Index Membership and Small Firm Financing

Abstract

This paper investigates the extent to which index membership affects small firm financing. Using a regression discontinuity specification around the lower cutoff of the Russell 2000 small-cap index, we find that index membership causes small firms to transition away from bank financing in favor of seasoned equity offerings. These effects are concentrated in the year following Russell 2000 additions and do not reverse immediately upon deletions. Liquidity, the elasticity of demand for equity, and analyst coverage also significantly increase following Russell 2000 additions but do not significantly decrease following deletions. Finally, firms added to the Russell 2000 obtain lower spreads and have fewer covenants on the bank loans that they do initiate. Our findings are consistent with index membership mitigating the financing frictions of small firms by improving their information environment through increased investor awareness. This paper was accepted by Amit Seru, finance.

Who monitors opaque borrowers? Debt specialisation, institutional ownership, and information opacity

“…Consistent with the monitoring hypothesis, we find that firms with high‐quality accruals have lower debt specialisation when institutional stakes are large (column (1)) and equity stakes are held by transient and quasi‐indexed investors (columns (2)–(5)). The predicted effect of quasi‐indexed investors (e.g., having a value‐increasing role) is compatible with the previous research on index reconstitution and corporate decision‐making (e.g., Crane et al ., ; Cao et al ., ; Harford et al ., ). The result that dedicated institutions are not more influential than transient institutions is perhaps surprising.…”

“…() show that concentrated holdings have a positive effect on post‐merger performance and that concentrated institutional holdings influence management decisions to reverse bad investment decisions. Using stock index reconstitution to draw causal inferences, empirical studies show that higher institutional ownership causes firms to pay more dividends (Crane et al ., ), access bank loans with lower spreads and fewer covenants (Cao et al ., ), and invest in more innovative projects (Aghion et al ., ).…”

Institutional Blockholders and Voluntary Disclosure

“…The specifications in the literature range from regression discontinuity to instrumental variable estimation. According to Appel et al (2020), papers that use unbiased estimators find that Russell index assignments have little to no impact on total institutional ownership (e.g., Appel et al, 2016, Wei & Young, 2019 and only increase ownership by index funds (e.g., Appel et al, 2016Appel et al, , 2020Ben-David, Franzoni, & Moussawi, 2019;Cao, Gustafson, & Velthuis, 2019;Glossner, 2019). Consistently, in untabulated results, using Russell 1000/2000 assignment shows no significant changes in institutional ownership and in blockholdings.…”

Identifying the Effect of Stock Indexing: Impetus or Impediment to Arbitrage and Price Discovery?

“…Our article demonstrates how researchers can use the Russell reconstitution as a source of exogenous variation in index investing not only at the upper cutoff, separating large-and mid-cap stocks from small-cap stocks, but also at the lower cutoff, separating small-from micro-cap stocks. In this regard, our application is related to Cao, Gustafson, and Velthuis's (2019) article on the effect of index membership on small firm financing. Our evidence further highlights the economic significance of the lower cutoff as an important experimental setting.…”