Excess corporate payouts and financial distress risk

• Published date: 01 November 2021
• Author: Dimitris Andriosopoulos,Amedeo De Cesari,Konstantinos Stathopoulos
• Date: 01 November 2021
• DOI: http://doi.org/10.1111/eufm.12291

Eur Financ Manag. 2021;27:865–898. wileyonlinelibrary.com/journal/eufm © 2020 John Wiley & Sons Ltd.

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DOI: 10.1111/eufm.12291

ORIGINAL ARTICLE

Excess corporate payouts and financial

distress risk

Dimitris Andriosopoulos

1

|Amedeo De Cesari

2

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Konstantinos Stathopoulos

2

1

Strathclyde Business School, University of

Strathclyde, Glasgow, UK

2

Alliance Manchester Business School, The

University of Manchester, Manchester, UK

Correspondence

Amedeo De Cesari, Alliance Manchester

Business School, The University of

Manchester, Booth St West, Manchester

M15 6PB, UK.

Email: amedeo.decesari@manchester.ac.uk

Abstract

Firms that follow excessive payout policies (over‐payers)

are higher on the financial distress spectrum and have

lower survival rates than under‐payers. In addition, over‐

payers endure lower future sales and asset growth than

under‐payers and experience negative abnormal returns

in the bond and stock markets. Exogenous import tariff

reductions and commodity price jumps reduce the like-

lihood of overpayment. We interpret this as evidence

consistent with financial flexibility considerations, rather

than risk‐shifting, explaining the decision to overpay.

We also find that CEO overconfidence and catering

incentives affect overpayment.

KEYWORDS

financial distress, financial flexibility, firm survival, over‐payers,

payout policy

JEL CLASSIFICATION

G32; G33; G35

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We thank the Editor (John A. Doukas), an anonymous referee, Nihat Aktas, Christian Andres, Shantanu Banerjee,

Michael Brennan, Murillo Campello, Sudipto Dasgupta, Ran Duchin, Robert Faff, Joan Farre‐Mensa, Daniel Ferreira,

David Hillier, Aneel Keswani, Mauricio Larrain, Meziane Lasfer, Gyongyi Loranth, Alberto Manconi, Maria Marchica,

Andrew Marshall, Patrick McColgan, Roni Michaely, Grzegorz Pawlina, Magdalena Pisa, Dimitris Petmezas, Ragha-

vendra Rau, Pedro Saffi, Karin Thorburn, Nickolaos G. Travlos, participants at the 2019 Concurrent Issues in Finance

and Accounting UIBE Conference, the 35th Annual Conference of the French Finance Association (AFFI), the 3rd Paris

Financial Management Conference, the 6th Financial Engineering and Banking Society Conference, the 2016 European

Finance and Banking Conference, and the 2016 FMA Annual Meeting, as well as seminar participants at the Adam

Smith School of Business, Glasgow, Audencia Nantes School of Management, Lancaster University Management

School, Strathclyde Business School, Surrey Business School, Swansea University, University of Coventry, University of

Exeter Business School, University of Sussex, and WHU‐Otto Beisheim School of Management for helpful comments.

All remaining errors are our own.

It concerns us that, in the wake of the financial crisis, many companies have shied away from

investing in the future growth of their companies….Too many companies have cut capital

expenditure and even increased debt to boost dividends and increase share buybacks.…We

certainly believe that returning cash to shareholders should be part of a balanced capital

strategy; however, when done for the wrong reasons and at the expense of capital

investment, it can jeopardize a company's ability to generate sustainable long‐term returns.

(Larry Fink, CEO of BlackRock. Open letter to shareholders, Reuters and Wall Street Journal,

March 26, 2014)

1|INTRODUCTION

Record payouts, which reached an all‐time high of $1.37 tn in 2018, have fuelled extensive

debate in the financial press

1

over current corporate payout policies. They also featured

prominently in the 2016 US presidential race, when the Democratic nominee's economic plan

focused on excessive corporate buybacks and their impact on long‐term investment.

2

The

overarching concern in this debate is that high payouts drain firms of important resources,

reducing investment, and leading to greater risk and instability in listed firms, which pro-

pagates to the financial markets. In the currently unfolding economic crisis caused by the

Covid‐19 pandemic, this concern appears to have been the major driver behind regulators'

and central banks' decisions to limit corporate payouts especially for firms receiving state‐

backed bailouts .

3

In this paper we argue that, to better understand the relation between large payouts and

firm risk, in particular financial distress risk, the focus should be on excessive payout policies. It

is overpayment

4

that could lead to a significant reduction in liquid assets and retained earnings,

which reduces financial flexibility and increases distress risk (the reduced‐flexibility hypothesis).

At the same time, it is well established in the literature that firms with high levels of debt and

facing significant financial distress risk have an incentive to transfer wealth from creditors to

shareholders through major, frequently excessive, payouts (the risk‐shifting hypothesis; e.g.,

Acharya et al., 2017; Black, 1976; Smith & Warner, 1979). These two hypotheses are not

mutually exclusive; in fact, they could be linked since, for example, risk‐shifting could lead to

reduced flexibility and vice versa.

Overall, it is reasonable to expect a positive relation between overpayment and financial

distress. We investigate this prediction by building a simple model of expected payout based on

standard accounting, financial, and market variables to identify over‐payers and examine their

distress risk as well as their future survival compared to under‐payers. In the spirit of Opler

et al. (1999), we define as excess payout the difference between the actual and expected level,

where the expected payout is based on a number of factors shown in the literature to explain the

1

See for example “Global dividends hit new record.”—Beioley, FT (February 22, 2019); “The amount of cash corporate

America is dishing to investors sends a scary signal about the stock market's future”—Udland, Business Insider US

(July 1, 2016).

2

See www.hillaryclinton.com/briefing/factsheets/2015/07/24/encourage-long-term-growth/ (accessed December

16, 2016).

3

See for example “UK bailout scheme companies barred from paying bonuses and dividends”—Thomas and Pickard, FT

(May 19, 2020); also see https://www.bankofengland.co.uk/prudential-regulation/publication/2020/pra-statement-on-

deposit-takers-approach-to-dividend-payments-share-buybacks-and-cash-bonuses (accessed July 22, 2020).

4

Hereafter, we use the terms “excessive payout”and “overpayment”interchangeably.

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ANDRIOSOPOULOS ET AL.

decision to initiate a payout or change the payout level and composition.

5

This paper does not

claim to construct an optimal payout model. Rather it calculates expected payout based on a

number of well‐established in the literature observable payout determinants. Even though the

potential of unobservable bias is omnipresent in any empirical study in finance, our model

includes a comprehensive range of the most important payout determinants according to prior

work. Furthermore, we cannot think of any reason why any omitted variables will system-

atically bias the results in favour of our conclusions.

What, though, leads firms to overpay? In a frictionless environment with perfect capital

markets, firms are able to adjust their capital structure without incurring costs (Miller &

Modigliani, 1961). However, capital markets are not frictionless, which drives firms to maintain

financial flexibility to meet unexpected capital shortages (Denis, 2011). Surveyed executives

regularly cite financial flexibility as the most prominent factor in determining their firms'

capital structure and payout policy (Brav et al., 2005; Graham & Harvey, 2001). Empirical

evidence also suggests that firms want to maintain financial flexibility, especially when they

face high cash flow variability, growth, and R&D expenditure (Bates et al., 2009; Harford, 1999;

Opler et al., 1999). However, maintaining financial flexibility comes with the disadvantage of

agency costs (Jensen, 1986). These costs lead firms to adjust their financial flexibility under

increasing pressure from investors to make payouts (DeAngelo et al., 2018), since payouts are

used for reducing the cash balance available to managers, especially entrenched ones (Harford

et al., 2008). Within this framework, there are three well‐established channels that could

influence managers' decision to overpay.

First, shareholder demands about achieving excess returns through investment opportu-

nities outside the firm could make managers overpay. This channel is consistent with catering

considerations (Baker & Wurgler, 2004) explaining overpayment. At the same time, pressure

from short‐term‐oriented shareholders to prop up share prices leads to significant increases in

share buybacks (Gaspar et al., 2012). Second, managerial incentives could lead to increases

in share repurchases. Cheng et al. (2015) find that, when a CEO's bonus is tied to earnings per

share (EPS) targets, her firm is more likely to buy back shares. They show that share re-

purchasing increases the probability of the CEO receiving a bonus as well as the magnitude of

that bonus. Thus, establishing a link between CEO pay structures and repurchasing activity. In

addition, Hribar et al. (2006) suggest that managers make use of repurchases as a tool to meet or

exceed analysts' EPS forecasts. Third, managers tend to have their own styles for policies such

as capital structure and payouts (Bertrand & Schoar, 2003) and make suboptimal decisions due

to overconfidence (Chen & Wang, 2012; Malmendier & Tate, 2005; Malmendier et al., 2011),

past life experiences (Bernile et al., 2017), career experiences involving financial distress

(Dittmar & Duchin, 2016), or through routinely mis‐calibrated predictions about future cash

flows and demand volatility (Ben‐David et al., 2013).

The decision to overpay can also be driven by risk‐shifting incentives as firms become more

levered and distressed (Galai & Masulis, 1976; Jensen & Meckling, 1976). While most prior work

has identified assetsubstitution as the most likely form of risk‐shifting (e.g., Eisdorfer, 2008; Gilje,

2016), a distressed firm's shareholders can also engage in overpayment to transfer wealth from

creditors (e.g., Smith & Warner, 1979). In the extreme, as Black (1976) argues, firms can pay

out all their assets to shareholders, leaving the creditors with an “empty shell”.Thiswealth

transfer effect is empirically supported for share repurchases (Maxwell & Stephens, 2003),

5

For example see DeAngelo et al. (2006), Fama and French (2001), Francis et al. (2011), Grinstein and Michaely (2005),

Grullon et al. (2002), Jagannathan et al. (2000), and Kulchania (2016).

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