Managerial ownership and corporate investment under asymmetric information

Corporate investment faces the dual asymmetric information problem: managerial entrenchment (an internal moral hazard) and lack of complete information about firms’ productivity levels and consequent biased assessment of firm’s value in external financing (external adverse selection). While managerial entrenchment per se often tends to cause physical capital investment to exceed its profit-maximizing level, incomplete information in external financing may lead to not only over investment (to low-productivity firms) relative to its efficiency level but also under investment (to high-productivity firms). Such distortive impacts of dual asymmetric information on corporate investment can become complicated when managers are also shareholders of a firm.

Managerial ownership could either improve or worsen investment efficiency, depending on whether entrenchment cost exceeds potential entrenchment benefits. We model the effect of managerial ownership on corporate investment in two distinctive channels: while managerial ownership leads to improved alignment of interests between managers and shareholders, which helps with external financing, managerial entrenchment as an agency cost impairs external financing. As a result, there is a nonlinear relationship between loan availability/loan cost and managerial ownership. As equity financing is considered as a last resort after debt financing, how managerial ownership affects debt financing can eventually influence the scale of corporate investment through the firm’s financing constraint. Our research question is: In the presence of the dual asymmetric information problem, how sensitive are investment distortions to the managerial ownership-entrenchment nexus? Our model is anticipated to predict a non-monotonic influence of managerial ownership on corporate investment distortions.

We conduct sensitivity analysis of corporate investment behavior with respect to managerial entrenchment and managerial ownership for both the under investment regime and over investment regime. We then further investigate how the entrenchment effect on corporate investment changes with managerial ownership. The resulting theoretical predictions will be tested with the panel data of U.S. firms extracted from the Harvard Business School database - Research Insight/Compustat. Our empirical methodology concerns two steps: first, to estimate the investment benchmark and use the estimated residual to compile a measure of investment distortion; second, to regress the investment distortion against a set of control variables such as entrenchment index and managerial ownership among others.