Investment and the Strategic Role of Capital Structure in Regulated Industries: Theory and Evidence

In this paper we study the effect of privatization and regulatory independence on the capital structure of regulated firms, their investments, and the effect of financial leverage on regulated prices. The theoretical predictions that we establish in the paper are that (i) regulated firms should become more leveraged and should invest more when they are subject to regulation by IRAs, (ii) regulated firms should become more leveraged and should invest more when they are more privatized (the state holds a smaller stake in the firm), and (iii) higher financial leverage should lead to higher regulated prices. The empirical results, which are based on evidence from the EU 15 countries, provide strong support for hypotheses (i) and (iii) and much weaker support for hypothesis (ii). Specifically, we find that EU regulated firms tend to have higher leverage and tend to invest more when they are subject to regulation by an IRA. In particular, our estimates reveal that the introduction of an IRA is associated with a long-run increase in leverage by 7.2% for the full sample and 8.3% for the subsample of firms that remained privately- or state-controlled throughout the period. The long-run effect of an IRA on the leverage of regulated firms is even larger if we restrict attention to privately-controlled firms: the long-run effect then is 9.2% for all privately-controlled firms and 11.9% for firms that were privately controlled throughout our sample period. Moreover, the introduction of an IRA is associated with a long-run increase of 2.5% in the investment rate for the full sample and 2.6% for firms that remained privately- or state-controlled throughout our sample period. These effects are substantial given that the mean rate of investment in our sample is 11.1%. Our results on privatization are less conclusive: in and of its own, private control does not have a significant effect on leverage or on investment. However, when attention is restricted to firms that are regulated by an IRA, we do find a positive and significant effect of private control on leverage, though not on investment. In particular, in the presence of an IRA, private control is associated with an increase in leverage by 7.7% for all privately-controlled firms and 8.3% for firms that were privately controlled throughout our sample period. In addition, we also find, in line with hypothesis (iii), that so long as firms are privately-controlled and/or are subject to regulation by an IRA, lagged market leverage has a significant positive effect on regulated prices, but not vice versa. These results are consistent with the main premise of our theoretical model that regulated firms choose their leverage strategically in order to induce regulators to set higher prices. Our results indicate that the “dash for debt” phenomenon observed in many countries is a natural response of regulated firms to the privatization process and the establishment of independent regulatory agencies. Our results also indicate that while the increase in debt is associated with higher regulated prices, it is also associated with higher investments and hence may be welfare enhancing.