How Institutional Monitoring Creates Value: Evidence for the Free Cash Flow Hypothesis

Abstract

Institutional ownership of U.S. equities increased from 9.4% in 1980 to 42.9% in 2009. This paper analyzes the indirect role of institutional investors in monitoring firm managers and in the process of shareholder wealth maximization. Institutional monitoring reduces the agency problem of free cash flow. Controlling for reverse causality, we find that increased institutional ownership results in lower leverage and dividend payout that consequently lead to greater cash holdings and firm value. The results are consistent with the free cash flow hypothesis and provide an alternative explanation for why firms hold so much cash and why debt and dividends have decreased during the last thirty years.

Keywords: Agency problem, Free cash flow hypothesis, Institutional ownership, Cash holdings, Capital structure, Dividends

JEL Classification: G23, G32, G35