Index Membership and Small Firm Financing: New Evidence on the Bank Hold-Up Problem

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 because it improves the information environment through increased investor awareness.