higher equity volatility among R&D-intensive firms is fewer financing constraints on firms’ ability to access growth options. I provide evidence for this effect by studying how persistent shocks to the value of firms’ tangible assets (real estate) affect their subsequent equity volatility. The analysis addresses concerns about the identification of these balance sheet effects and shows that these effects are consistent with broader patterns on the equity volatility of R&D-intensive firms. I would like to thank Harry DeAngelo, Oguzhan Ozbas, Gordon Phillips, John Matsusaka, Michael Roberts, two anonymous referees, and seminar participants at the University of Hong Kong and USC Marshall School of Business for helpful comments. † University of Southern California, Marshall School of Business, 3670 Trousdale Parkway, BRI 308, Los Angeles, CA 90089-1427, U.S., E-mail: daniel.carvalho@marshall.usc. edu. 1 Firms experience substantial volatility in their equity value. Though most firm equity volatility is idiosyncratic, it matters for several reasons. For example, idiosyncratic volatility is important for determining portfolio allocations (Campbell et al. (2001)) and for the large number of investors that are imperfectly diversified (Campbell (2006)). It can also directly affect firm value in the presence of frictions, such as financing constraints, and plays a central role in a large literature studying corporate risk management policies. It also matters for large shareholders who might play an important corporate governance role (Shleifer and Vishny (1986)), managers who typically hold equity stakes due to compensation policies, and because it limits firms’ ability to provide incentives through these policies. Additionally, arbitrageurs who trade to exploit the mispricing of individual stocks face risks that are related to idiosyncratic return volatility. Therefore, larger pricing errors are possible when equity volatility is higher (Shleifer and Vishny (1997)). Finally, equity volatility plays an important role in the pricing of derivatives such as options on a given stock. While previous research suggests that firms’ cash flow fundamentals might play a significant role in explaining their equity volatility, we still have a limited understanding of the underlying economic factors determining the level of firms’ equity volatility. Understanding this link is important because, in its absence, higher firm equity volatility is often viewed as capturing non1 For example, see Froot, Scharfstein, and Stein (1990); Opler et al. (1999); Almeida, Campello, and Weisbach (2004); and Bates, Kahle, and Stulz (2009). 2 Even in the United States, large shareholders are important in most publicly traded firms (e.g., Amit and Villalonga (2009)). Panousi and Papanikolaou (2012) also provide evidence that ownership by insider managers is significant for a large subset of firms, especially small firms with high idiosyncratic volatility. Previous research has suggested, both theoretically and empirically, that greater firm-specific risks lead to weaker incentive contracts for managers and leads them to lower firm investment (e.g., Aggarwal and Samwick (1999); Lin (2002); and Panousi and Papanikolaou (2012)). 3 Variation in equity volatility across both firms and time is positively correlated with higher cash flow volatility (e.g., Pastor and Veronesi (2003); Comin and Philippon (2005); and Irvine and Pontiff (2009)). Moreover, decompositions of firm-level stock price fluctuations suggest that news about expected cash flows plays an important role in driving them (Vuolteenaho (2002)). 2 fundamental trading, such as noise trading or speculation, and motivates policies addressing it. Moreover, different interpretations for the underlying economic risks driving higher levels of firm equity volatility can lead to different implications. This paper studies the role of financing constraints in determining firms’ equity volatility. I argue that higher equity volatility can be a product of fewer financing constraints on firms’ ability to take advantage of growth options. When capital markets are imperfect, the availability of financial resources is a natural factor determining firms’ ability to access growth options. If uncertainty about future growth opportunities is an important source of risk for firms, and future investment opportunities can become highly valuable relative to current opportunities, then the following growth-options channel can become important. As financing constraints are relaxed, firms decide to largely preserve their increased access to liquidity to fund future potential growth opportunities, as opposed to finance their current investment. Consequently, firms are mostly affected through an increase in the value of unexercised growth options, and this leads to higher equity volatility. Given that R&D investments represent a major source of growth options, this growth-options channel is arguably most important for R&D-intensive firms. This channel suggests that higher levels of equity volatility among small and young firms, particularly R&Dintensive and innovative firms, might capture reductions in frictions usually associated with higher firm value and economic growth. 4 For example, see Stiglitz (1989); Summers and Summers (1989); Schwert and Seguin (1993); Davila (2014); and the references therein for discussions of policies addressing higher stock return volatility caused by non-fundamental trading. Previous research has provided evidence suggesting that non-fundamental trading such as noise trading or speculation by retail investors can be important in explaining firm stock return volatility (e.g., Brandt et al. (2010) and Focault, Sraer, and Thesmar (2011)). 5 According to this view, financing constraints cannot explain the greater volatility of small and young firms, which might be explained instead by their greater economic exposure to growth options. However, financing constraints can explain why such firms might have higher volatility in environments with fewer financing frictions limiting small and young firm growth. For example, Bartram, Brown, and Stulz (2012) provide evidence that U.S. firms have significantly higher equity volatility than similar firms in other countries. 3 The implications of financing frictions for firm equity volatility can be significantly different if these frictions mostly matter by shaping firms’ exposure to liquidity risks. Previous research argues that financing frictions lead to undesirable fluctuations in firms’ liquidity positions that can affect decisions such as firm investment (Froot, Scharfstein, and Stein (1990); Holmstrom and Tirole (1998); and Opler et al. (1999)). According to this literature, such liquidity risks reduce firm value and create a motive for financially constrained firms to attempt to reduce fluctuations in their value through risk management policies. Since firms might be limited in their ability to reduce their exposure to liquidity risks, a natural possibility suggested by these ideas is that higher financing constraints leads to increases in firms’ equity volatility as a consequence of such increased risks. Therefore, higher levels of equity volatility among small and young firms might be explained by greater financing constraints and liquidity risks, which might significantly reduce firms’ value and impose costs on their investors. Two main challenges arise in addressing the importance of these effects. First, it is necessary to identify some significant source of variation across firms in the importance of financing frictions. Second, it is necessary to empirically disentangle variation in the importance of these frictions from variation in the underlying economic conditions faced by firms. This paper addresses these challenges by examining the impact of persistent shocks to the value of firms’ real estate holdings. A large literature emphasizes how increases in the value of firms’ tangible assets can relax financing constraints and that shocks to the value of firms’ real estate holdings are an important and frequent source of shocks to the balance sheets of many firms. While 6 An important issue is that relaxed financing constraints will lead to endogenous changes in firms’ financial policies (e.g., higher leverage) that can also affect the volatility of firm value. This issue is addressed in the empirical analysis. 7 For example, see Hart (1995) and the references therein. Gan (2007) and Chaney, Sraer, and Thesmar (2012) provide evidence that increases in the value of firms’ real estate holdings lead to increases in their borrowing 4 R&D-intensive firms rely less on tangible assets, a significant fraction of R&D-intensive firms are potentially exposed to this source of variation in financing constraints. As a first step in the analysis, I illustrate the theoretical possibilities previously discussed in the context of a framework where firms make investment decisions subject to collateral constraints, and increases in the value of tangible assets relax financing constraints. Instrumented shocks to local real estate prices are then constructed by using differences across U.S. regions in the geographically determined availability of land, which leads different regions to have different exposures to national real estate cycles. I estimate the effect of shocks to the value of firms’ real estate holdings by combining these local real estate shocks with preexisting differences across firms in their exposure to real estate in their balance sheet. Based on this approach, I find that increases in the value of firms’ real estate holdings lead to significant increases in the subsequent volatility of their stock returns. Moreover, the