Do financially constrained firms generate higher returns?
We examine the effect of financing constraints on corporate investment, risk and equity returns
In corporate finance, financing constraints refer to the idea that raising external finance is costly for firms. Because of these costs, firms prefer to rely on internal sources, like retained earnings.
The academic literature in corporate finance has dedicated a large amount of papers to this topic. For example, the graduate textbook of Jean Tirole (The Theory of Corporate Finance) is mostly about the sources of financing constraints. Tirole, who later got the Nobel Prize for his work on asymmetric information (as well as for many other contributions), shows us that information frictions affect all aspects of a firm’s life, and in particular they affect how firms finance themselves (at least another five Nobel Laureates can be referred to theories of information frictions, namely George Akerlof, Michael Spence, Joseph Stiglitz, Oliver Hart, and Bengt Holmstrom).
financing constraints refer to the idea that raising external finance is costly for firms
The celebrated Pecking Order Theory of capital structure, developed by Stewart Myers and Nicholas Majluf in the 1980s, is fundamentally a theory of financing frictions. Firms are reluctant to access financial markets, in the fear of having to issue equity (but also bonds) that are underpriced. For this reason, firms prefer to rely on internal sources of capital.
This is to say that financing frictions play a key role in how academics think about corporate finance, and markets. But the question is: do financing frictions matter in practice for equity returns?
do financing frictions matter in practice for equity returns?
To answer this question, we will review a number of tests that establish a relation between financing constraints and returns. The bottom line is that if financing constraint matter (as theory suggests), then they should be reflected in the returns on equity.
What are financing constraints?
Let’s begin by introducing financing constraints from a conceptual point of view. Understanding the true meaning of financing constraints is not simple. In one way or another, one needs to talk about asymmetric information, which is always a hard and rather abstract topic. We will try to explain the concept by means of an example.
Suppose there are two types of firms, in 50%-50% proportions: high quality and low quality. The value of the stock of a high-quality firm is $100, while that of a low-quality firm is $40.
Consider first the case of symmetric information, where both investors and firms can observe firm quality perfectly. In this case, the price of a stock of a high-quality firm will be $100 and that of a low-quality firm will be $40. Both securities are priced correctly, in the sense that the price is set equal to the present value of the cash flows, as follows
Let’s now examine the case of asymmetric information. Firms know their quality, but investors do not. In this case, (a possible outcome is that) the stock price is set at the average between high- and low-quality firms, that is all firms have a price of 70$. Investors break-even on average, as they overpay by 30$ on 50% of the shares and underpay by 30$ the remaining 50% of the shares.
This means that high-quality firms issue underpriced stock and lose 30$ on each share. Low-quality firms issue overpriced stock and make 30$ on each share. There is an information discount equal to 30$ on the stock price of high-quality firms. For the high-quality firms, the pricing formula becomes as follows:
where the information discount is equal to 30$.
It is now easy to see why high-quality firms may be unwilling to raise new capital in the market. To avoid the information discount, high-quality firms prefer to rely on internal sources to finance investment.
This is not a problem if their investment needs can be fully covered by their internal sources. However, if investment needs are large, internal sources will not be enough. At which point, a quality-firm faces a dilemma: better to raise external capital at a discount, or limit investment to what can be financed internally? Either way investment will be below its optimal level. In this sense, high-quality firms are financially constrained.
How do we measure financing constraints?
The arguments presented in the above example are actually quite hard to test in the data. First and foremost, as external observers we do not know how much information the various market participants (firms and investors) have, which means that we cannot observe the degree of asymmetric information for a firm. Then, there is the issue of high- and low-quality firms: what does it actually mean in practice?
Still, at a conceptual level the idea that asymmetry of information leads to a discount on the price of securities seems sound, so much that the famous Pecking Order Theory of capital structure was built around that concept. Additionally, the data show that firms rely vastly on internal resources, a fact that is certainly in line with the idea that raising external finance is costly.
If we want to measure financing constraints, somehow, we need to rely on proxies. Academics have discussed many alternative measures of financing constraints (and I plan to write a separate article specifically on the topic). For now, I will focus only on three popular measures.
The first measure that we look at is the index of Whited and Wu (2006) (WW), which is based on firm characteristics, including profitability, dividend payment, leverage, size, and sales growth. According to this index, firms are more constrained if they are smaller, have low sales growth, do not have a bond rating, and have little coverage by analysts. Constrained firms tend to invest less, have more cash and less debt.
Constrained firms tend to invest less, have more cash and less debt
The second measure is the index of Kaplan and Zingales (1997) (KZ), which is also based on similar firm characteristics as the WW index. According to the KZ index firms are more constrained if they have higher Tobin’s Q, are smaller, have a bond rating, and have large coverage by analysts. Constrained firms tend invest more, have less cash and more debt.
As you probably have noticed already, the indices of WW and KZ yield almost exactly the opposite predictions along several dimensions! Also, the two indices have practically zero correlation between each other. Table 1 reports the full results.
Which index should we trust, the KZ or the WW index? The WW index is preferable, because its predictions are much more intuitive, and because it is more grounded in theory (it comes from the estimation of the Euler equation of a structural model of the firm). Small size, low analysts’ coverage and lack of a bond rating are all proxies for information asymmetries. One should expect these firms to be more financially constrained, and precisely because they are more constrained, these firms invest less, leverage up less and hold more cash.
A third measure of financial constraints is that of Buehlmaier and Whited (2018) (BW). The authors analyze the “Management’s Discussion and Analysis” section of 10-K filings, which contains a narrative explanation of the past performance of the firm, its financial condition, and its future prospects. From the file of each firm, they extrapolate a score of how financially constrained the firm is.
What is the relation between equity returns and financing constraints in the data?
As can be expected, the data show different results depending on the index that we use. Firms with a high value of the KZ index have on average a monthly excess return of 0.30, while those with a low value have an average of 0.43, which means that returns are negatively related to the KZ index. However, within each size group the relation between returns and the KZ index is unclear. The results are reported in Table 2.
Rather differently, when we examine the relation between the WW index and stock returns, we find that the average monthly excess return is 0.93 for the group with high WW values, and 0.75 for the group with low WW values, which indicates that returns are positively related to the WW index.
This relation tends to survive also within each size group. The results are reported in Table 3. In additional tests, Whited and Wu show that controlling for other known factors, higher values of the WW index are associated with higher equity returns. The differences in returns across groups is statistically significant.
For the Buehlmaier and Whited index, the data show that financially constrained firms have higher returns than unconstrained firms. The difference is particularly large for the version of the BW measure that focuses on constraints related to debt issuance. The results are reported below in Table 4. Additionally, Buehlmaier and Whited show that the source of risk associated with the BW index is not captured by other known pricing factors.
So far, the KZ index is generating results that are in contrast with the WW and BW index. Li (2011) shows that the results on the various indices can be reconciled if one controls for the effect of R&D. Li argues that unlike capital expenditures, R&D investment is often much less flexible and often determined by science and/or regulation. If a firm cannot raise enough funds to conduct the required tests, it has to suspend the project, often with severe consequences for R&D-intensive firms. Indeed, when the KZ index is interacted with R&D expenses, it turns out that the KZ index is associated with higher equity returns, as is also the case for the WW index.
What have we learnt from the data so far?
The KZ index yields a negative relation with returns, while the WW and BW indices show a positive relation.
The positive sign of WW and BW is not significant in the unconditional tests, but it is significant once we control for other factors
Once interacted with R&D, the KZ and WW indices report a positive and significant coefficient
The financing constraint “factor” is not entirely captured by other factors such as SMB and HML
Why are financing constraints priced?
While the evidence presented so far points at a positive relation between financing constraints and returns, we still have no clear explanation for why financing constraints represent a source of risk for investors.
The most intuitive way of connecting the dots is in terms of “Investment Based Asset Pricing”, a theory that goes back to John Cochrane’s earlier work. Here, I will follow the intuition provided by Livdan, Sapriza and Zhang (2009). Here, the objective is to explain why financially constrained firms are riskier, and should therefore generate higher returns. Keep in mind that the only risk that matters for well-diversified investors is systematic risk. Thus, we need to explain how financing constraints increase a firm’s exposure to systematic risk.
financing constraints increase a firm’s exposure to systematic risk
The first pillar is to assume that managers have the maximization of equity value as their main objective. This can be achieved in two ways: either they increase expected cash flows, or they reduce the cost of capital.
The second pillar is to understand that profitable investment opportunities tend to come up more during economic expansions (“good times”) than in recessions (“bad times”). In good times, firms want to invest as much as possible, while in bad times firms are reluctant to increase their assets, and might actually prefer to scale down.
The third pillar is that investors value cash flows more during bad times than in good times. This is the fundamental prediction of the Consumption CAPM.
Take first the case of an unconstrained firm. This firm has potentially unlimited sources of capital, and it will invest until it runs out of profitable investment opportunities. This means that during good times unconstrained firms will invest vastly, and will have relatively little cash flow to distribute to investors because it is all taken up by investments. Because unconstrained firms have invested during good times, when times turn bad, they will stop investing, and will cash in the returns from their investments.
Because investment opportunities happen in good times, and cash flows are more valued in bad times, unconstrained firms can catch two birds with one stone. By having access to a lot of capital, they can fully benefit from investment in good times. And, because they return most of their cash flows in bad times (when they are valued the most by investors), unconstrained firms have a lower cost of capital. Or put it another way, they are less risky.
Financial constraints limit the ability of firms to invest optimally over the business cycle. This increases the covariance of their returns with the economy
The case of a constrained firm is now simple to explain. Because of its constraints, this firm cannot fully invest in good times, which in turn means that it has less cash flow to pay to investors in bad times. The covariance of its payoffs with the economy is higher than that of an unconstrained firm, because this firm does not pay much cash in bad times, as instead is the case for an unconstrained firm. For this reason, the constrained firm is riskier and has a higher cost of capital. Specifically, higher equity returns.
Conclusions
Financial constraints limit the ability of firms to invest optimally over the business cycle. This increases the covariance of their returns with the economy (systematic risk). As they carry more systematic risk, financially constrained firms must generate higher returns on equity in equilibrium.
In practice, how to measure financial constraints is debatable. The results on the relation between financial constraints and returns crucially depend on whether financial constraints are measured correctly (KZ, WW, BW?).
Overall, the data show a positive relation between the WW and BW indices and stock returns. While the relation is negative for the KZ index. However, the relation is positive for both the KZ and WW indices once they are interacted with R&D expenses, indicating that financial constraints matter more for R&D intensive firms.
Essential Bibliography
Buehlmaier, M.M. and Whited, T.M., 2018. Are financial constraints priced? Evidence from textual analysis. The Review of Financial Studies, 31(7), pp.2693-2728.
Lamont, O., Polk, C. and Saá-Requejo, J., 2001. Financial constraints and stock returns. The Review of financial studies, 14(2), pp.529-554.
Livdan, D., Sapriza, H. and Zhang, L., 2009. Financially constrained stock returns. The Journal of Finance, 64(4), pp.1827-1862.
Li, D., 2011. Financial constraints, R&D investment, and stock returns. The Review of Financial Studies, 24(9), pp.2974-3007.
Whited, T.M. and Wu, G., 2006. Financial constraints risk. The Review of Financial Studies, 19(2), pp.531-559.
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