The Dividend Policies of Private Firms: Insights into Smoothing, Agency Costs, and Information Asymmetry

We compare the dividend policies of privatelyand publicly-held firms in order to examine Lintner’s (1956) model of dividends, as wells as more recent agency-based and informationbased explanations of observed dividend behavior. Our findings suggest that both public and private firms exhibit a strong aversion to dividend cuts and omissions; however, public firms adhere to a consistent policy of small increases in dividends that result in a relatively smooth path of dividends that is largely insensitive to transitory earnings shocks. Private firms, on the other hand, immediately distribute a significantly larger fraction of transitory earnings shocks that leads to a relatively more erratic path of dividends. We also find that public firms distribute a larger fraction of earnings through dividends and that their dividend policies are more sensitive to investment opportunities and free cash flow relative to those of private firms, consistent with the importance of shareholder protection in mitigating agency conflicts. Miller and Modigliani (1961) show that dividend policy is irrelevant for firm value when markets are “perfect” and investment is held constant. However, both empirical (e.g. Allen and Michaely (2003)) and survey evidence (Lintner (1956) and Brav et. al. (2005)) strongly suggest that dividend policy is anything but irrelevant to managers and markets. Rather, corporate dividend policies exhibit very clear tendencies. In particular, dividends are “smoothed,” dividends are rarely decreased, and investors react positively to dividend increases and negatively to dividend decreases. While these stylized facts are well-established, the economic mechanism behind these facts that is, how and why firms decide about a particular dividend policy is not well understood. The most popular explanations for these facts come from theories predicated on either information asymmetry or agency problems between managers and shareholders. Under asymmetric information, dividends are used as a signal to convey information about future profitability (e.g., Bhattacharya (1979), Miller and Rock (1985), John and Williams (1985), and Bernheim and Wantz (1995)). In contrast, agency theories suggest that dividends are a means to mitigate perquisite consumption, empire building, or other value-destroying activities (e.g., Jensen and Meckling (1976), Easterbrook (1984), Jensen (1986), La Porta et al. (2000)). While both sets of theories are consistent with the link between dividend changes and the subsequent stock price reaction, other implications for dividend policy emanating from these theories have received mixed empirical support from a number of studies examining the dividend behavior of publicly traded firms. In this paper, we depart from the strategy of previous empirical studies by comparing the dividend policies of publicly-held firms with those of privately-held firms in the United 1 See Allen and Michaely (2003) for a survey of the relevant empirical evidence.