How do institutional investors dictate corporate cash holdings in a financially constrained environment?

Abstract

Institutional investors use voting power to influence firms’ financial decisions, such as their inclination toward large cash during heightened economic uncertainty and slack resource environment. This paper exploits agency theory and institutional channel in developing a theory-driven empirical apparatus to provide direct evidence that a country's political climate is instrumental in determining the extent financial constraints are an effective moderating tool for negotiating an optimal contract between the power of institutional investors and firms’ cash holdings. In our empirical narrative, we assert the punctuating role of legal frameworks on institutional investors’ actual influences on firms’ financial decision-making. By using a sample of 30,000 firms from selected emerging and developed economies over a period of two decades, a suit of endogeneity-mitigated dynamic panel regressions helps elicit a strong negative relationship between institutional ownership and corporate cash holdings. Our results indicate that institutional investors motivate firms to downsize excess cash. Furthermore, we document that financially constrained firms tend to hold more cash in both emerging and developed countries whereas firms in common-law countries (both developed and emerging) prefer less cash as compared to firms in civil law countries.