Does executive ownership lead to excess target cash? The case of UK firms

• Published date: 02 October 2017
• Date: 02 October 2017
• DOI: https://doi.org/10.1108/CG-02-2017-0028
• Pages: 876-895
• Author: Alfonsina Iona,Leone Leonida,Alexia Ventouri
• Subject Matter: Strategy,Corporate governance

Does executive ownership lead to excess

target cash? The case of UK firms

Alfonsina Iona, Leone Leonida and Alexia Ventouri

Alfonsina Iona is Senior

Lecturer in Finance at

School of Economics and

Finance, Queen Mary

University of London,

London, UK.

Leone Leonida is Senior

Lecturer in Finance at

School of Management

and Business, King’s

College London, London,

UK. Alexia Ventouri is

Lecturer in Banking and

Finance School of

Management and

Business, King’s College

London, London, UK.

Abstract

Purpose –The aim of this paper is to investigate the dynamics between executive ownership and

excess cash policy in the UK.

Design/methodology/approach –The authors identify firms adopting an excess policy using a joint

criterion of high cash and cash higher than the target. Logit analysis is used to estimate the impact of

executive ownership and other governance characteristics on the probability of adopting an excess

cash policy.

Findings –The results suggest that, in the UK, the impact of the executive ownership on the probability

of adopting an excess cash policy is non-monotonic, in line with the alignment-entrenchment

hypothesis. The results are robust to different definitions of excess cash policy, to alternative

specifications of the regression model, to different estimation frameworks and to alternative proxies of

ownership concentration.

Research limitations/implications –The authors’ approach provides a new measure of the excess

target cash for the firm. They show the need to identify an excess target cash policy not only by using

an empirical criterion and a theoretical target level of cash, but also by capturing persistence in

deviation from the target cash level. The authors’ measure of excess target cash calls into questions

findings from previous studies. The authors’ approach can be used to explore whether excess cash

holdings of UK firms and the impact of managerial ownership have changed from before the crisis to

after the crisis.

Practical implications –The authors’ measure of excess target cash allows identifying in practice

levels of cash which are abnormal with respect to an equilibrium level. UK firms should be cautious in

using executive ownership as a corporate governance mechanism, as this may generate suboptimal

cash holdings and suboptimal firm value. Excess cash policy might be driven not only by a poor

corporate governance system, but also by the interplay between agency costs of managerial

opportunism and cost of the external finance which further research could explore.

Originality/value –Actually, “how much cash is too much” is a question that has not been addressed

by the literature. The authors address this question. Also, this amount of cash allows the authors to study

the extent to which executive ownership contributes to explain the out-of-equilibrium persistency in the

cash level.

Keywords Managerial ownership, Corporate governance characteristics., Excess cash policy

Paper type Research paper

1. Introduction

The large increase in corporate cash holdings over the past three decades has drawn the

attention of researchers on the determinants of corporate cash level. A strand of corporate

finance theory refers to the manager-shareholder agency conflict in explaining why some

firms choose to hold substantial cash reserves. Easterbrook (1984) and Jensen (1986)

argue that self-interested manager values financial flexibility, which allows him/her to

escape the capital market discipline. In trading-off investment and dividends versus

financial flexibility, the manager tends to give higher weight to the latter by accumulating

cash reserves. A relatively large empirical literature provides evidence that firms that are

subject to the manager-shareholder agency conflict tend to hold more cash. Large cash

Received 4 February 2017

Revised 25 April 2017

Accepted 2 May 2017

PAGE 876 CORPORATE GOVERNANCE VOL. 17 NO. 5 2017, pp. 876-895, © Emerald Publishing Limited, ISSN 1472-0701 DOI 10.1108/CG-02-2017-0028

holdings allow managers to consume large amounts of perks and/or to invest in negative

net present value projects that provide personal diversification benefits at the expenses of

shareholders (Myers and Rajan, 1998;Harford, 1999;Dittmar et al., 2003;Ferreira and

Vilela, 2004;Pinkowitz et al., 2006;Kalcheva and Lins, 2007;Dittmar and Mahrt-Smith,

2007;Harford et al., 2008). Contrary to the majority of these studies, Mikkelson and Partch

(2003) show that firms holding large amounts of cash do not perform any worse than other

firms, and high cash policies do not necessarily lead to value decreasing investments.

A number of studies have attempted to answer the long-standing question in corporate

governance about whether managerial ownership influences the firm cash policy. The

corporate governance theory argues that, if interests of managers are different from those

of shareholders, shareholders can use managerial ownership to make managers acting in

the best interest of shareholders. It is suggested that, while at low levels managerial

ownership ensures the alignment of managers and shareholders’ interests, at high levels,

it may lead to managerial entrenchment (Jensen and Meckling, 1976;Morck et al., 1988;

McConnell and Servaes, 1990;Stulz, 1988,1990;Jensen, 1993;McConnell et al., 2008). As

a result, the corporate governance debate on the effects of managerial ownership has

investigated the potential role of the alignment-entrenchment effect of managerial

ownership on cash policy.

The existing literature provides mixed results. Some studies find an inverse relationship

between managerial ownership and cash, while others find a positive or even a

non-monotonic relationship between managerial ownership and cash levels. The vast

majority of this research focuses on the US economy (Opler et al., 1999;Dittmar and

Mahrt-Smith, 2007;Harford et al., 2008;Akguc and Choi, 2013;Gao et al., 2013), despite

the evidence that executive directors in the UK are the second-largest shareholders class

(Florackis and Ozkan, 2009). The only exception which we are aware of is Ozkan and

Ozkan (2004) that, however, focuses on the impact of the managerial ownership, not

executive ownership, on the average cash level of UK firms. The underlying hypothesis is,

therefore, that executive and non-executive directors respond to alignment and

entrenchment effects in a similar way, although it is known that insider and outsider

directors have different theoretical roles and financial incentives (Fama, 1980;Fama and

Jensen, 1983). Also, a distinction between executive and non-executive equity stakes is

especially important from the perspective of UK Corporate Governance guidelines

(Cadbury, 1992;Higgs, 2003), which have specified the financial relationship of executive

and non-executive directors within the firm (Filatotchev et al., 2007).

As UK shareholders prefer to compensate non-executive directors with cash rather than

shares to protect their independence (Cadbury, 1992;Higgs, 2003), we do not expect cash

levels be significantly affected by non-executives’ shareholdings. On the contrary, we

expect it to be significantly affected by executive shareholdings (Florackis, 2005;Mura,

2007). In addition, while the Greenbury (1995) Report in the UK encourages executive

directors to build up shares, the Company Act 1985 confers to executive directors with 5

per cent voting stakes the power to propose counter-resolutions to resolutions proposed by

other shareholders and the obligation to disclose their strategic intent to shareholders only

when their equity stake is between 5 per cent and 15 per cent of the share capital. In light

of this, we expect that outside this range, executive directors might be more likely

entrenched. There is, indeed, evidence that UK boards become entrenched at higher

ownership levels than in their US counterparts (Short and Keasey, 1999;Mura, 2007).

The interest in shares held by executive directors is also reinforced by the evidence that,

in the UK, a lack of external market discipline and efficient monitoring by financial

institutions causes executive directors more likely to be entrenched (Franks et al., 2001;

Goergen and Renneboog, 2001). Differently from the USA, the UK boards are dominated

by executive directors (Vafeas and Theodorou, 1998;Pass, 2004) and non-executive

directors have a more advisory, rather than a disciplinary, role (Franks et al., 2001;Petra,

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