Financial Constraint, Liquidity Management and Investment[*]
Timothy J. Riddiough
School of Business
University of Wisconsin-Madison
Zhonghua Wu
School of Business
FloridaInternationalUniversity
This Draft: November 2007
Abstract
Investment and liquidity management are analyzed in a sectorwherefirms are exogenously cash flow constrained. Across the entire sector, we find high investment sensitivity to both qandmeasures of financial market frictions. Liquidity is managed through cash retention (dividend) policy and access to short-term bank finance, in which bank line of credit smoothes variation in available cash flow and accelerates investment. We show that cash flow constraint is not equivalent tofinancial constraint, where more (less) financially constrained firms in our sample exhibit high (low) investment and liquidity management sensitivity to variables that measure financial market frictions.Empirical results provide support for debt overhang, free cash flow and asset tangibility as important financial market frictions that influence investment outcomes.
Financial Constraint, Liquidity Management and Investment
1. Introduction
Fazzari, Hubbard, and Petersen (1988) convincingly argue that internal versus external sources of finance are imperfect substitutes in the context of funding investment, and hence that financial constraints impede the efficient allocation of resources. Their study has had wide impact, and has come under intense scrutiny.
Critics, beginning with panelists that provided comments and discussion published alongside the original Brookings paper, have generally focused on threeinstrumental issues: i) endogeneity of financial constraint proxies; ii) measurement error in Tobin’s q; and iii) omitted variables and channels that provide more complete information about the link between financial market frictions and real investment outcomes. Chirinko (1993) concisely summarizes these concerns by stating, “It is unclear whether significant liquidity and net worth variables are capturing a structural element heretofore missing in the investment equation or are merely reflecting a general misspecification.”
Previous studies have addressed one or two of theseinstrumental issues at a time, but none have addressed all three in a systematic and comprehensive manner. For example, Whited (1992) and Kaplan and Zingales (1997) primarily address the financial constraint issue, while Erickson and Whited (2000) focus on measurement error in q and Almeida, Campello and Weisbach (2004) emphasizethe link between cash flow sensitivity of cash holdings and financial constraint. The intent of this study is to address all three issues—endogeneity of financial constraint proxies, measurement error in q, and omitted variables/channels—simultaneously and comprehensively in order to provide additional perspective onthe effects of financial constraint on investment decisions.
To address endogeneity in the financial constraint proxy and measurement error in q, we analyze a specific sector that provides an attractive natural economic laboratory: publicly traded firms that own commercial real estate assets in an investment vehicle called a Real Estate Investment Trust (REIT). These firms are regulated to pay out at least 90 percent of their GAAP net income as dividends, and mostpay out at least 100 percent of GAAP net income to avoid negative tax effects. This implies that the entire sector is constrained in its ability to retain cash, andtherefore depends heavily on external finance to fund investment, which mitigates concerns over confounding effects in identifying constrained firms. These firms also have well measured q values, due to the competitive nature of the industry and characteristics of the underlying commercial real estate assets.
The third instrumental issue revolves around omitted variables and resource channels. We make two contributions in this regard. First, we recognize that cash is not a sufficient statistic for available liquidity. Firms will vary in their capacity and need to hold liquidity, and may decide to hold less internal liquidity when low-cost external sources such as bank lines of credit (L/C) exist. Consequently, firms that might appear to be liquidity constrained may in fact have more than adequate stores of liquidity when external sources are recognized. Second, we specify and estimate a structural model that accounts for endogeneity in cash flow retention, bank L/C usage, and investment decisions. Cash flow retention and bank L/C usage together account for a firm’s liquidity management policy as related to investment, where simultaneous consideration allows us to better disentangle cause and effect as well as to better assess investment-cash flow and other sensitivities that have been a focus in the literature.
A unique panel data setcovering the years 1990-2003 has been assembled to analyze these issues. Preliminary analysis shows that REITs retain less cash flow, have a lower stock of cash, and use more bank L/C than a broad cross-section of other publicly traded firms. In other words, based on these measures, REITsappear to be financially constrained. We also find that REIT bank L/C usage increases monotonically with investment. This suggests that, in the short run, and given their significant constraints on cash flow retention, bank L/C substitutes for internal cash in funding investment.
Full sample structural 3SLS estimation produces a number of noteworthy results. First, in the investment equation, q and the liquidity flow measures of retained cash flow and bank L/C use all significantly affect investment, with coefficient estimates that imply high investment sensitivities. Investment sensitivity to q is such that the elasticity of investment with respect to q is just shy of one, which places it near what standard q-theory would predict.Given the cash flow constraints faced by REITs together with the fact that commercial real estate assets are tangible with significant debt capacity, high investment sensitivity to both retained cash flow and bank L/C use is consistent with effects of asset tangibility (Almeida and Campello (2007)) and incentives to accelerate current investment in order to create additional external financing capacity in the future (Hennesey, Levy, Whited (2007)).
Across the full sample, firms are seen to invest at a rate of approximately 20 percent per year, which exceeds rates of investment by the broad cross-section of comparison industrial firms. Moreover, most REITs pay well in excess of the minimum dividend payout requirement. This raises the issue of whether these cash flow constrained and equity dependent firms are really financially constrained. In other words, why is external finance available and affordable to these firms?
We conjecture thatlimited discretion on cash retention mitigates adverse selection costs associated with raising outside finance. This chain of reasoning implies that, contrary to conventional wisdom that emphasizes the primacy of information-based costly external finance as a premier financial market friction, cash flow constraints and equity dependence are not sufficient conditions for financial constraint.
To differentiate between the effects of cash flow constraint and financial constraint on investment and liquidity management, we split the sample based on Kaplan and Zingales’ (1997) methodology for indexing financial constraint. Based on KZ index scores, we find the more constrained sub-sample invests less, generates lower cash flow and has a lower stock of cash, pays fewer dividends, employs more leverage, and is less likely to maintain relationships with bank lenders and security underwriters. In other words, the KZ index method appears to accurately classify firms in our sample as more or less financially constrained.
Simultaneous equation estimation reveals substantial differences between firms that are more versus less financially constrained. Consistent with arguments of Gomes (2001), the less financially constrained firms are responsive to investment signals contained in their stock prices, while the more constrained firms are not. This outcome refines results of Baker, Stein and Wurgler (2003), who do not differentiate equity dependent firms on the basis of financial constraint.
Sensitivityof investment and liquidity management to proxies for financial market frictions is generally much higherin the sub-sample of more financially constrained firms. For example, cash retention policy responds to a number of variablesin the financially constrained sub-sample of firms, including investment. Establishing a statistically significant link between dividend policy and investment is a new result (see Fama and French (2002) for additional background), in which firmsdecrease their dividend payout when investment increases—presumably to redirect scarce cash flowaway from shareholders towards capital acquisition. Variables that causedividend payout to increase in the more constrained sub-sample include equity issuance, a positive change in bank L/C capacity and a positive change in bank L/C use. None of these variables have any effect on dividend payout in the less constrained sub-sample.
Stark differences between sub-samples also exist with respect to bank L/C usage. An extra $1 of retained cash flow causes L/C usage to decrease by more than $1 in the more constrained sub-sample, whereas retained cash flow has no effect on L/C use in the sample of less constrained firms. Thus, more financially constrained firms treat cash as negative short term debt by saving cash out of cash flow, whereas cash constrained but less financially constrained firms do not. Consistent with Sufi (2007), these results suggest that financially constrained firms closely monitor their bank L/C use due to concerns over covenant violations that would impose significant additional costs. Bank L/C use is also highly responsive to investment, leverage and firm age in the more constrained sub-sample, while there is either less or no responsiveness to these effects in the less constrained sub-sample.
Thus, we show that cash flow constraint is not the same thing as financial constraint. Sub-sample estimation reveals thatcash flow constrained firms that are classified as financially constrained are highly responsive to shocks in variables that proxy for financial market frictions. Higher cash flow results in a simultaneous paydown inbank L/C use and increase in investment, achieved in part through reduction in dividend payout. Less financially constrained firms, in contrast, exhibit stability in their dividend policy with no sensitivity to investment or L/C use. These findings point to the importance of agency costs over information-based costs of external finance in governing investment and liquidity management policies of financially constrained firms. Our resultsare also generally consistent with cash flow focused liquidity management effects emphasized in Almeida et al. (2004) and Almedia and Campello (2007).
The paper is organized as follows. Section 2 provides further background on REITs and bank L/C usage. Hypothesis development and empirical model specification are addressed in section 3. Data are described and a preliminary analysis of the data are reported and analyzed in section 4. Simultaneous system equation estimation for the full sample is undertaken in section 5, and sub-sample results are considered in section 6. Section 7 concludes the paper.
2. Further Background on REITs and Bank Lines of Credit
The data employed in previous studies of corporate investment generally have limited and noisy variation. One solution to the problem is to apply alternative specifications and more sophisticated econometric analysis (see, e.g., Hoshi, Kashyap and Scharfstein (1991), Erickson and Whited (2000)). A more direct solution is to try to obtain better data. We emphasize the latter approach, and examine the Real EstateInvestment Trust (REIT) sector.
The REITsector, for several reasons, provide an attractive natural laboratory to study the effects of financialmarket frictions on firm investment. First, all REITs are cash flow constrained by regulation, as they are required to payat least 90 percent of taxable income toshareholders in the form of dividends.[1] After accounting for the effects of depreciation and the fact that most REITs pay in excess of the minimum payout requirement, 65 to 90 percent of current cash flow is typically paid out as dividends.[2]Cash flow constraints of this magnitude are typically thought to imply financially constraint due to the presumed high costs of accessing external finance. Consequently, based on this logic, exogenously imposed cash flow constraints substantially reduce endogeneity problems associated with identifying financially constrained firms.
Combined adjustment and purchasing costs of investment should not exceed the shadow value of newly installed capital. Shadow value follows frominvestor expectations of the marginal contributions of new capital gains to future profit. In theory, marginal q provides a direct (isomorphic) measure of the shadow value of capital. Marginal q is generally unobservable in the data, however, so analysts rely on average q. If marginal q is badly measured by average q, an investment-cash flow relation may be a spurious, as current cash flow may contain information regarding investment opportunities.
Hayashi (1982) has shown that average q is a sufficient statistic for investment when the following necessary conditions are satisfied: i) there is perfect competition in factor and product markets, ii) fixed capital is homogeneous, and iii) product and adjustment costs are linearly homogeneous.Commercial real estate asset markets and the firms (REITs) that own these assetssatisfy these conditions to a remarkably close approximation. The factor market is primarily land and physical capital, with relatively little reliance on human capital, and these markets are generally quite competitive. Competitive market structure is important, since imperfectly competitive industries will generate quasi-rents that can cause a spurious correlation between cash flow and investment after controlling for averageq (Abel and Eberly (2001), Cooper and Ejarque (2003)).
A large proportion of real estate asset operating expenses go topay utilities, insurance and property taxes, which are effectively linear in scale. Investment, which in this sector is primarily the acquisition of built (productive) assets, results in adjustment costs that are linearly homogeneous. Furthermore, investment in built assets requiresvery little “time-to-build”, and also contain little option value that potentially distorts the marginal-average q relation. In addition, regulation requires REITs to be monoline (non-integrated) companies.This suggests that imperfect product substitution that confounds many multi-product firms is less problematic with REITs, which strengthens the link between average and marginal q.[3]Finally, there are no taxes at the entity level to distort investment incentives.
Compounding theusualmarginal q–averageq measurement error problem is that average q is often badly measured in the data due the reliance on asset book values to proxy for the replacement cost of firm assets. As Hartzell, Sun, and Titman (2006) and others have pointed out, however, book asset value is a relatively accurate measure of replacement cost with commercial real estate assets. For example, they report a correlation of .92 between their book asset measure of q and a net asset value measure of q that is based on market sales data.
To begin to get a sense of the data, Figure 1 shows how average q varies by year for REITs in our sample, where q is defined as market value of equity plus book value of debt divided by asset book value as of the beginning of the year. Quartile cutoff values are displayed in addition to mean values. Mean and median q values generally exceed 1.0 over the sample period, but not by a large amount. It is also apparent that there is significant cross-sectional variation in q values in the early years of the sample period (particularly in 1992 and 1993), whereas this variation decreases after 1994.
Figure 1 Here
In Figure 2 the time-series of average qand rates of investment by year as a percentage of year-beginning asset value are displayed. There is a clear direct contemporaneous relation between investment and average q, with cross-correlation measured at .78. Note that investment is in the 10 percent range for most years, but that the years 1995-98 resulted in higher rates of investment that generally exceeded 20 percent of year-beginning book assets.
Figure 2 Here
In their analysis of the REIT sector, Ott, et al. (2005) document that only seven percent of firm-level investment was funded by retained cash earnings, as compared to 70 percent for other publicly traded firms. Because of their inability to retain cash, REITs rely on outside financing sources to facilitate investment. Seasoned equity, long-term unsecured debt, and secured mortgage debt are the claims typically issued to permanently finance acquisitions (see Brown and Riddiough (2003) for additional background).
In the short term, REITs rely heavily on bank lines of credit (L/C) to fund investment.[4],[5] The typical funding cycle is as follows. A firm identifies an investment opportunity, which often requires partial or full payment atclosing. Anticipating these investment opportunities, the firm arranges a bank L/C with sufficient capacity to meet its liquidity needs. The bank L/C is drawn down to fund the investment, where the firm subsequently begins to work with an investment or commercial bank to secure permanent sources of finance. Once there is sufficient scale, equity or long-term debt is issued with proceeds used to pay down bank L/C and hence recreate capacity to fund the next round of acquisitions.