Bachelor Thesis, 2012, 24 Pages
University of Tubingen, Grade: 1,3
II List of Figures
2 Agency problem and shareholder protection
2.1 The scope of managerial discretion
2.2 Concentrated ownership
2.3 Legal shareholder protection around the world
3 Inside ownership and firm valuation
3.1 Managerial incentive alignment and entrenchment
3.2 Empirical analyses with basic regression models
3.3 Model expansion, intermediates, and endogeneity issues
3.3.1 Investment policy
3.3.2 Leverage policy
3.3.3 Dividend policy
3.3.4 Determinants of managerial ownership and unobserved firm heterogeneity
Fig. 1: Non-monotonic relationship between managerial ownership and Tobin’s Q using a piecewise linear OLS regression
Fig. 2: Relationship between managerial ownership (MANA), Tobin’s Q, and capital structure
Fig. 3: Endogenous inside ownership (δ*) and estimated productivity parameters for managerial input (z) and investment (y) for 30 different industry groups
Investors, in particular minority shareholders, face a permanent dilemma. Once they part with their money, the investment is “sunk” and managers have almost full discretion to use these funds for personal benefits. Many countries have laws in place that limit managerial expropriation of shareholders, but in most cases these laws are not sophisticated enough or are poorly enforced. Weak investor protection is especially problematic for small shareholders whose voting rights are practically nonexistent. They need to gauge potential risks and return, and might decide not to invest at all. Mistrust and fear of deception can thus severely cripple capital markets and hamper firms’ ability to secure necessary funding for the realization of profitable business opportunities.
It is the purpose of this paper to examine to what extent ownership structure can alleviate the agency problem described above. Since stock options and other forms of equity are frequently used as compensation for managers, special emphasis will be placed on the question of how managerial ownership1 can affect agency costs and firm value. This paper will refrain from discussing differences in legal systems and their effects on minority shareholders in detail, since such laws are subject to broad interpretation and frequent changes. As an outsider, it is also difficult to evaluate the quality of a legal system in a given country. Therefore, legal shareholder protection will only be regarded as a framework that may or may not influence ownership structure and shareholder value. The extent to which ownership structure affects agency costs will be “measured” by variations in the market value2 of the firm. This approach is reasonable because agency costs and managerial expropriation harm shareholders by their negative effect on profits, which affect share prices. To evaluate the impact of ownership patterns on shareholder value, this paper will survey and reinterpret scientific advances in the corporate governance literature. A significant part of the analysis will cover the question of how ownership, corporate policies, and shareholder value are interrelated.
The remainder of this thesis is structured as follows. Section two discusses the agency problem and how ownership concentration and legal shareholder protection can help to reduce the scope of managerial discretion. Section three as the central element of this paper analyses the relation between managerial ownership and firm value. Section four summarizes the main findings in a brief conclusion.
Ownership structure and investor protection are cornerstones of the principal-agent theory which describes the complex relationship between investors (principals) and managers (agents). Investors want to generate returns on their investment and are willing to entrust both funds and residual control rights to professional managers in exchange for their expertise and profitable investment opportunities. Since investors are not qualified to assess managers’ decisions and are unable to effectively monitor their work, managers end up with substantial discretionary power to use funds for self- interested behavior.3 Such behavior will reduce shareholder value unless managers’ and shareholders’ interests are closely aligned. Examples for “managerial expropriation” of shareholders are excessive executive compensation, consumption of perquisites (e.g. expensive offices and company airplanes), tunneling (selling company assets at below market prices to firms affiliated with management), inefficient pet projects, empire building (expanding the firm for personal prestige), or simply shirking responsibilities.4 Another kind of expropriation is “managerial entrenchment” which will be explicitly discussed in the third section of this paper.
Of course, investors do have certain control rights that most countries guarantee by law, e.g. voting on corporate matters such as mergers, and participation in board elections. However, these control rights are rarely exercised by small shareholders who have no incentive to collect information or to actively monitor management. These “dispersed shareholders” rather count on (short term) share appreciations, a practice traditionally referred to as the free-rider problem.5 Even if shareholders in widely held firms are willing to use their control rights, concerted action against incumbent managers is difficult and costly because “control rights are of limited value unless they are concentrated.”6 In addition, elected boards need not necessarily represent minority shareholders’ interests, and courts are unlikely to interfere in business matters unless managers severely violate their fiduciary duty towards shareholders.7 As a result, managers often end up with considerable control power, leaving even more room for managerial expropriation.
The above summary of the agency problem suggests three key areas that determine the scope of managerial discretion: (i) managerial incentive alignment, (ii) ownership structure, and (iii) legal investor protection. While there are other important determinants such as the market for corporate control and the (executive) labor market, the focal point of this paper shall be the extent to which ownership structure (especially inside ownership) can help to reduce agency costs and align managerial incentives.
Concentration of control rights in the hands of individual or institutional investors supposedly helps to alleviate the agency problem, because large investors have both incentives and substantial means to monitor and discipline managers. They carry enough control power to enforce changes in corporate policy and managerial behavior, or to replace the management. Shleifer and Vishny argue that alliances between large minority shareholders are easier to forge than alliances in dispersed firms, though they may still require a “sophisticated” legal system because managers could try to obstruct concerted actions against themselves.8
One could conclude that concentrated ownership keeps management in check by the threat of dismissal and disciplinary actions. However, large shareholdings also entail costs. The literature particularly emphasizes the problem of expropriation of small investors and other stakeholders by large shareholders.9 Large investors can use their voting power not only to monitor management but also to benefit themselves from otherwise inefficient actions, thereby destroying shareholder value. They may also pay themselves special dividends or use their informational advantage (e.g. in case of banks) at the expense of small shareholders.10 Furthermore, large shareholders may collude with managers and share the private benefits of control. This scenario can probably be observed in many family-controlled businesses where a family member acts as CEO of the firm. In this case, the monitoring role is clearly compromised and shareholder value jeopardized (especially if the manager is not suited for the position). La Porta et al. find that family-controlled firms usually do not have another large shareholder that could monitor or discipline the controlling family.11 If this is accurate, this kind of concentrated ownership could eventually aggravate the agency problem.
In a survey of literature, Gillan suggests that concentrated (institutional) ownership moderates executive compensation (indicating more efficient monitoring efforts) and that shareholder value increases in the presence of an “active” blockholder.12 The previous paragraph demonstrated how collusion between blockholders and management in family-controlled businesses could interfere with monitoring activity. The same can be said about institutional investors with substantial stakes, considering some of them have business ties with the respective firm’s management. Rapp and Trinchera address this problem by analyzing how shareholder types differ in regard to monitoring efficiency. They claim that institutional investors mainly invest for financial reasons, while “strategic investors” (including individuals and families) are also interested in private benefits. They further distinguish institutional investors into “independent institutions” (e.g. mutual funds) and “grey institutions” (e.g. banks and insurance firms), arguing that “the former are generally interested in security returns only, [while] the latter are often also interested in ongoing (and potential) business relationships.” The authors’ findings suggest that “strategic” and “grey” investors have limited monitoring incentives and may affect firm value negatively. In contrast, independent institutions have a positive effect on monitoring effort and valuation.13
Claessens at al. observe a generally positive effect of large shareholdings on firm value. They show that valuation increases “with the share of cash-flow rights in the hands of the largest shareholder,” but decreases if voting rights exceed cash-flow rights.14 This occurs when some shareholders own dual-class shares with superior voting rights which allow them to effectively control a firm with a relatively small fraction of cash-flow rights. Claessens et al. also refer to this practice as “entrenchment” (compare with “managerial entrenchment” in section three). La Porta et al. provide evidence that the separation of voting rights and cash-flow rights is very common, especially in countries where legal shareholder protection is weak. For example, while there is almost no deviation from the one-share-one-vote principle in the United States and other common law countries, owners in countries such as the Netherlands and Denmark control 20% of the voting rights on average, with only about 15% of the cash-flow rights. In similar fashion, controlling shareholders use pyramid structures to control chains of firms through holding companies (which hold large stakes in other firms and so on).15 In summary, small shareholders can be deprived of their control benefits and hold a high risk of expropriation. The question remains how firms with such an ownership structure can attract any outside capital at all. Eventually, large shareholders need to increase their equity stake to a sufficiently high level to prove to outside shareholders that they have an incentive to maximize firm value.
Ownership concentration cannot entirely solve the agency problem, for example, due to affiliations between owners and managers. In some cases, the costs of large shareholdings may reverse the positive incentive effect. Some authors even argue that managers reduce their efforts because of large shareholders’ “high powered incentives,” for instance if managers are (too) closely monitored and controlled.16 But despite its shortcomings, ownership concentration can reduce agency costs and perhaps compensate for poor legal shareholder protection in some countries, as will be illustrated in the following subsection.
Shleifer and Vishny contend that “concentration of ownership leverages up legal protection.”17 This is a common theme in the corporate governance literature that is immediately intuitive. If investors are not very well protected from expropriation they will either refrain from becoming shareholders in the first place or find ways to concentrate control rights. La Porta et al. propose a reverse interpretation. Accordingly, controlling shareholders in countries with good legal protection of minority shareholders “have less fear of being expropriated themselves in the event that they ever lose control […] and might be willing to cut their ownership.”18 As a result, firms in countries with better legal protection should have more dispersed ownership structures than firms in countries with less sophisticated legal systems (e.g. developing countries). Based on this hypothesis, La Porta et al. investigate country differences in ownership patterns and attribute their findings to the legal system of the surveyed countries. Under the assumption that shareholdings are concentrated when the “ultimate owner” owns 10% of the stakes or more, 34% of firms in countries with a “good” legal system are widely held, in comparison to only 16% of firms in the “bad” subsample.19
1 In this paper, managerial (or “inside”) ownership is defined as the fraction of equity held by officers and directors of the board.
2 For reasons of simplification, market value, firm value, valuation, and shareholder value will be used synonymously.
3 Shleifer and Vishny (1997), pp. 740-741.
4 Shleifer and Vishny (1997), p. 742.
5 Shleifer and Vishny (1997), p. 741.
6 Shleifer and Vishny (1997), p. 764.
7 Shleifer and Vishny (1997), pp. 751-752.
8 Shleifer and Vishny (1997), pp. 753-756.
9 Shleifer and Vishny (1997), p. 758.
10 Shleifer and Vishny (1997), pp. 758-759.
11 La Porta et al. (1999), p. 505.
12 Gillan (2006), p. 390.
13 Rapp and Trinchera (2011), pp. 4-6.
14 Claessens et al. (2002), pp. 2757-2758.
15 La Porta et al. (1999), pp. 498-501.
16 Shleifer and Vishny (1997), p. 760.
17 Shleifer and Vishny (1997), p. 753.
18 La Porta et al. (1999), p. 473.
19 La Porta et al. (1999), p. 493.
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