Internal capital markets and financial constraints

Internal capital markets and financial constraints

Duchin (JF 2010) empirically finds that multidivisional firms with robust internal capital markets retain about half as much precautionary cash balances as highly specialized firms do. These multidivisional firms enjoy the benefits of coinsurance. This coinsurance reduces their exposure to distress risk and allows them to hold lower precautionary cash in contrast to their standalone counterparts. Duchin and Sosyura (JF 2013) mark a clear watershed between the bright and dark sides of internal capital markets. The bright-side view posits that multidivisional firms benefit from fewer information asymmetries while this benefit helps with better fund allocation (Naveen and Tice, JF 2001; Maksimovic and Phillips, JF 2002). The dark-side view suggests that multidivisional firms suffer from the divisional managers' pursuit of private interests in the form of managerial rent (Scharfstein and Stein, JF 2000; Rajan, Servaes, and Zingales, JF 2000; Ozbas and Scharfstein, RFS 2009). In multidivisional firms with robust corporate governance, social ties between the CEO and each divisional manager positively correlate with investment efficiency and firm valuation. In multidivisional firms with subpar corporate governance, social ties between the CEO and each divisional manager negatively correlate with investment efficiency and firm valuation. In essence, the bright and dark sides of internal capital markets often reflect the quality of corporate governance (in terms of the G-index, the E-index, or the index for anti-takeover provisions etc). Sound corporate governance limits managerial entrenchment and rent protection and therefore helps improve investment efficiency and firm valuation.

 

To the extent that corporate diversification relaxes the firm's financial constraints, this relaxation should manifest in the complementary metrics of financial-constraints risk. These metrics of financial-constraints risk include the Kaplan-Zingales index (Kaplan and Zingales, QJE 1997; Lamont, Polk, and Saa-Requejo, RFS 2001), the cash flow sensitivity of cash (Almeida, Campello, and Weisbach, JF 2004), the Whited-Wu index (Whited and Wu, RFS 2006), and the cash flow sensitivity of investment (Fazzari, Hubbard, and Petersen, BPEA 1988). The econometrician can use Tobin’s q excess value imputation to gauge the degree of corporate diversification. Also, the econometrician can calculate a wide variety of descriptive statistics, especially Sharpe ratios, across the full sample, the subsamples for dictatorship and democracy, and the excess-value decile ranks.

 

Financial constraints risk quantification follows several landmark empirical studies:

1. Almeida, Campello, and Weisbach (JF 2004) focus on the cash flow sensitivity of cash;
2. Faulkender and Wang (JF 2007) propose the marginal firm value of each incremental dollar of cash;
3. Bates, Kahle, and Stulz (JF 2009) recommend the secular time-series trend in cash-to-assets intensity;
4. Gao, Harford, and Li (JFE 2013) target cash-ratio adjustment speed via Fama-MacBeth cross-sectional regressions, mean-differencing and long-differencing panel regressions, and dynamic GMM panel regressions

 

Fama-MacBeth (JPE 1973) cross-sectional regressions help determine whether multidivisional diversification helps better decipher:

1. the empirical nexus between risk and return (in the form of both long-run Fama-French multifactor alphas and Sharpe ratios),
2. the firm-specific heterogeneity in M&A, R&D, and capital investment efficiency (in the form of short-run cumulative abnormal returns around the announcement date),
3. the firm-specific heterogeneity in operating performance (in the form of industry-adjusted ROA).

 

Fama-French (JFE 1993, JFE 2015), Carhart (JF 1997), and Hou-Xue-Zhang (RFS 2014) time-series regressions help assess whether greater corporate diversification yields econometrically significant long-run multi-factor alphas and Sharpe ratios. Further, the econometrician can carry out the event-time convention of Denis and Sarin (JF 2001), Chan, Ikenberry, and Lee (JFQA 2004), Titman, Wei, and Xie (JFQA 2004), and Chen, Chen, Liang, and Wang (JFQA 2014) to compare the abnormal returns for both corporate diversifiers and their standalone peers around major earnings announcements. Developing robust internal capital markets can yield tangible corporate diversification benefits in the form of higher Sharpe ratios, investment efficiency gains, and higher operating synergies in the long run. A geometric interpretation suggests that the better development of internal capital markets pushes the efficient frontier outward in the northwest direction.

 

An empirical analysis of the interaction between cash management and banking relationship management at Kauffman Firm Survey (KFS) private firms shines fresh light on the pure precautionary motive for cash stockpiles in the absence of agency conflicts. The econometrician develops the *banking relationship hypothesis* that private firms with multiple banking relationships retain less cash for precautionary motives in comparison to private firms with no banking relationships, even during tight credit years of the global financial crisis 2008-2009. Private firms with more multiple banking relationships have greater financial flexibility in the form of available debt capacity that private firms with no banking relationships appear to lack, especially under severe macroeconomic downturn conditions.

 

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