Corporate Governance and Investment Conservatism: Evidence from Industry Shocks

Abstract:     
This paper examines the effect of governance on firm investment in industry downturns. Existing work offers a variety of theories of governance and investment. We consider the governance-investment relation in a new and important setting. Large exogenous industry shocks increase the risk to managerial human capital. Self-interested managers can preemptively cut back on risky investments during negative industry shocks in an attempt to conserve the firm's cash flow and lower the chances of liquidation, thus preserving their human capital and stream of private benefits. Since poorly monitored managers have more discretion in investment policy, they exhibit greater conservatism in bad times.
Empirically, we test our conservatism hypothesis against competing predictions of overinvestment, shirking and quiet life. We find strong evidence in support of conservatism. Poorly monitored managers make greater cutbacks in risky investment in bad times. Internal mechanisms of monitoring, including institutions and boards, are more effective than the takeover market at mitigating conservatism. We do not observe significant governance-related differences in investment around positive industry cash flow shocks. The results are robust to a battery of sensitivity tests, including controls for other determinants of firm investment and potential endogeneity.

Keywords: corporate governance, investment, shocks, institutional ownership, anti-takeover protections

JEL Classifications: G31, G30, G34

Working Paper Series