Private benefits of corporate philanthropy and distortions to corporate financing and investment decisions

• Published date: 01 May 2023
• Author: Ronald W. Masulis,Syed Walid Reza
• Date: 01 May 2023
• DOI: http://doi.org/10.1111/corg.12476

ORIGINAL ARTICLE

Private benefits of corporate philanthropy and distortions to

corporate financing and investment decisions

Ronald W. Masulis

1

| Syed Walid Reza

2

1

UNSW School of Business, University of New

South Wales, Sydney, New South Wales,

Australia

2

School of Management, SUNY at

Binghamton, Binghamton, New York, USA

Correspondence

Syed Walid Reza, School of Management,

SUNY at Binghamton, Binghamton NY 13902,

USA.

Email: sreza@binghamton.edu

Abstract

Research Question/Issue: This study examines whether private benefits of control,

as measured by corporate philanthropic activities, distort corporate financing and

investment decisions.

Research Findings/Insights: We find that corporate giving represents a private bene-

fit of control that distorts corporate investment and financing activity, consistent

with free cash flow agency theory. Corporate giving discourages managers from pur-

suing external financing, especially debt issuance, to minimize outside monitoring. It

creates preferences for internally financed cash acquisitions for the same reason.

These distortions reduce shareholder wealth. Following both the 2003 dividend tax

cut and hedge fund activism, corporate charitable contributions fall while investment

rises, suggesting suboptimal investment caused by managerial private benefit extrac-

tion. Acquisition announcements of firms making large charitable contributions show

negative stock market reactions that are more pronounced for acquirers with poor

corporate governance.

Theoretical/Academic Implications: Our findings suggest that due to agency prob-

lems and managerial rent extraction, corporate philanthropic activities can distort

corporate financing and investment decisions and yield corporate charitable contribu-

tion allocations that personally benefit a firm's CEO at shareholder expense.

Practitioner/Policy Implications: As corporate philanthropy imposes a significant

cost to shareholders, managers may seek shareholder approval on corporate philan-

thropic activities. The Securities and Exchange Commission may also require timely

disclosure of corporate donations.

KEYWORDS

corporate giving, corporate governance, private benefits of control, investment decisions,

financing decisions, hedge fund activism

1|INTRODUCTION

It has long been recognized that separation of corporate ownership

and control creates managerial incentives to extract private benefits

at the expense of shareholder wealth creation.

1

Since most private

benefit consumption is difficult to observe, assessing the importance

of such opportunistic behavior is a serious challenge to empirical

researchers. Consequently, existing studies resort to using various

indirect measures of managerial rent extraction such as price pre-

miums on the sale of controlling share blocks (Dyck & Zingales, 2004)

and the market value of a firm's liquid assets relative to its face value

(Faulkender & Wang, 2006). Existing studies document a few direct

channels of managerial rent extraction such as CEOs' private use of

corporate jets (Yermack, 2006) and excessive managerial

Received: 16 September 2021 Revised: 6 June 2022 Accepted: 9 June 2022

DOI: 10.1111/corg.12476

464 © 2022 John Wiley & Sons Ltd. Corp Govern Int Rev. 2023;31:464–490.wileyonlinelibrary.com/journal/corg

compensation (Bebchuk & Fried, 2004; Bertrand & Mullainathan,

2001) that lead to reduced firm value. In this study, we analyze corpo-

rate charitable activities as another important direct measure of CEO

rent extraction. We contribute to the literature by showing that mana-

gerial efforts to avoid restrictions on private benefit extraction by

external capital providers create economically important distortions in

corporate financing and investment decisions.

Concerns about the agency conflicts associated with the private

benefits of corporate philanthropy have a long history in the corpo-

rate finance literature (Atkinson & Galaskiewicz, 1988; Cai

et al., 2021; Cespa & Cestone, 2007; Friedman, 1970; Jensen &

Meckling, 1976; Masulis & Reza, 2015; Prior et al., 2008). To further

validate that corporate giving represents a form of managerial rent

extraction given its positive image as a social good, we investigate

whether the disciplining role of hedge fund activism leads to a signifi-

cant reduction in corporate charitable contributions. We find that

after a hedge fund acquires substantial firm ownership, corporate giv-

ing falls significantly as seen in Figure 1. These results are inconsistent

with the hypothesis that corporate giving is a shareholder wealth

maximizing decision (e.g., “trust hypothesis,”which argues that corpo-

rate giving can build up good relations and trust with stakeholders).

But this evidence is consistent with the hypothesis that corporate giv-

ing is generally a manifestation of a managerial rent extraction prob-

lem. We also find in later analysis that the negative relations of

corporate giving with firm financing and investment decisions are fun-

damentally different from the positive relations of advertising and

(even) employee matching grants, which prior research has shown to

increase firm value and employee morale.

2

Drawing on free cash flow theory, we hypothesize that consump-

tion of large private benefits such as corporate giving creates a mana-

gerial aversion to new external financing due to the threat of

enhanced scrutiny of corporate expenditures by external capital pro-

viders (Jensen, 1986).

3

To explore this issue, we first estimate a model

of net debt and equity issuances following Almeida and Campello

(2010) to capture firms' external financing patterns. We find that a

typical firm raises about 33.5 cents of new external capital for each

dollar of internal cash flow shortfall. If a firm's charitable contribution

rises from the 50th to the 90th percentile, then predicted external

financing falls by 7.5 cents, which represents a tangible 22.4% fall in

external financing level.

Consistent with managerial rent extraction, we find particularly

strong aversion to external debt financing. Specifically, modeling a

firm's net debt issuance in the spirit of Shyam-Sunder and Myers

(1999), we find that a typical firm raises about 94 cents of new debt

for every dollar rise in its financing deficit, which is defined as a firm's

uses of funds minus its sources of funds. Yet, new debt issuance

declines by 10.8 cents per dollar if a firm's charitable contributions

rise from the 50th to 90th percentile level. Given debt contracts both

require debt payments that reduce free cash flows and protective

covenants that are tied to minimum financial ratios, they discourage

managers from wasting valuable corporate resources since otherwise

they risk covenant violations, financial distress, or bankruptcy. More-

over, bank approvals of new loans involve a review of a firm's current

financial condition and expenditures. Our finding that new debt issu-

ance falls with corporate giving provides support for managerial aver-

sion to debt discipline prediction. We also show that these external

financing effects are more pronounced in firms where managers are

more protected from the corporate control market, serious product

market competition, and monitoring by institutional investors and cor-

porate boards, which are alternative governance mechanisms for

disciplining managers and limiting their extraction of private benefits.

The external financing effects are also more pronounced in firms

where managers are relatively more powerful and have less share

ownership, thus reducing their alignment of interests with outside

shareholders.

Corporate investment frequently requires external financing,

while managers extracting large private benefits have incentives to

avoid the added scrutiny of new external capital providers. Thus,

pursuing new investment inevitably creates tension for such man-

agers when they face limited internal funds to finance both capital

expenditures and their private benefits of control. In this environ-

ment, we evaluate how private benefit consumption affects current

investment decisions. When managers avoid monitoring by new

external capital providers, we find that corporate giving distorts the

relation between capital investment projects and internal sources of

financing as each dollar of charitable donations is one less dollar of

internal cash flow available to finance new corporate investment.

4

We find that the effect of corporate giving on corporate investment

is economically important. Using the mean cash flow of a typical

firm in our sample as a benchmark, we find that a rise from the

50th to the 90th percentile in corporate giving reduces investment

expenditures by approximately 1%.

5

To address endogeneity concerns in the above analysis of exter-

nal financing activities and investment, we conduct a quasi-natural

experiment. Specifically, we use the 2003 dividend tax cut, which

reduces individual income tax rates on dividends from 35% to 15%

(Chetty & Saez, 2005) and, thus, dramatically raises the after-tax cost

of private benefit consumption from 0.65 per dollar to 0.85 per dollar.

We find that after the 2003 tax code change, firms substantially

FIGURE 1 Average and median charitable contributions of

publicly listed Fortune 500 firms before and after hedge fund activism

(HFA) during 1998–2006. The darker (lighter) column presents

median (average) values

MASULIS AND REZA 465