Do Shareholder Preferences Affect Corporate Policies ? – Job Market Paper –

This paper examines the preferences of institutional investors for firm policies and the relationship between these preferences and firm decisions. I find that institutions exhibit systematic differences in their preferences for financial and investment policies of the firms they invest in. Furthermore, these preferences are related to subsequent changes in the financial and investment policies of firms. In particular, a firm is more likely to decrease (increase) its leverage ratio if its current leverage is higher (lower) than the preferences of its institutional shareholders. A firm is also more likely to increase (decrease) its investment if its current investment ratio is lower (higher) than the revealed preferences of its institutional shareholders. Overall, the evidence in this paper suggests that the preferences of institutional shareholders are an important determinant of corporate policies. ∗PhD Candidate, Finance Department, McCombs School of Business, The University of Texas at Austin. Email: johan.sulaeman@phd.mccombs. utexas.edu. †I am particularly indebted to Aydoğan Altı and Sheridan Titman for their continuous guidance and support. I also thank Will Goetzmann, Jennifer Huang, Laura Starks, Andrey Ukhov, and seminar participants at University of Texas for valuable comments and suggestions. All errors are solely mine. Any comments and suggestions are welcome. It is well understood that different institutional investors have different investment styles and tend to hold stocks with different characteristics e.g., value versus growth. In this paper, I document that institutional investors also have heterogeneous preferences for financial and operating characteristics in the firms they invest in. For example, some institutional investors tend to hold stocks of firms that are underleveraged relative to other firms in their industries with similar characteristics, while others tend to hold stocks that are overleveraged. Furthermore, I show that the preferences of the institutional investors that hold a firm’s stock are related to the firm’s future financial and investment policies. Institutional investors can have heterogeneous preferences regarding the investment and financial policies of the firms they include in their portfolios for a variety of reasons. For example, investors can have different opinions on the potential growth opportunities in the economy. This can affect their preferences through several different channels. First, given a particular firm’s investment rate, some investors will avoid the firm’s equity because they feel that its managers are overinvesting or underinvesting relative to the investors’ expectations of the investment opportunities available to the firm or to the economy as a whole. At the same time, other investors will include the firm in their portfolios because they believe that its managers are making the correct amount of investment given the economic and industry conditions faced by the firm. Second, in the presence of agency issues due to the separation of ownership and control, investors with a negative opinion on growth prospects may prefer a higher amount of debt to reduce the amount of free cash flow available to managers and the flexibility managers have to invest in negative NPV projects (Jensen (1986)). This beneficial effect of debt comes at a cost as managers saddled with too much debt may underinvest and pass up positive NPV projects due to debt overhang (Stulz (1990)). Consequently, institutional preferences for leverage may be driven by their consideration of the cost, benefit, and effectiveness (relative to other governance mechanisms e.g., the board) of debt as a managerial disciplining tool. Institutional preferences for leverage may also be affected by other costs (e.g., potential distress costs) and benefits (e.g., reduction in tax payments) of debt.