Organizational Capital and Investment‐Cash Flow Sensitivity: The Effect of Management Quality Practices

• Date: 01 September 2014
• Author: Najah Attig,Sean Cleary
• DOI: http://doi.org/10.1111/fima.12046
• Published date: 01 September 2014

Organizational Capital and

Investment-Cash Flow Sensitivity: The

Effect of Management Quality Practices

Najah Attig and Sean Cleary∗

This paper examines the influence of organizational capital, as evident in management quality

practices, on the response of firm investment to internal cash flows. We provide novel and strong

evidence that investment sensitivity to internal cash flows decreases in the presence of superior

management practices. We also find that superior management practices reduce the firm’s fi-

nancing frictions, evident in lower capital constraints. Our results are robust to numerous tests.

Overall, our findings suggest that intangible organizational capital is important for investment

decisions and that superior management practices contribute to value-maximizing behavior.

How does organizational capital, as revealedthrough f irm management practices, affect firms’

investment decisions? In this paper, we examine how organizational capital alters the sensitivity

of corporate investment to internal cash flows (or investment cash flow sensitivity ICFS]). Lev

and Radhakrishnan (2005) define organizational capital as “an agglomeration of technologies,

business practices, process and designs, and incentive and compensation systems” (p. 75) that

efficiently drives firm growth and outcomes. Consistent with this definition, as our proxy for

organizational capital, we use unique survey-based data on management quality practices (MQP)

at the plant level that have been demonstrated as a relevant and reliable measure of organization

capital (Bloom and Van Reenen, 2007). Management practices (organizational capital) differ

significantly from management style (human capital) in several important ways. While styles

may change significantly over a relatively short time due to management turnover, MQP remain

with the firm and do not change very easily or quickly. The impact of this continuity will likelybe

larger for manufacturing firms since they invest heavilyin production innovation and management

skills. We argue that superior MQP lead to a reduction in the information asymmetry problems

and agency costs faced by a firm.

We make several significant contributions. First, and perhaps most importantly, by examining

the effect of a survey-based measure of otherwise unobservable management practices, this study

departs from the burgeoning empirical line of inquiry that attributes unexplained differential in

∗Najah Attig is the Canada Research Chair of Finance and an Associate Professor of Finance at the Sobey School

of Business at Saint Mary’s University in Halifax, Canada. Sean Cleary is the BMO Professor of Finance at Queen’s

Business School at Queen’sUniversity in Kingston, Ontario, Canada.

The authors acknowledge, with much appreciation, the comments and suggestions by Raghu Rau (Editor), Steven N.

Kaplan, and Sandra Waddock. We also thank an anonymousreferee, Sadok El Ghoul, Omrane Guedhami, Brian Meagher,

Mohammad Rahaman, Ashraf Zaman, and participants at the Saint Mary’s University Finance Seminars, Dalhousie

University Mackay Finance Seminars, and the NFA 2011 meetings for their helpful comments and suggestions. Najah

Attig is particularly gratefulto Nicholas Bloom and John Van Reenen forgranting the right to use “management quality”

survey data and for providingvaluable comments. The authors appreciate the generous financial support from Canada’s

Social Sciences and Humanities Research Council.

Financial Management •Fall 2014 •pages 473 - 504

474 Financial Management rFall 2014

corporate outcomes to the fixed effects in panel data, often labeled as “managerial quality.” Thus,

we identify management practices and how they contribute to this previously documented, but

unexplored “fixed effect.” In addition, since management practices are considered an important

constituent of intangible organizational capital (Bloom and Van Reenen, 2007), our work adds to

the literature that stresses the relevance of firms’ intangible “organizational capital” in shaping

corporate outcomes.

Moreover, our study contributes to the voluminous ICFS literature dealing with the response

of corporate investment outlays to internal cash flows. We depart from previous approaches by

drawing on the literature concerning intangible organizational capital, behavioral economics,

and upper-echelon theory to emphasize the role of managers and MQP in shaping the re-

sponse of firm investment outlays to internal cash flows. In particular, by investigating the

impact of MQP on ICFS, we depart from extant studies that examine the link between tra-

ditional governance mechanisms (e.g., ownership structure, institutional investment horizon,

board structure, and Chief Executive Officer [CEO] compensation) and ICFS. In addition, our

sample is composed entirely of medium-sized manufacturing firms. This reduces systematic

biases introduced by firms in service industries, as they tend employ different processes and

structures.

Our main empirical result confirms that organizational capital affects the relationship between

firm investment and its internal cash flow. Specifically, we find that superior management

practices decrease investment sensitivity to cash flow. Additional tests suggest that superior

management practices reduce the firm’s financing frictions, evident in lower capital constraints

according to the commonly used measures of Kaplan and Zingales (1997), Whited and Wu

(2006), and Hadlock and Pierce (2010). These novel findings are strong and robust to a wide

array of checks. In particular, they are robust to the inclusion of a range of control variables

and a set of noise controls to mitigate biases across interviewers and types of interviewees. They

also hold when we control for potential endogeneity issues by implementing an instrumental

variables approach where we use a proxy for product market competition (i.e., the average value

of the Herfindahl-Hirschman index over the past three years), firms’ CEO succession policies,

as well as other measures related to management influence and/or competitive factors.1Our key

findings also hold after controlling for traditional governance mechanisms, such as institutional

ownership, institutional investmenthorizon, family ownership, and Gompers, Ishii, and Metrick’s

(2003) governance index, stressing the role of superior management practices as a distinct,

value-enhancing mechanism.

Taken together, our findings suggest that superior MQP lead to organizational performance

improvements. These improvements alleviate capital market imperfections and reduce capital

constraints. This reduces the wedge between the cost of internal and external financing, leading

to lower ICFS. More broadly, the findings of this study suggest that idiosyncratic management

practices map onto firms’ investment policies, adding credence to the value relevanceof intangible

assets and to the theoretical argument that corporate outcomes are reflections of management

practices and competencies.

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

describe our main hypothesis. Section II describes our sample construction and explains our

empirical models. Section III reports our main results, while Section IV presents the results of

our robustness tests. In Section V, we provide our conclusions.

1Wethank the editor for this suggestion.

Attig & Cleary rOrganizational Capital and Investment-Cash Flow Sensitivity 475

I. Literature Background and Hypothesis

A. Investment Sensitivity to Cash Flow

Contrary to the assumptions behind Modigliani and Miller’s (1958) frictionless world, the

investment decisions of the firm have been shown to depend upon its financial situation. This

is the case as agency costs and asymmetric information problems create a “wedge” between the

cost of internal and external funds, resulting in a positive and significant relationship between

investment outlays and internal cash flow availability. Numerous studies, including the seminal

work of Fazzari, Hubbard, and Petersen (1988), Almeida and Campello (2007), and Beatty, Liao,

and Weber (2010), find that more financially constrained firms display higher ICFS than less

constrained firms.2

In contrast, however, Kaplan and Zingales (1997) confir m that less constrained firms display

higher ICFS, a result also documented in Cleary (1999) and several subsequent studies. These

studies stress the influence of financial health on ICFS. Other studies have subsequently attempted

to resolve these apparently contradictory results. For example, Cleary, Povel, and Raith (2007)

stress the importance of employing a reliable proxy for the marginal cost of capital reflecting the

level of market imperfections faced by the firm. Other studies cast doubt on ICFS as a measure

of financial constraint by demonstrating that these relationships are particular to fir ms with only

positive internal cash flows or that theychange over time (Allayannis and Mozumdar, 2004; Agca

and Mozumdar, 2008; Brown and Petersen,2009; Chen and Chen, 2012). Of par ticular relevance

to our study, Kaplan and Zingales (2000) advocate that managers, through their conservatism or

nonoptimizing behavior, play an important role in shaping ICFS. Further, Bertrand and Schoar

(2003) provide evidence that manager fixed effects explain, to an important extent, the hetero-

geneity in the sensitivity of investment to cash flow. We depart from previous approaches by

emphasizing the role of MQP in shaping the response of firm investment outlays to internal cash

flows.

B. Organizational Capital, Management Quality, and Corporate Actions

Our study contributes to the line of research that stresses the relevance of firms’ intangi-

ble organizational capital as a major driver of firms’ (and national) growth and competitive-

ness (Youndt, Subramaniam, and Snell, 2004; Lev and Radhakrishnan, 2005; Berk, Stanton,

and Zechner, 2010, among others). Our approach of quantifying organizational capital us-

ing survey data on management practices has been used in related studies (Black and Lynch,

2001, 2004; Bloom and Van Reenen, 2007). Graham, Li, and Qui (2012) also use a survey-

based method to quantify behavioral traits of executives and provide insight regarding the

people and processes behind corporate decisions. While these studies provide persuasive evi-

dence concerning the link between MQP and organizational performance, little has been said

about the precise channels through which MQP exert this effect. We address this issue, ar-

guing that MQP alleviate capital market imperfections, which decrease the sensitivity of a

firm’s corporate investment outlays to internal cash flows and lead to improved corporate

performance.

While several studies attribute unexplained differentials in corporate outcomes to managers’

fixed effects (e.g., Bertrand and Schoar, 2003; Bamber, Jiang, and Wang, 2010, among many

others), Demerjian, Lev, and McVay(2012, 2013) criticize the diff iculty in implementing the fixed

2Hubbard (1998) provides a reviewof the literature and empirical evidence.