Does institutional ownership affect the cost of bank borrowing?
Introduction
Institutional ownership represents an important form of corporate governance which brings closer monitoring of executive activities along with pressure to reform governance to conform with best practices. These effects have grown in importance with the growth of institutional shareholding from 5% in 1945 to 56% in 2001 (Conference Board, 2003). At the same time, regulatory changes have made it easier for institutions to intervene in corporate governance in a more effective manner, and organizations have been established for the purpose of coordinating monitoring efforts among institutional investors.1 For example, in the US, the Council of Institutional Investors represents about 150 public, union and company pension funds with $3 trillion in assets. Anecdotal evidence further supports the active role of institutional investors in corporate governance. For instance, the Council of Institutional Investors sought to intervene as turmoil unfolded within Morgan Stanley between its CEO, Phillip Purcell, and former dissident directors.2
The present paper is the first to examine the impact of institutional ownership on bank loans. From a theoretical perspective, the presence of institutional investors may reduce the cost of borrowing since firms with greater proportions of institutional investors are likely to have lower agency costs due to better monitoring.3 At the same time, however, the presence of institutional equity investors may exacerbate the classic risk shifting problem, prompting lenders to charge higher spreads. Thus, the impact of institutional equity ownership on loan spreads remains an empirical issue.
In the closest antecedent to our research, Bhojraj and Sengupta (2003) find that greater institutional ownership reduces interest costs on public bonds consistent with lower agency costs. Bank loans, however, differ from bonds in several important ways that could potentially undermine the importance of institutional monitoring. Compared with holders of public bonds, banks can provide more effective monitoring at a lower cost due to their role as both insider lenders and delegated monitors (Diamond, 1984). In the former role, banks have easy access to firms’ information generated from previous business relationships. The intensive monitoring in the private loan market stands in sharp contrast to the lack of monitoring in the public bond market caused by the widespread free rider problem among public lenders. Further, private lenders’ incentive to monitor is reinforced by the fact that these lenders cannot cash out their position as easily as equity or bond investors.4
Taking these special features of bank loans into account, we investigate whether the negative relationship between institutional ownership and debt cost documented for public debt also holds in the loan market by employing a sample of approximately 7800 loans issued to a wide cross-section of US firms between 1995 and 2004. Following prior literature on loan pricing, we control for both firm characteristics and loan features found to have a significant impact on loan pricing. Our main results support both the hypotheses outlined above: the presence of institutional equity investors initially reduces loan spreads supporting the view that monitoring by these investors is a useful complement to bank oversight. Such benefits to borrowers decrease as the concentration of institutional equity ownership increases, thus documenting a “U”-shaped relationship between loan spreads and institutional equity ownership. Further, the more concentrated the equity ownership (i.e., distributed across fewer institutional investors) the greater the decrease in the loan spreads to the borrowers. This finding is consistent with an increasing amount of risk shifting as institutional ownership becomes highly concentrated. Finally, we also show that the initial reductions in loan spreads are significantly larger for firms with more pronounced information asymmetry consistent with the view that relatively greater gains are expected from institutional investors monitoring informationally opaque firms.
Our results are important for two reasons. First, the loan market constitutes an important laboratory for testing the role of governance because it is the most important source of external corporate financing for US firms and has distinctly different features from the corporate bond market.5 Second, the overwhelming majority of previous studies focuses on the impact of institutional investors on the equity side, exploring issues such as operational performance, firm value and major corporate decisions. As a result, research on loans has the potential to open a new window on the impact of institutional ownership on corporate governance.
The organization of this paper is as follows: Section 2 reviews relevant prior research and presents our hypotheses. Section 3 describes the data and the methodology and Section 4 presents our empirical findings. Section 5 provides the robustness checks while Section 6 concludes.
Section snippets
Literature review
A growing body of research supports the view that institutional owners monitor corporate activities including research and development, capital expenditures, anti-takeover amendments and executive compensation. After summarizing prior research in this area, Hartzell and Starks (2003) find that firms with more concentrated institutional ownership display greater pay for performance sensitivity and lower compensation levels. Further, institutional monitoring can improve the quality of information
Data and methodology
We draw on the SDC Syndicated Loan Database over the period 1995–2004 to collect loan information including the signing date, maturity, initial all-in-drawn spread, the identity of lenders and borrowers and loan size. The institutional ownership in each borrower is collected from the Thomson Financial 13F Database. A 1978 amendment to the Securities Exchange Act of 1934 (Rule 13F) requires all institutions with portfolios over $100 million under discretionary management to report their equity
Preliminary analysis
Before proceeding to the formal regression analysis, we divide the entire sample into deciles based on institutional ownership to obtain a general idea of the relationship between institutional ownership and the spread. We then compare mean spreads between adjacent deciles.
It is clear from Panel A in Table 2 that from Decile 1 (lowest institutional ownership) up to Decile 6, without exception, firms in deciles with lower institutional ownership pay higher spreads. Further, the t-tests on the
Sub-sample regression results
The main theme of this paper is that institutional owners play an active role in corporate governance and engage in monitoring which leads to a reduction in the cost of loans. In contrast, recent research has found that weaker governance in the form of anti-takeover provisions that entrench management can be favorable for debtholders. Klock, Mansi and Maxwell (2005) report that greater power of management to defend against takeover attempts is associated with lower costs of public bonds. The
Conclusions
Equity ownership by institutional investors has increased significantly during the past several decades motivating research on whether an increased role for institutional investors in corporate governance creates value for shareholders. Because this body of work has produced mixed results, it is useful to assess the role of institutional investors from a new perspective: that of corporate debt. In this vein, Bhojraj and Sengupta (2003) show that equity ownership by institutional investors can
Acknowledgements
The authors received valuable comments from the referee as well as from Franklin Allen, Donald Mullineaux, Jay Ritter, Paul Schure, Henri Servaes, and John Smithin. They also benefited from comments from audiences at the University of Arizona, York University, Ryerson University, the 2005 Northern Finance Association and 2006 Eastern Finance Association Meetings. Financial support for this research came from the Social Sciences and Humanities Research Council of Canada and the National Research
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