INSTITUTIONAL INVESTORS AND THE AGENCY COSTS OF OVERVALUED EQUITY: EVIDENCE FROM EARNINGS MANAGEMENT ACTIVITY

Abstract

This study examines whether institutional investors play a monitoring role in mitigating the agency costs of overvalued equity, specifically earnings management activity. US firm-level and institutional holdings data from 1980 to 2010 show support for the “monitoring hypothesis” where institutional ownership has a positive effect in reducing earnings management activity associated with overvalued equity. This evidence extends current literature showing evidence of the monitoring benefits institutional investors bring through monitoring and influencing corporate behaviour. This study also provides evidence of a complementary relationship between institutional ownership (an internal governance mechanism) and the takeover market (an external governance mechanism) from an earnings management perspective.