Suboptimal financial policies and executive ownership in the UK: evidence from a pre-crisis

• Date: 01 February 2016
• DOI: https://doi.org/10.1108/CG-01-2015-0005
• Published date: 01 February 2016
• Pages: 187-210
• Author: Alfonsina Iona,Leone Leonida
• Subject Matter: Strategy,Corporate governance

Suboptimal financial policies and

executive ownership in the UK: evidence

from a pre-crisis

Alfonsina Iona and Leone Leonida

Alfonsina Iona is based

at the School of

Economics and Finance,

Queen Mary University of

London, London, UK.

Leone Leonida is based

at the School of

Management and

Business, King’s College

London, London, UK.

Abstract

Purpose –The purpose of this paper is to identify firms in the UK adopting a policy of high cash and low

leverage and investigate how executive ownership contributes to this decision.

Design/methodology/approach –Firms following this policy are identified both by using a fixed

classification approach and the analysis of the distribution of cash and leverage. Logit analysis is then

used to estimate the probability of adopting the policy as a function of executive ownership.

Findings –Extreme financial policies are suboptimal as firms adopting these policies tend to

undershoot (overshoot) their target leverage (cash holdings) ratios. The impact of the

executive ownership on the probability of adopting this policy is U-shaped, in line with the alignment–

entrenchment hypothesis.

Practical implications –Despite the substantial presence of non-executive directors in the boards

and a significant amount of shareholdings by executive directors, the firms under analysis have adopted

suboptimal financial policies possibly because poorly governed or because executive ownership is the

range where entrenchment is feasible.

Originality/value –This is the first attempt at recognising policies of high cash and low leverage as

being explicitly interdependent. It is also the first study focussing on the UK, a country of interest,

because ownership structure is relatively dispersed. Moreover, instead of choosing fixed threshold

levels of the variable in defining the extreme financial policy, this paper proposes the analysis of the

distribution of cash holdings and leverage and accounts for target levels of cash and leverage.

Keywords Executive ownership, Extreme financial policy

Paper type Research paper

1. Introduction

The aim of this paper is to identify firms adopting financial policies of high cash and low

leverage and study the potential alignment/entrenchment role of executive ownership in the

probability of firms adopting such policies in the UK. To this aim, a sample of non-financial

UK firms adopting what we define extreme financial policy is identified, via both the

classification rules proposed in the literature and the analysis of the distribution of cash and

leverage. Then, a logit framework is used to estimate the likelihood of firms adopting

extreme financial policies as a function of executive ownership, holding constant a number

of other potential determinants.

Results suggest that a relevant proportion of firms in the UK adopts extreme cash and

leverage policies, and that these policies are suboptimal as these firms tend to undershoot

(overshoot) their target leverage (cash holdings) ratios. Results also suggest that the

impact of executive ownership on the probability of adopting an extreme cash and leverage

policy is non-monotonically U-shaped. Hence, in line with the alignment-entrenchment

hypothesis, results suggest that executive incentives towards extreme cash and leverage

policies depend on the level of executive ownership. The main implication of these findings

is that, despite the presence of a substantial representation of non-executive directors in

the UK boards and a large amount of shares held by executive directors, these firms have

Received 6 January 2015

Revised 18 November 2015

Accepted 19 November 2015

DOI 10.1108/CG-01-2015-0005 VOL. 16 NO. 1 2016, pp. 187-210, © Emerald Group Publishing Limited, ISSN 1472-0701 CORPORATE GOVERNANCE PAGE 187

adopted suboptimal financial policies either because of poorly governed or because of

executive ownership being in the range where entrenchment is feasible.

This paper adds to the existing literature on four main grounds. First, when the scope of the

researcher is identifying extreme financial policies, high-cash and low-leverage policies

have typically been used independently from each other. To the best of our knowledge, this

is the first attempt to study the extent to which the two policies co-exist. This decision is

theoretically well grounded. The pecking order theory predicts that firms should exhaust

internally available funds first and then resort to more expensive external debt and equity

financing (Myers, 1977;Myers and Majluf, 1984). Similarly, the agency theory suggests that

these policies are likely to coexist because managers have incentives to stockpile cash to

avoid the use of debt financing (Jensen and Meckling, 1976;Jensen, 1986). It is also

argued that, to the extent that substantial cash holdings point to current (or even expected)

financial constraints, firms with large cash balances are more likely to be restricted in the

access to external finance and hence follow low-leverage policies (Kim et al., 1998;Bates

et al., 2009). Hence, in an attempt to take a closer look at what constitutes a suboptimal

financial policy we take these theoretical suggestions on board and investigate high cash

and low leverage policies jointly.

Second, to the best of our knowledge, this is the first study analysing the impact of

executive ownership on financial policies of high cash and low leverage in the UK. The only

relevant studies in the area are Ozkan and Ozkan (2004), focussing on cash policy and

managerial ownership, and Florackis and Ozkan (2009), focussing on leverage policy

instead. The interest in the UK comes both from the relative scarcity of previous studies,

and because of the more dispersed ownership structure in this economy with respect to all

OECD countries that, in turn, makes the shareholders control over managerial opportunism

more difficult (Short and Keasey, 1999;Faccio and Lasfer, 1999). The peculiarity of this

economy also explains the choice of focussing on executive ownership, where higher

executive ownership and lack of efficient monitoring by financial institutions in the UK is

thought to lead to entrenchment (Franks et al., 2001;Goergen and Renneboog, 2001). In

addition, executive directors dominate boards in the UK (Vafeas and Theodorou, 1998;

Pass, 2004), and non-executives have an advisory role (instead of the disciplinary role) with

respect to the USA (Franks et al., 2001;Petra, 2005). Our study focuses on the role of

executive ownership, by holding as constant a number of variables which proxy for

financing frictions and precautionary motives to hold high cash and low leverage (Myers

and Majluf, 1984;Kim et al., 1998;Graham and Harvey, 2001;Hermalin and Weisbach,

2003;Bates et al., 2009). In a final attempt of isolating the impact of executive ownership

on cash and leverage policies from the impact of financing frictions and precautionary

motives, we exclude the period of the financial crisis which caused an immediate increase

(decrease) in cash reserves (leverage).

The third contribution our paper provides is methodological. When it comes to define the

extreme financial policies, previous empirical studies adopt fixed threshold levels of either

cash holdings or leverage. Building on this approach, the analysis used in this paper is

based both on these rules and on the non-parametric estimated distribution of cash

holdings and leverage. The latter enables the researcher to decide the point at which the

sample is split (cut-off point) based upon the shape of the distribution of the variable

without imposing any particular shape to the distribution and without imposing any priori

(and somewhat arbitrary) threshold. Not least, the approach based upon fixed

classification rule cannot account for the evolution of the distribution of leverage and cash

holdings over time that allows the cut-off points to change over time instead. This approach

is convenient because the distribution of these variables may change not because of the

role of executive ownership, but because of exogenous shocks to the economy.

Finally, we provide some evidence on whether extreme policies of high cash or low

leverage are optimal for these firms. Prior literature provides evidence that firms behave as

they have target levels of leverage and cash holdings (Opler et al., 1999; and

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