Peer firm return shocks are associated significantly with equity issuance and leverage decisions. Namely, firms alter their financing policy in response to their peers. In addition, smaller, less successful firms are highly sensitive to their larger, more successful peers, but not vice versa, thereby establishing typical cases of leader–follower behavior.
Firms may choose to increase their leverage in response to higher leverage at peer firms. Likewise, they are more likely to issue equity following equity capital raising by peer firms. Such evidence showcases the impact that peer firm behavior may have on the capital structure of an individual firm. This mimicking behavior is consistent with leader–follower models in which smaller, unrated, less profitable firms are highly sensitive to financial policy changes of larger, rated, more profitable firms in the industry, probably motivated by wanting to learn techniques for their own firms or improve their reputation.
How Is This Research Useful to Practitioners?
Most previous research on corporate financial policy assumed that capital structure choices are conditional on the characteristics of the incumbent firm, such as profitability, corporate valuation, and investment opportunities. But the authors find that peer firm effects also seem to matter for corporate managers when determining their firms’ optimal level of leverage. In fact, peer effects are perceived as more economically important in explaining firm-specific capital structure than other traditional firm-specific determinants, such as the market-to-book ratio, sales, profitability, and level of investments in fixed assets.
Going a step further, the authors show that individual firms change their leverage in response to a peer firm’s exogenous shock only if it is accompanied by a change in the peer firm’s leverage. Thus, they identify financial policy actions, such as leverage increases, as the primary route through which the impact of peer firms’ exogenous shocks is transmitted to incumbent individual firms, rather than such corporate characteristics as risk and profitability.
The interdependence of the financial policy decisions of the individual firm and its peers translates to mimicking patterns, whereby firms that are more constrained in terms of profitability, growth potential, liquidity, and market penetration follow the leader in their industry.
On the basis of the inferences drawn from the empirical results, when deciding whether a firm should borrow or issue equity, corporate managers should evaluate the impact of their decision on their peers and incorporate such side effects into their decision making. Moreover, when performing their equity research, apart from firm-specific fundamentals in terms of risk and profitability, portfolio managers should also assess recent financial decisions taken by peer firms’ management and their potential impact on the capital structure and cost of capital of the incumbent firm.
How Did the Authors Conduct This Research?
The sample consists of data for 9,126 nonfinancial, nonutility firms during the period between 1965 and 2008, corresponding to 80,279 firm-year observations drawn from the CRSP/Compustat merged database.
The authors effectively tackle two main challenges faced by their empirical testing. First, they overcome the endogeneity bias that would have been incurred if peer firms’ leverage were included as a regressor in the estimation model by replacing it with the idiosyncratic equity return (i.e., equity return shock) perceived to be exogenous to the estimation. Moreover, to ensure that latent common factors are not driving the correlation between firm-specific leverage and peer firm equity return shocks, the authors substitute equity return shocks to peer firms’ customers that do not have supply chain links to the particular firm for equity return shocks to peers. Results in favor of the significant influence of peer effects do not qualitatively change following a number of robustness tests and different specifications.
Using a two-stage least-squares estimation, whereby peer firm equity return shocks are used as an instrumental variable, the authors manage to quantify the economic significance of peer effects and proceed with the measurement of the within-industry amplification and spillover effects evident on firm-specific leverage. Indicatively, they find that changes in firm-specific leverage as a result of exogenous variable shocks may be magnified by 71% because of externalities flowing through peers in industries with three firms or fewer.
In sum, the authors empirically confirm that peer effects play a significant role in determining variation in corporate leverage ratios and security issuance decisions. Namely, when making these choices, firms respond to their competitors’ own changes in capital structure. One could plausibly infer the motives behind such evident interdependence. Yet, what remains to be investigated is whether this mimicking behavior is actually contributing to the pursuit of value maximization among corporate managers and investors.