The impact of shareholder intervention on overinvestment of free cash flow by overconfident CEOs

This paper examines the impact of shareholder intervention on investment distortions, which we capture using overinvestment of free cash flow by overconfident CEOs. Using this definition and U.S. data for 1996–2014, our fixed effects and difference-in-difference matching estimation results provide consistent evidence that the threat of potential intervention of shareholders can curb overinvestment by overconfident CEOs. Specifically, firms with greater voting premium and hedge fund activism experience less overinvestment and exhibit lower sensitivity of free cash flow to investment. Such disciplining effects are stronger for firms managed by overconfident CEOs. Overall, our results suggest that shareholder intervention is particularly effective at mitigating overinvestment that is more likely to be distorted. •This study provides consistent evidence that shareholder interventions curb investment distortions along two dimensions: the voting premium, and hedge fund activism.•We find a negative association between overinvestment and the voting premium, and that overinvestment drops after hedge fund activists' entrance. Our findings hold only when CEOs are overconfident, and excess free cash flow exists in firms simultaneously.•The results suggest that stock market pressure does not uniformly deter all overinvestments but is particularly effective at mitigating overinvestment that is more likely to be distorted.