Investigations of the European frontier markets: ownership composition and financial performance

Transcription

1 Investigations of the European frontier markets: ownership composition and financial performance R.M. Ammar ZAHID*, 1, Alina TARAN 2, F.N. Can SIMGA-MUGAN 3 1 R.M. Ammar Zahid is PhD student in Accounting at Graduate School of Business, Izmir University of Economics, Izmir, Turkey Izmir and Instructor at Virtual University of Pakistan (currently on study leaves). His main area of interests are Financial Accounting, Corporate Governance and International Accounting. 2 Alina Țaran is PhD student Doctoral School of Economics and Business Administration, Alexandru Ioan Cuza University of Iasi, Romania, and at Lecturer, Faculty of Business, Izmir University of Economics, Izmir, Turkey. Her main research interests are international accounting, financial accounting, financial analysis and corporate finance. 3 F.N. Can Simga-Mugan, Ph.D. is Rector and Professor of Accountancy at Izmir University of Economics. She has published various articles in international journals and book chapters, and she has taught financial and managerial accounting, accounting theory and research courses. She participated as expert financial consultant in the World Bank and KfW infrastructure projects. 1 Corresponding author: PhD Fellow, Department of Business Administration, Izmir University of Economics; Sakarya Caddesi, no: 150, Balcova 35330, Izmir, Turkey; tel. ( ); address: amrzahid@gmail.com.

2 Investigations of the European frontier markets: ownership composition and financial performance Abstract In their path of transition and evolution, frontier markets provide unique opportunities of diversification and potential of growth. Development level of capital markets is a sign of economic prosperity and stability, and thus, the performance of companies from frontier markets represents an indicator of growth of these markets. The corporate governance literature indicates mixed findings and opinions regarding the role and influence of ownership in firm s performance. This study investigates the influence of ownership composition, as corporate governance mechanism, on financial performance of listed companies from European frontier markets. The ownership composition is assessed from three perspectives: concentration, diversity, and structure (foreign ownership, local ownership, state ownership and free float). The firm performance is also measured as both market performance (Tobin s Q) and accounting performance (Return on Assets). A sample of 94 indexed companies from 6 European frontier markets during has been analyzed. The results of panel regression estimations indicate that ownership concentration has significant positive impact on the market performance of the firms. As expected, the ownership diversity has an opposite effect, and thus, a significant negative relationship with market performance. Moreover, the share of local ownership has significant positive relationship with the firms market performance. No significant relationship was found between ownership and financial performance based on accounting measurement. These findings reveal the ownership characteristics in the region, and may impact potential and existing investors in their investing decisions. Keywords: Ownership structure, Ownership concentration, Corporate governance, Frontier markets, Firm performance. JEL classification: G32, O16, M49

3 1. Introduction: The influence of ownership types and characteristics on the firm s performance has been a highly debated topic in corporate governance literature, for many years. Two contesting theories explain this influence. First, concentrated ownership improves performance by decreasing the monitoring and control costs (Shleifer and Vishny, 1986, Shleifer and Vishny, 1997). If the legal system of a country is relatively weak, advantages of concentrated ownership are more obvious (La Porta et al., 1999), as in the case of most emerging and frontier markets. On the other hand, the expropriation risk enhances the conflict of interest between controlling and minority shareholders. Concentrated ownership and large shareholders may have additional private benefits (Hansmann and Kraakman, 2004b). In the frontier markets, less developed institutional structures and weaker external controls might aggravate such risks (Williamson, 1991, La Porta et al., 1999). As these theoretical perspectives are contradictory, the existing empirical evidence is also inconsistent. In a first stage, empirical studies about the relationship between ownership and firm performance analyzed developed countries. However, the theories of developed markets may not apply to developing markets. Thus, the focus of research has gradually oriented towards emerging markets. Hence, frontier markets as a distinctive category with specific characteristics have remained less explored. They are characterized by different economic, political and institutional conditions, which may not be properly captured by the empirical models of developed markets. Recent corporate governance literature indicates the significant role of legal and tax system, geographical position, industrial development and country level cultural characteristics. Frontier markets have a low level of development in comparison to developed and emerging markets, but they provide diversification opportunities to worldwide investors due to low integration with the other world markets (Berger et al., 2011). Thus, frontier markets are expected to continually evolve. For example, the launch of frontier market exchange-traded funds and mutual funds further promoted and accelerated investment in frontier markets. European frontier markets provide a unique case of investigation because of their geographic position, under the influence of Western developed markets, and under the European Union (EU) dominance. Historically, they faced numerous transformations and reforms, and

4 nowadays they are seeking to follow the model of the international best practices in order to attract both investors and companies. The objective of the current study is to analyze the impact of ownership composition on financial performance of companies from European frontier markets, and thus, to investigate the recent financial market development in the region. For this purpose ownership composition is measured as ownership concentration, ownership diversity, and ownership structure (foreign ownership, local ownership, state ownership and free float), and firm performance as Tobin s Q and ROA. A unique dataset, covering companies from the six frontier markets from European region and European Union (Bulgaria, Croatia, Estonia, Lithuania, Romania, and Slovenia; as classified by Morgan Stanley Capital International - MSCI classification 2017), was analysed during the recent period ( ). Data has been retrieved from Thomson Reuters Eikon database, and the applied method is cross-sections fixed effects panel regression analysis. It was found that ownership concentration has a significant positive impact on the market performance of European frontier firms, whereas ownership diversity has significant negative impact on Tobin s Q. Moreover, from the ownership structure components (i.e. foreign, local, state and free float) only local ownership has significant positive impact on the market performance of the listed companies. However, the analysis of ownership composition impact on accounting measure of firm performance does not provide significant results. These findings reveal the ownership characteristics in the region, and may impact potential and existing investors in their investing decisions. The remainder of the paper is organized as follows. Section 2 reviews the existing literature regarding the effects of ownership structure on firm performance. Section 3 describes variables and data selection, and the model specification. Section 4 introduces the empirical analysis and the results. Section 5 concludes the paper. 2. Literature review and theoretical background Corporate governance practices represent a mechanism to solve agency conflicts that appear due to the separation of interests between shareholders and management. The initial focus of the literature regarded the principal/agent conflict between owners and managers. This arises because of manager s interest to misappropriate perquisites from the firm s resources for its own interests, which conflicts to owner s interest (Jensen and Meckling, 1976). Therefore,

5 ownership concentration is considered an internal mechanism to alleviate owner manager conflict. When ownership is concentrated in few large shareholders, they will closely monitor managers performance, which will result in the alignment of the managers interests with those of the firm (Berle and Means, 1991, Demsetz, 1983, Shleifer and Vishny, 1986, Denis et al., 1997). Thus, both a firm s value and its performance increase with the concentration level of ownership. Other studies have assessed the impact of different groups of shareholders (e.g. foreign, local, state) on firms performance, and conclude that certain categories of investors perform the monitoring better than others, but the evidence is contradictory (Demsetz and Villalonga, 2001, Leech and Leahy, 1991, Wang and Shailer, 2015) In time, theory and studies have extended to principal/principal conflicts, which represent the conflicts between large and minority shareholders. Such conflicts may arise due to the large shareholders and the manager association (Denis and McConnell, 2003, Holderness, 2003) or misuse of private control benefits by the main shareholder to exploit the minority shareholders (Porta et al., 1998) and the firm s resources. Concentrated ownership results in conflicting interests and harmful control between the monitoring and minority shareholders. In such cases controlling shareholders may extricate private benefits at the cost of minority shareholders (Hansmann and Kraakman, 2004a), which means that the concentrated ownership may have negative impact on firm s financial performance. La Porta et. al., (1999) seminal work transformed the common notion of ownership structure and performance. They point out that benefits associated with the concentrated ownership are more obvious in countries with low levels of investor protection and weaker legal system, as in the case of many emerging and frontier markets (La Porta et al., 1999). Legislators have always been worried about safeguarding companies interests through restricting the possibility of management or majority shareholders powers and authority misuse. To restrain them from tunneling, related-party dealings or other dealing effecting the minority shareholders (Zattoni and Van Ees, 2012), protective legal frameworks have been developed. Their aim is to regulate principal/principal/agent conflicts, and the transactions associated with the conflict of interest. Ownership structure might have a positive or negative relationship with firm performance. The proponents of positive effect of ownership concentration on financial performance claim that the ownership concentration helps in interest alignment of principal/agent. Ownership works as an internal control mechanism to substitute weak legal and institutional environments. Thus, it

6 may have positive impact on the firm s performance. On the other hand, ownership concentration may have a negative relationship with firm performance because of principal/principal agency problem (i.e monitoring shareholders maximize their profits on the cost of minority shareholders/firm), or the cost of capital hypothesis (Wang and Shailer, 2015). From the above discussions, it can not be concluded whether ownership structure has a positive or negative influence on financial performance of a company. Empirical studies about ownership concentration and firm s performance have also found mixed results. Demsetz and Lehn (1985) analyzed the impact of ownership concentration on accounting profits and found no evidence. Hill and Snell (1988) and (1989) found that ownership structure has significant positive impact on performance of US firms, measured by profitability ratios or productivity proxy. Leech and Leahy (1991) also examined the impact of ownership concentration on UK firm value and profitability. They used different measures to define ownership structure and concentration, and found a significant negative relationship between ownership concentration and firm value and profitability. Mudambi and Nicosia (1998) also found a negative relationship between ownership concentration and firm performance in UK. Thus, the existing findings about the ownership concentration and firm performance relationship are conflicting, depending on the specific characteristics of countries and markets. Worldwide corporate governance mechanisms are diverse and they may generate variations in the impact of ownership structure on performance of firms. Shleifer and Vishny (1997) stated that corporate governance mechanisms around the world economies can be classified into three broad groups. First, there are the market-based economies, like UK and USA, in which the investors are legally protected, and ownership is dispersed among small shareholders. Second, there are the bank-based economies, like Germany and Japan, in which small investors have less importance then large investors, and the rules and regulations are mainly addressed to protect the large investors and banks. Third, there are the family ownership based economies, like Turkey or other transition economies, in which ownership is concentrated in family members, and legal protection is weak. Above differences in corporate governance mechanisms lead to different expectations regarding the relations between ownership and firm performance. The specific contexts in which firms are operating, legal and institutional mechanism heavily affect the governance structure of specific firms (Ararat and Dallas, 2011). Therefore, the country specific empirical

7 studies uncover the different corporate governance mechanism, especially in case of emerging and frontier markets. Thomsen and Pedersen (2000) found a positive relationship between ownership concentration and firm performance, for 12 developed European economies. However, the effects may not be homogeneous in whole the Europe, like Kirchmaier and Grant (2005) indicated. They showed that ownership concentration has negative impact on firm s performance in five developed European markets. Besides developed markets, Eastern European markets are rapidly growing but they still cannot be compared with Western European markets. In Eastern Europe, both emerging and frontier markets have unique institutional characteristics which differentiate them. They all faced the transition to the civil law tradition, as a part of EU membership. Moreover, Eastern European markets experienced a massive privatization process, but the number of listed companies is still low. Despite the adoption of the Anglo-American governance system, managers have considerable control on the cash flows, and dividend payouts are lower (Mueller and Peev, 2007). Regardless of the above insights regarding the impact of ownership characteristics on firm performance, this topic is found underexplored for the context of emerging, and especially frontier markets. The current study examines the influence of ownership composition on the financial performance of indexed listed companies from European frontier markets. These markets have underdeveloped financial systems, due to communist period, and have a certain number of common regulatory reforms such as the adoption of corporate governance codes.

8 3. Data and Research Design Data used in this study covers public listed companies from the six frontier markets in Europe. These markets are selected based on the classification of frontier markets made by MSCI in Our analysis includes the firms listed at the moment of the research in the benchmark indexes of the selected markets, as presented in Table 1. Table 1. Selected countries and the number of companies for analysis Country EU membership Index # companies Croatia 2013 CROBEX Index 19 Estonia 2004 OMX Tallinn General 16 Lithuania 2004 OMX Vilnius General 20 Romania 2007 BET Index 13 Slovenia 2004 SBITOP 11 Bulgaria 2007 Bulgarian Stock Exchange Index 15 Total 94 All data has been extracted from the Thomson Reuters Eikon database. The sample period extends from 2005 to 2016, being determined by the data availability, and capturing the effect of EU membership of the selected countries. The total number of the companies included in the analysis are 94 and the total number of firm-year observations for each variable after excluding the outliers are 799. The objective of the current study is to investigate the impact of ownership composition on the financial performance of the firms. For the empirical analysis, the following equation has been estimated:!" #,% = ( + * #,% +,-./ + 0 #,%, + 1 #,% where:!" #,% represents the performance of the firms alternatively Tobin s Q and ROA, OComp represents ownership composition alternatively (as ownership concentration ratio, ownership diversity ratio and ownership structure), and C represents the control variables. The selected model is fixed effect panel data model. Existing studies indicated that there is endogeneity problem in ownership structure relationships. However, fixed effects models are indicated as appropriate in addressing endogeneity issue arising due to unobservable firm related factors (Wang and Shailer, 2015).

9 The financial performance of the firms has been calculated by Tobin s Q, and ROA. Market performance measures such as Tobin s Q are considered forward-looking measures of firm performance, which reflect investors anticipations of the company s future. Compared to other measure these are less vulnerable to accounting manipulation and differences, however, effected by investor sentiment (Demsetz and Villalonga, 2001). Prior research indicates that apart from the ownership composition, different firm-specific characteristics also affect the firm performance. These factors can be: firm size (Fama and French, 1995), company age (Ang et al., 2000), financial structure (Grossman and Hart, 1982, Stulz, 1990) or country legal environment (Porta et al., 1998). Hence, the followings are used as firm level control variables in the estimated model: logarithm of total assets for size effect, logarithm of years of incorporation for the age of firm, debt ratio for the financial structure or leverage. Rule of law and regulatory quality, as scores reported in the Worldwide Governance Indicators (WGI) determined by World Bank, are used to control the country specific characteristics. Table 2 presents the measurement details of the selected variables.

10 Table 2. Definitions of variables Variables Definitions Dependent variables: Market measures Tobin s Q (Total Assets Total Equity + Market Capitalisation)/ Total Assets Book measures ROA Net income / Average of total assets (Source: Eikon database) Independent variables: Ownership Herfindahl Index (sum of squared percentage of shares held by Concentration each of the strategic shareholders) (Chen et al., 2014) Ownership diversity 1 / Sum of squared ratio of cumulative strategic ownership from each category (foreign, local, state)(chen et al., 2014) Ownership Structure FO Ratio of shares held by foreign strategic shareholders in total shares Ratio of shares held by local strategic shareholders except LO governmental authorities in total shares State Ratio of shares held by state shareholders in total shares FF Free float Control Variables: Firm level Size Total Assets Age Number of year since the incorporation date of the company Debts Total debt / Total equity Country level RQ (regulatory Reflects perceptions of the ability of the government to formulate quality) and implement sound policies and regulations that permit and promote private sector development. RL (rule of law) Reflects perceptions of the extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence. 4. Empirical Results and Discussions Table 3 exhibits the results of the descriptive statistic of the variables used in the model. The arithmetic means and median are close except for the ownership diversity and total assets. These two also have a large difference between the maximum and minimum values, so have greater standard deviation. For instance, total assets ranges from the 2.3 million (minimum) to 17 billion (maximum) with a standard deviation of 2.4 billion. The skewness and kurtosis of the of the ownership diversity are 24.7 and respectively. Similarly, total assets, age and Tobin s Q also have highly leptokurtic and positively skewed distributions. Logarithmic transformations are used to normalize these variables before using in the estimations. The Jarque-Bera normality test results also indicate that the null hypothesis of normality for all

11 variables has been rejected. Table 3: Descriptive statistic Mean Median Max Min Std. Dev. Skwns Krtos J-B TQ (6918.1)*** ROA (3453.6)*** OC (77.2)*** OD ( )*** FO (1619.9)*** LO (70.6)*** SO (1634.9)*** FF (36.3)*** TA ( )*** AGE (364.7)*** DR (103.9)*** RL (76.4)*** RQ (70.6)*** TQ represents the Tobin s Q, ROA = Returns on Assets, OC = Ownership Concentration, OD = Ownership Diversity, FO = Foreign Ownership, LO = Local Ownership, SO = State Ownership, FF = Free Float, TA = Total Assets, AGE = years from the date of incorporation, RL = Rule of law, and RQ = Regulatory Quality. J-B = Jarque- Bera normality test. *,**,*** denote significance at the 10%, 5% and 1% significance levels respectively. It is important to check the correlations among the variables before applying the final regression analysis. Table 4 presents the results of the Pearson correlation coefficients. It can be observed that the Tobin s Q have significant correlations with ROA, foreign ownership, state ownership, size and rule of law. However, the coefficients of correlation are very small. Overall, ownership concentration has significant negative correlations with ownership diversity and free float share with a coefficient of greater than 70%. Free floats are also significantly positively correlated with the ownership diversity (82.3%), as expected. Rule of law and regulatory quality are also significantly positively correlated with each other. For the rest of the pairs, correlation coefficients are very small.

12 Table 4: Pearson Correlations LTQ ROA OC LOD FO LO SO FF LTA LAGE DR RL RQ LTQ 1 ROA 0.394*** 1 OC ** 1 LOD *** 1 FO 0.073** *** *** 1 LO ** 0.224*** *** *** 1 SO *** *** *** ** *** 1 FF *** 0.823*** *** *** *** 1 LTA * 0.146*** 0.071** 0.296*** *** 0.220*** LAGE *** *** 0.113*** *** *** 0.167*** 1 DR *** *** *** 0.104** ** 0.085* *** RL 0.084** 0.075** *** 0.176*** ** *** 0.091* 0.130*** 1 RQ 0.128*** 0.102** 0.073** *** *** 0.321*** *** *** *** *** *** 1 Where LTQ represents the Log of Tobin s Q, ROA = Returns on Assets, OC = Ownership Concentration, LOD = Log of Ownership Diversity, FO = Foreign Ownership, LO = Local Ownership, SO = State Ownership, FF = Free Float, LTA = Log of Total Assets, LAGE = Log of years from the date of incorporation, RL = Rule of law, and RQ = Regulatory Quality. Note 2: throughout the manuscript, *,**,*** denote significance at the 10%, 5% and 1% significance levels respectively.

13 Overall, the correlation analysis indicates that there is an association between firm s performance and ownership structure. Further regression models are applied to investigate the relationship. Table 5 presents the results of panel data regression analysis. Cross-section fixed effects were included in order to control the firm characteristics. The impact of ownership composition on firm performance has been analyzed from three perspectives: ownership concentration, ownership diversity and ownership structure. Firm performance is also measured from two perspectives: Tobin s Q (market performance measure), and Returns on Assets (ROA) (accounting performance measure). Table 5 column 2 shows that ownership concentration has a significant positive impact on the Tobin s Q. Column 3 indicates the significant negative impact of ownership diversity on the Tobin s Q. Column 4 presents the relationship of ownership structure and market performance of the firm. Only the local ownership has significant positive impact on the Tobin s Q, from the four categories of ownership structure. Columns 5 and 6 also evidence similar positive and negative association of ownership concentration and diversity with the ROA respectively, but have no explanatory power. Ownership structure also does not have any significant relationship with ROA (column 7). In all the regression models, age of the companies has a significant negative relationship with the firm s performance. The size control (total assets) also have significant negative relationship in market performance measure models (Tobin s Q), but insignificant positive relationship with ROA (accounting performance measure). The leverage (debt ratio) and rule of law also have significant negative and positive respectively relationship with ROA. The overall model fit measure shows that all the estimated models have a good fit. Tobin s Q models explains about 64% (R 2 ) of the relationship, while models with ROA about 44% (R 2 ) of variations.

14 Table 5: Panel regressions: Performance and ownership composition Dependent variable TQ TQ TQ ROA ROA ROA C (4.26)*** (4.41)*** (3.74)*** (-0.11) (-0.09) (0.05) OC (1.85)* (0.27) LOD (-2.00)** (-0.29) FO (0.13) (0.02) LO (3.66)*** (-1.24) SO (0.43) (0.69) FF (1.58) (-0.38 LTA (-3.03)** (-3.03)** (-2.92)** (1.12) (1.13) (1.07) LAGE (-4.62)*** (-4.71)*** (-4.56)*** (-2.27)** (-2.28)** (-2.19)** DR (0.39) (0.53) (1.01) (-10.52)*** (-10.52)*** (-10.70)*** RL (-0.64) (-0.51) (-0.43) (1.87)* (1.86)* (1.85)* RQ (-0.27) (-0.26) (-0.48) (-1.54) (-1.52) (-1.61) R-squared Log likelihood F-statistic 12.60*** 12.64*** 12.60*** 6.00*** 6.01*** 5.84*** TQ represents the Log of Tobin s Q, ROA = Returns on Assets, OC = Ownership Concentration, LOD = log of Ownership Diversity, FO = Foreign Ownership, LO = Local Ownership, SO = State Ownership, FF = Free Float, LTA = Log of Total Assets, LAGE = log of years from the date of incorporation, DR = Debt ratio, RL = Rule of law, and RQ = Regulatory Quality.!" #,% = ( + * #,% +,-./ + 0 #,%, + 1 #,% where!" #,% represents the performance of the firms alternatively Tobin s Q and ROA, OComp - Ownership composition alternatively (OC-ownership concentration ratio, OD-ownership diversity ratio and OS-ownership structure) and C represents the control variables (size, age, leverage, regulatory quality and rule of law).

15 The significant positive/negative impact of ownership concentration/diversity on the firms market performance (Tobin s Q) respectively, provides the evidence in favor of Shleifer and Vishny (1986) hypothesis that large shareholders may reduce the problem of small investors, and hence increase the firm s performance. Significant association of Tobin s Q with ownership concentration and diversity also shows that the European frontier markets are efficient, and market information processing is faster then than the accounting information availability. The insignificant results of accounting performance measure (ROA) are contradictory to Abdel Shahid (2003) who concluded that accounting measure of performance are more important for investors rather than the market measure of performance. Hence, we can conclude that in case of European frontier markets are more future oriented, and investor also use other sources of information apart from accounting information. This finding is also contradictory to Kapopoulos and Lazaretou (2007) and Kowalewski et al. (2010) studies. Both of them found a positive association between ownership concentration and accounting profits, as measured by ROA. The ownership structure effects on firm s performance shows that only among the Foreign, Local, State and free float ownership, only Local ownership have significant positive impact on the Tobin s Q. 5. Conclusions One of the main research questions in corporate governance, the potential relationship between ownership composition and firm s performance, still has an unclear answer. Some of the theories suggest that ownership structure has positive or negative impact on firm performance, while others suggest the irrelevance of ownership structure with respect to firm performance. Similarly, empirical studies on ownership composition and firms performance also provides mixed results. The relationship also varied from market to market (e.g developed vs. developing). This study investigated the impact of ownership composition on the firms performance of European Frontier markets from three perspectives: ownership concentration, ownership diversity, and ownership structure (foreign ownership, local ownership, state ownership, and free float). The firm performance is also measured as both market and accounting measures. These frontier markets provides unique opportunity diversification and regulatory regime, and thus, the relationship between ownership and performance may further influence the investment decisions in these markets. The paper has very interesting and significant findings. The ownership concentration has

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