By Michael S. Weisbach
One of the most important decisions a financial manager must make is to determine how liquid his firm’s balance sheet should be. More liquidity means that a firm can make investment decisions without having to raise external capital. Consequently, liquidity on the balance sheet is most valuable to a firm when the cost of external finance is relatively high. One such time occurs during poor macroeconomic conditions, since both practitioners’ viewpoints and the academic literature suggest that most firms’ external financing costs are strongly pro-cyclical. Therefore, liquidity should be particularly important in facilitating firms’ abilities to invest efficiently during poor macroeconomic conditions.
Liquidity, however, comes at a cost. In addition to being inefficient from a tax perspective, too much liquidity can exacerbate agency problems, since managers are less likely to face capital market discipline for their investments. In other words, if firms hold sufficient liquidity to ensure optimal investments even in bad times, then they will have too much liquidity in normal times, when cash flows tend to be larger and financial markets have fewer frictions. A cost of having too much liquidity is that firms potentially will use this excess liquidity to make value-reducing investments.
This paper provides evidence on the nature of this tradeoff. It considers the way that macroeconomic conditions and firms’ liquidity affect firms’ acquisition decisions, one of the most important investment decisions that firms face. The idea is that a firm chooses its liquidity with these factors (and possibly others) in mind. Once the choice is made, however, it is sunk, and will affect a firm’s future investment decisions in predictable ways. A more liquid balance sheet should provide insurance against unreliable capital markets in bad times at the potential cost of exacerbating the firm’s free cash flow problem and leading to value-reducing investments in good times.
We study the effect of liquidity on the interaction of macroeconomic conditions and investment decisions using a sample of 47,378 acquisitions by public and private acquirers from 36 countries between 1997 and 2014. We focus on acquisitions because they are large, observable investments, over which firms have substantial discretion. Therefore, if liquidity affects investment, it is more likely to be observed doing so for acquisitions than for capital investments. We estimate the likelihood that a firm makes an acquisition as a function of both its own financial position and overall macroeconomic conditions. The international sample provides us with variation in economic conditions that allows us to identify the way that firms’ liquidity affects their investment decisions in differing economic conditions.
Similar to Harford (1999), we find that firms with higher cash holdings are more likely to make acquisitions in our much larger and non-overlapping sample. This finding could mean that cash relieves financial constraints and allows firms to invest efficiently, or it could mean that cash leads firms to overinvest and to make value-reducing acquisitions. In fact, if firms are choosing liquidity to trade off the costs and benefits of incremental liquidity, this positive relation between cash holdings and acquisitions could reflect both effects. During bad times, we expect higher liquidity to lessen the impact of credit rationing and consequently lower the impact of poor economic conditions in firms’ investments, while in normal times, we expect higher liquidity to lead to overinvestment.
The results in this paper have implications for our understanding of both corporate liquidity and the determinants of mergers and acquisitions. Much of the prior literature on liquidity focuses on the level of cash holdings, which serve as a hedge against potential financial shocks. This literature generally takes an ex ante perspective on liquidity management in that it considers the way firms choose their liquidity prior to any potential shocks. We extend this literature by using an ex post approach in which we examine the way in which liquidity affects firms once the shocks have occurred. Subsequent to shocks to firms’ financial conditions, differences in cash positions have a meaningful impact on firms’ abilities to invest.
In addition, the paper adds to our understanding of merger waves, which according to Brealey, Myers, and Allen (2015), is one of the most important unsolved questions in finance. The two leading (non-mutually exclusive) explanations for pro-cyclical merger waves are that opportunities for profitable acquisitions vary over the business cycle, and that acquirers’ financial resources vary over the business cycle. Our results provide evidence suggesting that the second explanation is at least part of the story: since having more cash can lessen the pro-cyclicality of acquisition decisions, it must be that part of the underlying reason why mergers are pro-cyclical is the inability of firms to finance deals during poor times. As such, our results suggest that the argument in the private equity literature that the cyclicality of private equity backed deals is a function of financing constraints and agency costs is more general, and applies to non-private equity backed deals as well.