Institutional Investors and Corporate Investment

This paper investigates whether institutional investors influence firms’ investment in real assets and reduce the managerial agency conflict in investment choices. Institutional investors’ holdings of U.S. firms have gone from 10% of shares outstanding in 1960, to well over 60% in 2005. Importantly, given their significant ownership stakes and investment horizons, we expect them to closely monitor firm managers and to affect important firm decisions. Using a sample of 2,511 firms that had an IPO over the period 1980-2003, after controlling for investment opportunities, financial constraints and industry affiliation, I find that the larger the stake held by long-term institutional investors, the lower the level of capital expenditure. I also find that investment reduction occurs precisely in firms that suffer from over-investment problems. To identify firms that over-invest, following existing literature, I use proxies for a firm’ optimal level of investment and measure over-investment as the difference between a firm’s actual level of investment and the proxies for its optimal level of investment. The first proxy for optimal investment level is given by the level of investment that a firm should have after controlling for its investment opportunities, financial constraints and industry affiliation. The second proxy is a firm’s industry median level of investment. Besides these, I also focus on firms with large availability of cash flows and few investment opportunities with respect to their industry level since these are more likely to suffer from overinvestment problems. I find that in firms that clearly over-invest, firms with large availability of cash flows, few investment opportunities and investment above their optimal levels, an increase in the stake held by long-term institutional investors is associated with subsequent reductions in the level of over-investment. Results are robust to different methodologies used to capture over-investment and several econometric tests. Importantly, I find that reductions in capital expenditure are associated with subsequent improvement in both firms’ operating performance and stock market performance. This confirms that institutional investors’ intervention aimed at reducing agency conflicts is value enhancing and is beneficial to all shareholders.