Institutional Investment Horizons and the Cost of Equity Capital

• Published date: 01 June 2013
• Author: Sean Cleary,Najah Attig,Omrane Guedhami,Sadok El Ghoul
• Date: 01 June 2013
• DOI: http://doi.org/10.1111/j.1755-053X.2012.01221.x

Institutional Investment Horizons and

the Cost of Equity Capital

Najah Attig, Sean Cleary, Sadok El Ghoul, and Omrane Guedhami∗

Weexamine the influence of institutional investors’ investment horizons on a firm’s cost of equity.

Weargue that the cost of equity will decrease in the presence of institutional investorswith longer-

term investment horizons due to improved monitoring and information quality. Our empirical

results demonstrate that the cost of equity declines in the presence of institutional investors

with long-term investment horizons, all else remaining equal. Our results indicate also that the

monitoring role of long-term institutional investors is more pronounced for firms with higher

agency problems (poorly governed firms). Overall, our evidence suggests that when considering

the influence of institutional investors,it is critical to account for institutional heterogeneity, which

leads to new directions for future research.

Understanding the effect of institutional investors’ characteristics on firms’ cost of equity

remains important to practitioners and researchers for several reasons. First, it is important not

only for firm managers, investors, and portfolio managers, but also for the real economy as

the cost of equity plays a central role in corporate financing and capital budgeting decisions.

In addition, the corporate landscape has witnessed a dramatic increase in the shareholdings of

institutional investors, who became dominant players in the financial markets (Gillan and Starks,

2007). Moreover,although extensive literature exists regarding the role of institutional investorsin

the financial markets, it overlooks the influence of the heterogeneity of their investment horizon.

Indeed, much of the prior research assumes that institutional investors are a homogeneous group

with similar goals and investment strategiesand focuses on their governance role that is evidenced

in institutional ownership. This paper attempts to fill this void by investigating the monitoring

and information quality effects associated with the investment horizons of institutional investors.

To this end, we empirically examine the relationship between institutional investors’ investment

horizons (IIIH) and the ex-ante cost of equity implied in stock prices and analysts’ earnings

forecasts.

We surmise that the monitoring incentive and the information role of institutional investors

are related to their heterogeneity, as evidenced in their different investment horizons. This is a

reasonable assumption since it is easy to envision hedge funds sitting at the short-term (myopic)

We thank Bill Christie (Editor), two anonymous reviewers, Narjess Boubakri, Eric Brisker, Kershen Huang, and par-

ticipants at the 2012 Eastern Finance Association Meeting, 12th Symposium on Finance, Banking, and Insurance, 2011

Northern Finance Association Conference, 2011 FMA Applied FinanceConference, and 2010 Southern Finance Asso-

ciation for their insights on an earlier version of this paper. We appreciate generous financial support from Canada’s

Social Sciences and Humanities Research Council.

∗Najah Attig is an Associate Professor at Saint Mary’s University, Sobey School of Business in Halifax, Canada. Sean

Cleary is the BMO Professor of Finance at Queen’s School of Business at Queen’s University in Kingston, Canada.

Sadok El Ghoul is an Associate Professor at the University of Alberta in Edmonton, Canada. Omrane Guedhami is an

Associate Professorat the University of South Carolina in Columbia, SC and an Adjunct Research Professor at Memorial

University of Newfoundland in St. John’s, Canada.

Financial Management •Summer 2013 •pages 441 - 477

442 Financial Management rSummer 2013

end of this investment horizon spectrum versus the many traditional pension funds sitting at the

opposite (long-term) end. Investment horizons will vary in response to differences in institutional

investors’ client base, liquidity needs, and demographics (Gaspar, Massa, and Matos, 2005),

which may, in turn, lead to their having different governance and information roles.

We provide two interrelated predictions that may account for the impact of the investment

horizon of institutional investors on the cost of equity. The first relates to the role of the investment

horizon in altering the monitoring effect of institutional investors. In particular, we argue that

institutional long-term investment horizons, combined with large shareholdings, will result in

“relationship investing” (Chidambaran and John, 2000). As a result, the long-term investment

plans of institutional investors will likely favor monitoring over short-term trading. This, in

turn, will prevent managerial myopia and better align managers’ interests with those of their

shareholders, thereby reducing agency costs. The second channel relates to their informational

role. Due to their very nature, long-term institutional investors have an informational advantage

that stems from their ability to engage in quality research and collect and process corporate

information more efficiently than short-term institutional investors (Attig et al., 2012). This will

generate more precise information and, as a result, long-term investors will revise their beliefs

less frequently (Chen, Harford, and Li, 2007).

To test our prediction, we use a sample of 32,234 US firm-year observations from 1985 to

2007. Our findings suggest that the presence of institutional investors with long-term investment

horizons is associated with significantly lower equity financing costs. The evidence in this paper

is consistent with the governance channel of IIIH, as we find that firms with higher agency

problems (poorly governed firms) benefit from the effect of long-term institutional investors in

reducing the firm’s cost of equity financing. In contrast, when we partition our sample based

on a firm’s level of information asymmetry, we find that the effects on equity financing costs

of long-term institutional investors are not significantly distinguishable from those of short-term

institutional investors, refuting the information channel of IIIH in our sample. Overall, our results

are robust to including an extensive set of control variables, to using different proxies for IIIH,

and for firms’ cost of capital. Although we cannot fir mlyrule out the possibility that endogeneity

drives our results (due to omitted variables or reverse causality), we employ several controls and

conduct numerous robustness tests to alleviate the influence of endogeneity bias on our findings.

Our analysis of the direct impact of IIIH on firms’ implied cost of equity makes several con-

tributions to related research streams. First, this study adds to a broader line of research that

investigates the association between governance indicators and the financing costs of f irms. For

example, previous studies have focused on numerous attributes thought to proxy for information

quality, such as accounting attributes and disclosure (Francis et al., 2004, 2005; Hail and Leuz,

2006; El Ghoul, Guedhami, and Pittman, 2011), earnings quality and insider trading (Aboody,

Hughes, and Liu, 2005), multiple large shareholders (Attig, Guedhami, and Mishra, 2008), cross-

listing (Hail and Leuz, 2009), legal protection (Chen, Chen, and Wei, 2009), and shareholder

rights (Chen, Chen, and Wei, 2011). In addition, we contribute to the research regarding the

governance role of institutional investors bystressing the impor tance of their investment horizon

beyond their ownership stakes. Moreover, by providing evidence about the role of institutional

investors’ heterogeneity in equity pricing, this study extends the literature on the effect of share-

holder heterogeneity (Brickley, Lease, and Smith, 1988; Bagwell, 1991; Bushee, 2001; Gaspar

et al., 2005; Chen et al., 2007). Furthermore, by examining the impact of the investment horizon

on the implied cost of equity, this study departs from, yet complements, the recent line of re-

search addressing the impact of institutional shareholders’ investment horizon (or stability) on the

sensitivity of firms’ investment outlays to internal cash flows (Attig et al., 2012), market anoma-

lies (Cremers and Pareek, 2011), firm performance (Elyasiani and Jia, 2010), fir m debt costs

Attig et al. rInstitutional Investment Horizons and the Cost of Equity Capital 443

(Elyasiani, Jia, and Mao, 2010), equity returns (Yan and Zhang, 2009), postmerger performance

(Chen et al., 2007), and management bargaining position in acquisitions (Gaspar et al., 2005).

Last, but not least, by underscoring the heterogeneity of institutional investors, this study sug-

gests a new avenue for future theoretical and empirical studies to explore the role of institutional

investment horizon in shaping different corporate outcomes. We also identify a channel through

which markets and market participants can benefit and provide some guidance for regulatory

authorities. More specifically, by demonstrating that the presence of institutional investors with

stable shareholdings is associated with more efficient monitoring, evidenced by the lowercost of

equity, investors, and portfolio managers can consider the presence of such institutional investors

in their screening of stocks. It is also in the interest of firms (e.g., to f inance their growth oppor-

tunities at lower cost) and regulators (e.g., to maintain the stability of the market) to be aware of

the importance of providing incentives to institutional investors to increase the stability of their

shareholdings and sustain their relationship investing.

The rest of the study is organized as follows.In Section I, we review related studies and describe

our main hypothesis. In Section II, we describe our data construction and explain our empirical

models. Our results are discussed in Section III, while our conclusions are drawn in Section IV.

I. Related Literature and Hypothesis

The impact of institutional ownership has been the subject of a long and livelydebate. Much of

this work falls broadly into twostreams. One stream considers the level of institutional ownership

as a proxy for institutional activism.The conceptual roots of this line of research lie in the argument

of Shleifer and Vishny (1986) that large shareholders can exert a monitoring role in mitigating

managerial agency problems. However, empirical evidence regarding the economic impact of

institutional ownership has been inconclusive. For instance, McConnell and Servaes (1990),

Smith (1996), and Del Guercio and Hawkins (1999) find that institutional ownership positively

and significantly affects firm performance. Barabanov et al. (2008) determine that f inancial

institutions provide a fiduciary role, and that “percentage changes in institutional ownership

are correlated with public information available.” Similarly, Hartzell and Starks (2003) and

Chung, Firth, and Kim (2002) confirm that institutional ownership is associated with reduced

agency problems evident in opportunistic managerial compensation and opportunistic earnings

management, respectively. Yet several other studies express skepticism about the eff iciency of

institutional investors’ governance role, pointing to evidence that institutional ownership has a

neutral effect on firm performance (Demsetz and Lehn, 1985; Agrawal and Knoeber, 1996; Faccio

and Lasfer, 2000). The second stream addresses the activismof f inancial institutions by examining

the impact of their direct involvement in corporate governance. This stream has also reached no

consensus to date. For instance, Gillan and Starks (2007) find that corporate governance proposals

sponsored by institutional investors tend to receivemore favorable votes than those sponsored by

other investors, while Smith (1996) determines that news of a settlement between CalPers and

a targeted firm improved the firm’s stock return and operating performance. However, Pound

(1988) infers that institutional investors contribute to the entrenchment of incumbent managers

in proxy fights.

Most studies overlook the importance of institutional investors’ heterogeneity in shaping their

role in financial markets. Institutional investors share some commonalities, but they also differ

in their investment objectives and styles, and are subject to different regulatory restrictions and

competitive pressures (Yan and Zhang, 2009). These disparities may affect their informational and

governanceroles differently. Tobe sure, few studies have shed light on the relevanceof institutional