Managerial Entrenchment and Capital Structure: The Effect of Diversification

Abstract

This paper empirically examines how diversification influences the relation between corporate governance and capital structure. Consistent with the creditor alignment hypothesis, we find a positive relation between managerial entrenchment and leverage in diversified firms. In contrast, we find a negative relation between managerial entrenchment and leverage in focused firms, which supports the managerial entrenchment hypothesis. These effects are stronger or only exist in samples with low excess values, which supports the agency channel through which governance influences leverage decisions. The results are robust to different measures of leverage, diversification, and governance, and continue to hold when we correct for selection bias and account for the joint endogeneity of leverage, diversification, and governance. Our evidence shows that the conflict in the literature on the relation between leverage and managerial entrenchments is because earlier empirical studies do not condition on the diversification status of firms. Entrenched managers in focused firms eschew leverage, whereas entrenched managers in diversified firms take advantage of their better access to debt finance and use more financial leverage.

Keywords: Diversification, Financial leverage, Managerial entrenchment, Corporate governance

JEL Classification: G32, G34