1 Plan for the remaining part of the course Corporate governance, ownership and control of firms around the world. Why differences across countries? Law and Finance view Law and Finance view Other views (political economy, in particular) Other views (political economy, in particular) Implications for financial development Implications for financial development Choice of corporate governance by companies Does good CG create value? Does good CG create value? Incentives to practice good CG? Incentives to practice good CG? Effect of legal environment Effect of government predation

2 Law and Finance La Porta, Lopez-de-Silanes, Shleifer, and Vishny (LLSV) Main messages of the Law and Finance theory: Weak shareholder protection raises obstacles to financial market development through hampering external finance Weak shareholder protection raises obstacles to financial market development through hampering external finance Weak shareholder protection results in greater ownership (and control) concentration in firms. Ownership concentration is a second-best response to bad institutions Weak shareholder protection results in greater ownership (and control) concentration in firms. Ownership concentration is a second-best response to bad institutions Common law (Anglo-Saxon) countries have better shareholder protection more developed financial markets Common law (Anglo-Saxon) countries have better shareholder protection more developed financial markets Legal Shareholder Protection Possibilities for insider expropriation Ability to attract external finance Ownership and control structures Development of financial markets

3 How does it work? La Porta et al (2002), Shleifer and Wolfenzon (2002) Weak legal shareholder protection increases insiders (entrepreneurs, managers) benefits from diversion/self- dealing/private benefit extraction larger agency cost Larger insiders share creates better incentives less diversion (meaning higher equity valuation) for a given protection Better shareholder protection less diversion (higher equity valuation) for a given insiders share Assume an insider needs to raise external finance by selling shares. Then he bears the (agency) costs. He can try to minimize them by retaining a greater fraction of equity. But this has two effects: Better incentives: commitment not to expropriate investors too much investors are more willing to provide funds Better incentives: commitment not to expropriate investors too much investors are more willing to provide funds Lower share available for sale to outside investors limits insiders ability to raise funds Lower share available for sale to outside investors limits insiders ability to raise funds

4 Under weak protection the incentive effect dominates (see Note below). As a result: Insider retains more shares to compensate for low quality of legal protection Insider retains more shares to compensate for low quality of legal protection However, it costs him a reduction in the funds raised However, it costs him a reduction in the funds raised Moreover, this compensation is only partial. Despite an increase in insiders share there is still more expropriation under weaker legal protection Moreover, this compensation is only partial. Despite an increase in insiders share there is still more expropriation under weaker legal protection Note: The (theoretical) result on the effect of law on insider share is not quite robust. The following feature is needed: marginal increase in insiders share must have greater effect on incentives under weak protection. La Porta et al (2002) test the latter, they get the predicted sign but coefficient is insignificant La Porta et al (2002) test the latter, they get the predicted sign but coefficient is insignificant

5 Conclusions. Under weaker legal protection Higher private benefits of control and more self-dealing Higher private benefits of control and more self-dealing Lower valuation of firms Lower valuation of firms Higher ownership concentration Higher ownership concentration Less funds is raised, i.e. smaller size of projects (firms) Less funds is raised, i.e. smaller size of projects (firms) Fewer firms are set up (fewer firms go public) Fewer firms are set up (fewer firms go public) Stock markets are smaller Stock markets are smaller Empirics largely confirms these results (in fact, empirics came out first) Implication: Why capital does not flow to developing countries? Because they have worse investor protection

6 Another explanation for ownership concentration in countries with weak shareholder protection Burkart, Panunzi and Shleifer (2003): Examine the decision of a founder to resign and hire professional manager: The founder can hire a manager, sell a part of his shares and remain a large outside shareholder Large shareholder monitoring reduces managerial opportunism Large shareholder monitoring reduces managerial opportunism Hence, it is more valuable when there is more room for opportunism, i.e. under weak shareholder protection Hence, it is more valuable when there is more room for opportunism, i.e. under weak shareholder protection I.e. outside ownership concentration grows as shareholder protection worsens (i.e. is a substitute for shareholder protection) I.e. outside ownership concentration grows as shareholder protection worsens (i.e. is a substitute for shareholder protection) However, monitoring/diversion tradeoff is costly. As legal protection worsens this cost goes up, at some point the founder decides to keep control in the family, instead of hiring a manager However, monitoring/diversion tradeoff is costly. As legal protection worsens this cost goes up, at some point the founder decides to keep control in the family, instead of hiring a manager Indeed, family controlled firms are more widespread in countries with weak shareholder protection Indeed, family controlled firms are more widespread in countries with weak shareholder protection

7 What about concentration of control? Control is not the same as ownership: they can be separated Shares with differential voting rights Shares with differential voting rights Pyramids Pyramids Cross-ownership Cross-ownership Trust agreements Trust agreements In fact, outside US and UK, such separation is very common Greater separation and greater concentration of control seem to be more common in countries with weak legal shareholder protection Not surprising: control is very valuable there, more valuable than CFR Not surprising: control is very valuable there, more valuable than CFR Separating it from CFR gives possibility to retain control while selling CFR Separating it from CFR gives possibility to retain control while selling CFR

8 Example. Control structure of Microsoft Bill Gates (chairman) – 9.2% Steven Ballmer (CEO) – 4.4% Almost all the rest is free float (institutional investors, mutual funds, individuals) No pyramids, no cross holdings, only one type of shares

9 Example. Nordström family control of Realia (Sweden) Nordström family is the largest shareholder of Realia: control rights are 39.3%, though CFR are only 2.66% But its control is likely to be restricted by Blockfield Properties (14.1% of control rights) Note: Realia has 2 classes of stock: million of A-shares with 1 vote each and million of B-shares with 1/10 vote each

10 Ownership and control around the world La Porta et al (JF 1999) Take 27 mainly developed countries, 20 largest firms in each country Take 27 mainly developed countries, 20 largest firms in each country Trace ultimate beneficial owners. Trace ultimate beneficial owners. At 20% control threshold only 36% of large corporations in the world are widely held At 20% control threshold only 36% of large corporations in the world are widely held 30% of firms are family-controlled 30% of firms are family-controlled In Continental Europe and Asia widely held firms are rare and family-controlled firms are more common In Continental Europe and Asia widely held firms are rare and family-controlled firms are more common In countries with high shareholder protection (mostly Anglo-Saxon) widely held firms are common and family-controlled firms are rare In countries with high shareholder protection (mostly Anglo-Saxon) widely held firms are common and family-controlled firms are rare

11 Control of large publicly traded firms over the world (LLS (1999)). High antidirector rights subsample

12 Control of large publicly traded firms over the world (LLS (1999)). Low antidirector rights subsample

13 One-share one-vote, cross-shareholdings, and pyramids (LLS (1999)). High antidirector rights subsample

14 One-share one-vote, cross-shareholdings, and pyramids (LLS (1999)). Low antidirector rights subsample

15 Family control in large traded firms (LLS (1999)). High antidirector rights subsample

16 Family control in large traded firms (LLS (1999)). Low antidirector rights subsample

17 Example: Wallenberg family Controls about 40% of Swedish stock market. Mostly through Investor AB. Investor AB core investments (from Investor AB website): ABB - power and automation technology (7.2% Stake, 7.2% Voting rights) ABB - power and automation technology (7.2% Stake, 7.2% Voting rights) Atlas Copco - industrial tooling and equipment (15.4% Stake, 21.2% Voting rights) Atlas Copco - industrial tooling and equipment (15.4% Stake, 21.2% Voting rights) Astra Zeneca - pharmaceuticals (3.5% Stake, 3.5% Voting rights) Astra Zeneca - pharmaceuticals (3.5% Stake, 3.5% Voting rights) Electrolux - consumer appliances (11.9% Stake, 28.2% Voting rights) Electrolux - consumer appliances (11.9% Stake, 28.2% Voting rights) Ericsson - telecommunications (5.1% Stake, 19.5% Voting rights) Ericsson - telecommunications (5.1% Stake, 19.5% Voting rights) Husqvarna - Auto, chainsaw and sewing machine manufacturer (14.1% Stake, 27.5% voting rights) Husqvarna - Auto, chainsaw and sewing machine manufacturer (14.1% Stake, 27.5% voting rights) Saab - aviation and military technology (19.8% Stake, 38.0% Voting rights) Saab - aviation and military technology (19.8% Stake, 38.0% Voting rights) Scania – heavy trucks, buses, engines (11% Stake, 20% Voting rights) Scania – heavy trucks, buses, engines (11% Stake, 20% Voting rights) SEB - banking (20% Stake, 20.3% Voting rights) SEB - banking (20% Stake, 20.3% Voting rights)

18 Concentration of control at the country level. East Asia Source: Claessens, Djankov and Lang (JFE 2000), based on 2980 public corporations, ultimate owners are traced, control threshold is 20%

19 Concentration of control at the country level. Europe Source: Faccio and Lang (2002), based on 5232 public corporations, ultimate owners are traced, control threshold is 20%

20 How do controlling owners enhance their control in Asia?

21 How do controlling owners enhance their control in Europe? Source: Faccio and Lang (2002)

22 How do controlling owners enhance their control in Europe? Subsample of family controlled firms

23 How large are largest shareholders? Average largest holder in listed companies (in terms of voting rights): East Asia: from 10.33% in Japan to 35.25% in Thailand East Asia: from 10.33% in Japan to 35.25% in Thailand Europe: from 25.13% in UK to 54.50% in Germany Europe: from 25.13% in UK to 54.50% in Germany In Russia: average largest holder in listed companies controls 50+% ?

24 Whats the degree of separation of ownership and control? Average ratio of cash flow rights to control rights: East Asia: from 0.6 in Japan to 0.94 in Thailand East Asia: from 0.6 in Japan to 0.94 in Thailand Europe: from 0.74 in Switzerland to 0.94 in Spain Europe: from 0.74 in Switzerland to 0.94 in Spain Russia ? Russia ?

25 How valuable is control? Control premia are higher in countries with weaker shareholder protection, weaker enforcement Difference between price of voting and non- voting shares (Nenova (2003)) Difference between price of voting and non- voting shares (Nenova (2003)) 0% in Denmark, 2% in the US, 46% in Mexico Difference between price of block and market price of dispersed shares (block premium) (Dyck and Zingales (2002)). Difference between price of block and market price of dispersed shares (block premium) (Dyck and Zingales (2002)). 2% in Denmark, 5% in the US, 30% in Mexico

26 Ownership concentration around the world. Summary Except US and UK ownership and control in firms are concentrated in the hands of one or few large shareholders ownership and control in firms are concentrated in the hands of one or few large shareholders These large shareholders often belong to few families that control large part of the countrys economy These large shareholders often belong to few families that control large part of the countrys economy Concentration of control in firms and separation of CR from CFR seem more widespread in countries with weaker shareholder protection Control is more valuable in countries with weak shareholder protection, weak enforcement

27 Russia Guriev and Rachinsky (2004) Control structure of 1700 large firms in 45 sectors in % of Russias total industrial output. Control structure of 1700 large firms in 45 sectors in % of Russias total industrial output. Traced ownership to 627 ultimate owners or groups of owners Traced ownership to 627 ultimate owners or groups of owners Ended up with the list of 22 largest private domestic owners (or groups), each of them controlling assets that either generate > $700 million in sales or have > 20,000 employees Ended up with the list of 22 largest private domestic owners (or groups), each of them controlling assets that either generate > $700 million in sales or have > 20,000 employees

28 Ownership concentration in Russian industry Source: Gurev and Rachinsky (2004). Numbers are calculated using the proportional method; if recalculated based on the majority rule numbers become bigger: 47% for employment and 43% for sales.

29 Comparing Russia to other countries Top 10 oligarchs (or groups) owned 60.2% of the stock market in June 2003 In developed Continental European countries top 10 families control 11-34% of the stock market (Faccio and Lang 2002) In East Asian countries top 10 families control: 58% of the stock market in Indonesia 58% of the stock market in Indonesia 52% in Philippines 52% in Philippines 43% in Thailand 43% in Thailand

30 Costs and benefits of family control for a firm Benefits of ownership concentration: Reduces separation of ownership from control, typical for US and UK firms Reduces separation of ownership from control, typical for US and UK firms No pandering to short-term market pressures, focus on long-term value No pandering to short-term market pressures, focus on long-term value Family values? Family values? Benefits related to groups/pyramiding Internal markets (capital, managerial, product) Internal markets (capital, managerial, product) Insurance against shocks (reduces fin. distress costs) Insurance against shocks (reduces fin. distress costs) Political connections Political connections

31 Costs of ownership concentration Lack of diversification for large shareholders Lack of diversification for large shareholders Lack of liquidity of a firms stock Lack of liquidity of a firms stock Agency problem: divergence of interest between large and small shareholders, especially when controlling holders control rights (CR) > his cash flow rights (CFR) Agency problem: divergence of interest between large and small shareholders, especially when controlling holders control rights (CR) > his cash flow rights (CFR) Uncontestable control – no market discipline Uncontestable control – no market discipline Costs of pyramids Magnify separation of control from CFR Magnify separation of control from CFR Succession problem. What if a heir is less competent than the founder? Dilemma: To pass control to the heir To pass control to the heir To hire a professional manager, but then separation of ownership from control To hire a professional manager, but then separation of ownership from control Note: Russian oligarchs are still too young to face the succession problem (Felix and Tatiana Evtushenkov, Anton Fedun, Olga Rashnikova…) Note: Russian oligarchs are still too young to face the succession problem (Felix and Tatiana Evtushenkov, Anton Fedun, Olga Rashnikova…)

32 Additional economy level costs of family control What is good for a group may be bad for economy Market power (especially in a closed economy) Market power (especially in a closed economy) Misallocation of recourses (even if inside the group allocation is efficient) Misallocation of recourses (even if inside the group allocation is efficient) Political influence may harm other economy participants (later on that) Political influence may harm other economy participants (later on that)

33 Empirical evidence on performance of family firms Free-standing family controlled firms outperform widely-held firms in the US (Anderson and Reeb (2003)) Especially if the firm is relatively young (Morck et al(1988), Anderson and Reeb (2003)) But (!) inherited control reduces firm value, especially if the heir appointed as CEO did not get proper education (Perez-Gonzales (2002)) Also, Anderson and Reeb (2003) find that firms managed by the founder descendants are valued lower than those managed by founders Also, Anderson and Reeb (2003) find that firms managed by the founder descendants are valued lower than those managed by founders

34 Pyramids/groups and bad? Morck et al (2000): family firms in Canada (often in pyramids) underperform similar Canadian and US widely-held firms Morck et al (2000): family firms in Canada (often in pyramids) underperform similar Canadian and US widely-held firms Khanna and Rivkin (2001) on developing countries: in the majority of countries group firms have higher ROA Khanna and Rivkin (2001) on developing countries: in the majority of countries group firms have higher ROA Khanna and Palepu (2000) on India: benefits of pyramids depend on degree of diversification in a group (moderate diversification is bad) Khanna and Palepu (2000) on India: benefits of pyramids depend on degree of diversification in a group (moderate diversification is bad) Why in developing countries pyramids perform better? Political connections are especially beneficial Political connections are especially beneficial Underdeveloped markets (relying on internal markets have greater value) Underdeveloped markets (relying on internal markets have greater value)

35 Empirical evidence on expropriation of small shareholders by families Greater separation of control from cash flow rights leads to lower market valuation (many studies on different countries) Firms in lower tiers of pyramids (i.e. where separation of CR from CFR is larger) suffer from tunneling – transfer of recourses to the apex (Bertrand et al (2002) on India, Bae et al (2002) on Korea) Holmen and Högfeldt (2002) do not find this for Sweden Holmen and Högfeldt (2002) do not find this for Sweden

36 Why are control structures differ across countries? Legal environment. Weak protection of minority shareholders (weak enforcement of property rights in general) encourages concentration of control Weak protection of minority shareholders (weak enforcement of property rights in general) encourages concentration of control Tax system taxation of intra-group dividends (US) discourages pyramids taxation of intra-group dividends (US) discourages pyramids Openness of the economy Makes political connections less valuable Makes political connections less valuable

37 Russia. How do oligarch-controlled firms perform compared to other firms? (Guriev and Rachinsky (2004)) Regression analysis results: Total factor productivity growth of oligarch-controlled firms is 8% higher on average (controlling for other things) Total factor productivity growth of oligarch-controlled firms is 8% higher on average (controlling for other things) This difference stems from a increase in output rather than employment cuts This difference stems from a increase in output rather than employment cuts Perhaps oligarchs simply acquired assets with faster productivity growth? No! Prior to 2002 productivity growth of oligarch- controlled firms was not different from other companies. Moreover, productivity levels were lower No! Prior to 2002 productivity growth of oligarch- controlled firms was not different from other companies. Moreover, productivity levels were lower Thus, it seems oligarchs took over poorly performing firms and turned them around Thus, it seems oligarchs took over poorly performing firms and turned them around