This paper investigates whether the level of institutional ownership has any effect on the market reaction to announcements of a firm-level ''event'', namely the issuance of equity. Previous studies that have examined the association between some proxy for firm value (either Tobin's q or a measure of accounting profitability) and ownership structure have a problem with the direction of causality. For instance, a positive association between firm value and institutional ownership can either be interpreted as evidence of monitoring by institutions or that institutions tend to invest systematically in high-value firms. If we find any relation between the announcement effects of equity issues, and therefore firm value, and institutional ownership, the direction of causality has to run from institutional ownership to firm values not the other way around. Furthermore, some earlier studies have examined the relation between firm value and ownership structure of the firm by focusing primarily on the stock price reaction to announcements of specific corporate decisions. We also examine revisions to analysts' earnings forecasts around these announcements. If the announcement of the decision to finance investment projects through the issuance of equity has an effect on the stock price, it is presumably because the market perceives changes in either the expectations of future earnings or in the variability of these earnings. Therefore, we also study the relation between revisions in analysts' earnings forecasts and institutional ownership to corroborate our stock price results. The proceeds from an equity issue give more discretionary cash to managers, which increases the likelihood of non-value-maximizing behavior by them. We hypothesize that under the effective monitoring hypothesis, higher institutional ownership will give institutional investors greater incentives to protect their investment in the firm's equity. They achieve this objective by carefully monitoring the use of the proceeds of the equity issue in order to ensure that the capital is used for productive purposes. This effective-monitoring hypothesis would then predict a positive relation between announcement-period abnormal stock returns and the level of institutional ownership. On the other hand, width higher institutional ownership, institutions may develop other profitable business relationships with the firm or may find it mutually advantageous to cooperate with the managers of the firm, thereby reducing the incentives to monitor the activities of the managers aggressively in order not to jeopardize these other beneficial relationships. We call this the ineffective-monitoring hypothesis. It predicts a negative relation between abnormal stock returns and institutional ownership. We first study the association between the announcement-period abnormal stock price reaction and institutional ownership. We find a significant positive relation between announcement-period abnormal stock returns and institutional ownership. This result suggests that higher levels of institutional ownership are associated with perceptions of institutions as more effective monitors of the uses of the cash Obtained from the equity issue due to their higher ownership stake in the firm. Given that the cash raised through the equity issue is typically used to finance long-term projects, monitoring by institutions will not impact current-year earnings but will have an effect on long-term earnings. Hence, if the documented stock price relation is the result of effective monitoring of the proceeds of the cash raised through the equity issue, there should be no relation between abnormal forecast revisions in current-year earnings with institutional ownership. Consistent with this, we find no relation between analysts' abnormal forecast revisions in current-year earnings and institutional ownership. However, there should be a positive relation between abnormal forecast revisions in five-year earnings growth and institutional ownership. We also find a significant positive relation between analysts' abnormal forecast revisions in five-year earnings growth and institutional ownership. These findings support the view that institutions are effective monitors of the equity issuance decision. Finally, we find that the significant positive relation between the announcement-period abnormal returns, as well as abnormal forecast revisions in five-year earnings growth, and institutional ownership is primarily explained by low-q (q < 1) firms. Managers of low-q firms are more likely to misuse the proceeds from the equity offering; hence, they are the targets of closer scrutiny by institutional investors with relatively high ownership stakes who wish to protect their investments in the firm. This result gives further credence to the effective-monitoring hypothesis. By studying the impact of the decision by firms' managers to issue equity on both stock prices and analysts' earnings forecasts, we find evidence of monitoring by institutions. The decision to issue equity to finance investment projects is just one among many important decisions that the firms' managers make. It is likely that institutional investors play a similar role regarding a whole set of decisions managers make. While we document evidence of monitoring by institutions, we are in no way advocating that firms should unequivocally seek to attract higher levels of institutional ownership because of potential monitoring benefits. They should do so if it is an attractive option after taking into account all potential benefits and costs of taking such a course of action. Finally, the ability of institutional investors to impose further capital market discipline on managers is likely to increase as institutional ownership grows and as the public policy debate comes to recognize the substantial costs of regulations which inhibit the ability of institutions to monitor managers.
