Do analysts matter for governance? Evidence from natural experiments

Tao Chen; Jarrad Harford; Chen Lin

doi:10.1016/j.jfineco.2014.10.002

Do Analysts Matter for Governance? Evidence from Natural Experiments

Tao Chen, Jarrad Harford and Chen Lin

2015 · Published in Journal of Financial Economics 115(2): 383–410 · DOI 10.1016/j.jfineco.2014.10.002

PDF of Do Analysts Matter for Governance? Evidence from Natural Experiments (Accepted manuscript, DR-NTU repository)

In one sentence

Financial analysts act as monitors: when a firm loses analyst coverage, its managers behave in ways that are worse for outside shareholders.

Summary

Using broker closures and mergers as exogenous shocks to analyst coverage, the paper estimates the causal effect of analysts on managerial expropriation of outside shareholders. After a firm loses coverage, shareholders value its cash holdings less, its CEO receives higher excess compensation, management is more likely to make value-destroying acquisitions, and managers engage more in earnings management. The effects are driven mainly by firms with smaller initial coverage and less product-market competition, and CEO pay becomes less sensitive to performance. The findings support the view that analysts play an important governance role.

Abstract as published

Building on two sources of exogenous shocks to analyst coverage (broker closures and mergers), we explore the causal effects of analyst coverage on mitigating managerial expropriation of outside shareholders. We find that as a firm experiences an exogenous decrease in analyst coverage, shareholders value internal cash holdings less, its CEO receives higher excess compensation, its management is more likely to make value-destroying acquisitions, and its managers are more likely to engage in earnings management activities. Importantly, we find that most of these effects are mainly driven by the firms with smaller initial analyst coverage and less product market competition. We further find that after exogenous brokerage exits, a CEO's total and excess compensation become less sensitive to firm performance in firms with low initial analyst coverage. These findings are consistent with the monitoring hypothesis, specifically that financial analysts play an important governance role in scrutinizing management behavior, and the market is pricing an increase in expected agency problems after the loss in analyst coverage.

Citation

Tao Chen, Jarrad Harford, Chen Lin (2015). Do analysts matter for governance? Evidence from natural experiments. Journal of Financial Economics, 115(2), 383–410. https://doi.org/10.1016/j.jfineco.2014.10.002

BibTeX

@article{chen2015analysts,
  title = {{Do analysts matter for governance? Evidence from natural experiments}},
  author = {Tao Chen and Jarrad Harford and Chen Lin},
  journal = {Journal of Financial Economics},
  year = {2015},
  volume = {115},
  number = {2},
  pages = {383--410},
  doi = {10.1016/j.jfineco.2014.10.002}
}