Ownership Structure, Corporate Structure and Economic performance: A Comparison in the Nordic Region

Transcription

1 MSc in Finance & International Business Academic Advisor: Morten Balling Ownership Structure, Corporate Structure and Economic performance: A Comparison in the Nordic Region Author: Ólafur Viðarsson Aarhus School of Business September/2008

2 This page has been left blank intentionally

3 1 Introduction Why this topic The research question Structure of the thesis Theoretical background Theory of the firm Agency theory Corporate governance Ownership structure Ownership concentration Identity of owners Board of directors Corporate structure Capital structure Industry Age of company and lifecycle Hypotheses for the study Corporate Governance and the Nordic environment Nordic financial markets Legal system and environment Codes and principles International bodies National codes and principles Implications for the study Comparative/empirical study in the Nordic Exchanges Introduction Data Datasources Quality of the data Explanatory variables Dependent variables...38 i

4 4.3 Model / Methodology Results Conclusion...44 Appendix...45 Definitions of CG from several CG bodies...45 Herfindahl-Hirschman Index (HHI) for ownership concentration...47 References...48 ii

5 1 Introduction Firms around the world need to be able to attract new funds from investors in order to grow and expand. When attracting money the firms must convince the investors that the business is well managed, that the business is financially sound and will yield good return for the investors, and they must demonstrate that the management is concerned about the investors funds. Investors rely on the company s financial information as well as information about the company s strategy and how the company is managed. The quality of disclosed information can affect the confidence of those who have invested their funds in the firms. Publicly listed firms are subject to disclosing immediately all information that might affect the price of their listed securities, both bonds and shares. Investors also rely on the company s annual- and interim reports to give the true and fair view of the business activities. These reports are, at least on an annual basis, subject to an audit of an external independent auditor that certifies that the reports are in accordance with accepted accounting standards. Investors should therefore be able to trust that all relevant information is well known to the market at any time. Due to the high profile corporate collapses of some large corporations, the issue of Corporate Governance has been widely discussed. Even though the company s disclosure, especially the annual and quarterly reports, gave no indication that the companies were not doing well, these collapses became a reality. As a result, investors lost their money, people lost their jobs and in some cases the security of the company pension also got lost, suppliers of goods and services to the failed company lost money etc. It is therefore inevitable that stakeholders to the companies ask why these collapses did occur, and if these collapses could have been avoided? What can be done to prevent any future collapses? And following these high profile collapses, companies have asked themselves how they can restore trust of investors again? All these questions have been related to the Corporate Governance (CG) concept

6 The purpose of this thesis is to examine the relationship between selected corporate governance characteristics and the performance of companies in the Nordic region. More specifically, the effect of ownership structure and corporate structure in corporations on their performance will be analysed by examining several common factors that are widely believed to influence this problem or be a common symptom associated with the problem. In this context, ownership structure refers to the composition and characterisation of the owners and corporate structure refers to characteristics of the company itself. Several ways to improve corporate governance exists. The most widely discussed are (a) setting regulations and codes that firms can follow, (b) aligning the interests of managers with those of the owners (more specifically the shareholders) and (c) direct monitoring of management to ensure that decision making will be in the interest of the owner. But even with all codes and regulations in place, the incentive for management not to behave in the best interest of the shareholders still exists. Other interesting solutions to the agency problems, which have been categorised under the CG umbrella, will not be part of this thesis. The link between performance and management remuneration has shown positive relationship and is often thought to be one of the best ways to align the interests of managers with those of the investors. Personal career of managers is not examined in the thesis, but the empire building of management is often discussed in this context and is seen as one source of the problem. Market for corporate control is not covered and no survey about corporate takeover is conducted. The market for corporate control has proved to restrict management actions that are not in the best interests of the shareholders and has had disciplinary effects on managers that they have not proved to be efficient on shareholders behalf. This is mainly because there is no active market for corporate control in the countries discussed in this thesis. At least, many state that there is no active market, but I might leave the reader with the question here whether there is an active market since there has been increase in takeovers in the Nordic countries where investors have mainly be focusing on companies that with poor performance

7 1.1 Why this topic Developments in the financial markets the past three decades, as well as several recent incidents, have demonstrated the increased importance of corporate governance in the business environment. The numbers of privatizations during the past 2-3 decades have raised the discussion about how companies should be owned and managed. The growth of institutional investors (active investors) and private savings spent on financial market through collective funds and pension plans has increased enough to influence the governance of companies. Increased mergers and (hostile) takeovers in USA in 1980s and in Europe in 1990s have also raised the corporate governance discussion. Some of the takeovers involved newly privatized companies and often the amounts in the takeovers reached heights not before seen in the business life before. Deregulation and integration of capital markets has resulted in increased number of cross border listings 1 as a new way for firms to raise money in new markets. The integration of capital markets have resulted in increased importance of CG codes to protect and encourage foreign investments in Eastern Europe, Asia and other markets. 2 The 1998 East Asia crisis and recent corporate scandals in USA and Europe have also fuelled the corporate governance discussion. Corporate governance is however also interesting for the fact that it can be applied to all companies where control has been separated from the ownership in order to increase performance but not only to prevent failures of companies. Decision making of the management must serve the company s short term and long term goals and the company s success depends on how well reasoned these decisions are. CG is therefore also concerned with the optimal control system and the main functions in the governance mechanism. Similarly, Corporate governance does not only relate to the going concern of companies, but can be seen as an optimization problem where the structure of ownership and the corporation is being optimized for performance. The Corporate Governance debate also discusses other problems, such as the minority vs. controlling shareholder agency problem but not just the traditional shareholder-manager agency problem. 1 Pagano, Röell and Zechner (2002) 2 Becht, Bolton, Röell (2002) - 3 -

8 By analysing the company structure and the ownership structure we might be able to identify companies that are better governed than other companies. Investors should be able to study the governance factors when choosing their investments, thus being more likely to invest in companies with higher profitability. 1.2 The research question The research question of the paper is to find out if Corporate Governance matters for firm performance, and if there is a relationship between some of the company and ownership characteristics and performance of the company. Which, if any, Corporate Governance elements converge with good performance of companies? Is there a difference whether a company is management controlled or ownership controlled and does the size of the largest owners matter for performance? Does the identity of the largest owners matter? Additionally, we also look at company characteristics: mainly the capital structure (debt equity ratio) and we also check for differences between different industries. To observe the influence on company s performance we look mainly at Tobin s q, but also at ROE, ROA were tested in parallel to the Tobin s q. 1.3 Structure of the thesis The main parts of the thesis are as follows: 1) The first chapter starts with the introduction of problems occurring in firms and businesses around the world recently, the problems are related to the theories of corporate governance and the research question is presented. 2) The second chapter deals with the theoretical background of corporate governance in general, explains the ownership structure and company structure of firms and explains the influence on the performance of firms and the development of their value, thus having great impact on all the constituents, being the shareholders, directors, managers, employees, creditors and other stakeholders. 3) The third chapter describes the situation in the Nordic countries, relating to the financial markets, the law system, codes and regulations in those countries

9 4) The forth chapter is the comparative empirical study conducted for the Nordic Exchanges. The study handles data material from databases and investigates the hypotheses put forth in chapter 2. 5) Conclusions are drawn from the research from the material handled to the extent that is reasonable. The results and conclusions are explained and related to results from previous work. Flaws and irregularities are handled and further investigations are pointed out or recommended. 6) Appendixes 1-10 contain tables and graphs with calculations, explanatory material and list of references

10 2 Theoretical background In this chapter I will discuss some of the corporate governance theories and some of the earlier studies conducted by researchers on various governance mechanism. First we will review the main theories associated with the corporate governance concept, and then discuss the corporate governance factors that relate to the ownership structure and corporate structure of companies. Eventually, hypothesis for the study performed in the thesis will be formulated. The theoretical discussion of corporate governance has often been initiated by the high profile business failures or scandals in corporations. The discussion was on the agenda in the 1990s in Britain when several corporate failures were traced to bad governance of companies and entrenchment of managers, and again in USA around the failures of Tyco, WorldCom, Enron and others. The discussion is again on the agenda at the time of this writing when the financial markets are seriously shaken and lacking trust, resulting in liquidity problems of financial institutions and failures of several large banks in the US and UK. The banks seem to have taken larger risk than has been signalled to the market. However, it is too soon to say whether the financial crisis in the 2007 and 2008 should be traced to bad governing of corporations. Although this discussion has been invoked by several large business failures the corporate governance discussion has however been traced back to much earlier work of Adam Smith in the 1870s 3 and Berle and Means in Steps have already been taken by different local and international bodies in order to prevent these collapses from happening again. OECD has issued CG Codes, first in 1999 and again in 2004, followed by country specific national codes set in most countries in the developed markets 5. Sarbans-Oxley Act of 2002 has also been considered to be the most sweeping corporate governance regulation in the past 70 years 6 which was set after the collapse of Enron who filed for bankruptcy late 2001 and WorldCom who filed for bankruptcy in July Most countries that have issued CG codes have requested 3 Adam Smith, (1776) 4 Berle and Means (1932) 5 See European Corporate Governance Institute (ECGI) for list of codes. 6 Byrnes et al., (2003) - 6 -

11 that companies comply with them, or explain if and why they do not, usually referred to as comply or explain rule. When discussing corporate governance it is mention other theories that relate to the concept and form the basis for CG framework. Of which some of them will be discussed in more details in this chapter. The initial discussion is the one about theory of the firm and the transformation to modern corporations. Problems surrounding the firm and how firms are driven by different stakeholders with different vested interest are next in the discussion. This problem is usually identified as the agency theory that defines the relationship between the principal delegating work and responsibility to another party, the agent. In the context of corporations the principal is the owner and the agent is the directors or managers. Thirdly there is the transaction cost economics that views the company itself as a governance structure. The choice of an appropriate governance structure can help align the interest of both parties, being the shareholders and directors. Fourth is the stakeholder theory accounting for the stake of other constituents than only shareholder and manager, that is employees, creditors and the community and in some cases stakeholders may be represented by a director. The fifth theory, stewardship, relates to the situation where directors are regarded as stewards of the company assets predisposed to act in the best interests of the shareholders. The sixth theory in this list, class hegemony, suggests that the directors view themselves as an elite at the top of the company and the final theory in this list, managerial hegemony, where the managers, superior in the knowledge of the day to day operation, dominate the directors and weaken their influence. 2.1 Theory of the firm In the aftermath of the Wall Street crisis of 1929 the changing role of the modern corporation was discussed among legal scholars. Berle and Means (1932) argued that company law in the United States enforced the separation of ownership and control because the management owned the company even though shareholders own the shares in the company entity. Management have the ability to manage the resources of companies to their own advantage without the effective shareholder scrutiny. They researched the consequences of this separation and argued that as companies grow the management would own proportionally smaller stake in the capital base and would rather - 7 -

12 be motivated by the salaries, but not the capital investment. With this view of the firm and the relationship between the management and company owners, the principal agent problem was first introduced. A common view of the organizational structure of firms is to view the company as a nexus of contracts where contracts are made between the stakeholders of the companies that define the roles and responsibilities of each stakeholder. This view was first introduced by Coase (1937), then developed further by Jensen and Meckling (1976) and Fama and Jensen (1983). The most basic form of organizations is where ownership and control are in the same hands. The incentives to make decisions are completely aligned with the interests of the owner and the decision maker enjoys all the economic benefits. As the firm grows in size the need to separate the ownership and control becomes imminent. The entrepreneur needs additional capital necessary for growing the firm and he also needs additional time for increased decision making necessary to run the firm. Coase identified certain economic benefits for the firm itself if it undertook transactions internally rather than externally due to the cost of market transactions. 7 Coase stated that firms would continue to expand up to the point where it would become cheaper or more efficient for the transactions to be undertaken externally. The contractual view of the firm helps understand what incentives drive organizations and how organizations are best understood. Instead of treating organizations as if they were persons, their behaviour can better be understood as if we view the organizations as a group of different agents each with different objectives and utility functions. Or as Jensen and Smith defined it: the behaviour of an organization is the equilibrium behaviour of a complex contractual system made up of maximizing agents with diverse and conflicting objectives 8. Since contracts cannot be written or enforced without cost the companies cannot write complete contracts that state all tasks of duties of all stakeholders. Companies therefore need to deal with the problem of incomplete contracts. In the absence of complete contracts, the proposed solution to the agency problem is often in the form of interest aligning, setting regulation and codes to comply with, monitoring the actions of managers etc. However, these solutions have not prevented the existence of agency 7 C. A. Mallin (2001) 8 Jensen and Smith (2000) - 8 -

13 problems, and they have not prevented the scandals and failures of companies. So, the problem still remains, and shareholders still seek solutions to assure themselves that other stakeholders fulfil their duties in order not to loose on their investments. 2.2 Agency theory Agency theory is a fundamental element in the corporate governance discussion and forms the base of this study. The agency relationship is defined as when a contract exists where one or more persons (principal) delegates some of the decision making authority to another person (agent) to take action on behalf of, and in interest of, the principal. The problems associated with delegating the decision making to the agent are a result of information asymmetry and different utility function of the principal and the agent. The agents decisions will be influenced by this difference and since complete contracts can not be written without cost the agency problem exists. Figure 1, Source: Wikipedia.org Berle and Means (1932) introduced the issue of principal agent problem that existed between managers and shareholders under the contractual framework of a firm. Jensen and Meckling (1976) applied the agency theory to the modern corporation and modelled the agency cost of outside equity. Jensen and Smith (2000) highlight the two different approaches when developing the theory of agency; the positive theory of agency and the principal-agent approach. The main difference between the two approaches is that positive theory of agency is usually nonmathematical and empirically oriented while the principal-agent literature has concentrated more on - 9 -

14 analysis of the effects of preferences and asymmetric information and less on the effects of the technology of contracting and control 9. Although the classical presentation of the principal agent problem usually involves the principal, as the shareholder, and the agent, as the manager, the principal agent roles have also been applied to other stakeholders of the company describing different aspects to the corporate governance discussion. Shareholder-manager The initial discussion of agency theory related to the problems that arise from the separation of ownership and control. Shareholders are one type of investors that invest in securities in order to increase their wealth. Owners of shares in companies are entitled to the residual earnings in a company unlike other form of securities issued by companies, e.g. fixed income instruments that pay pre-determined amount back to the investors. Owners of fixed income instruments are mainly concerned about the company s ability to meet with their interest payment obligations. When a manager has a different utility function from that of the shareholders he is more likely to engage in actions that are not in the best interest of the shareholders. The main drivers for managers not to behave in the interest of the shareholders are manager expropriation where managers extract wealth for themselves from the company. Another driver is when managers want to engage in empire building in the market for corporate control. The questionable mergers and acquisitions in the 1980s support the view that the managers own role building was the main driver in many of the mergers rather than the shareholders interest. The main remedies discussed in this problem is monitoring of the board or alignment of interest with remuneration systems. Jensen and Meckling (1976) started with the formulation of the Agency Theory, which related as far back as to Adam Smith 10, and proposed the Convergence-of-interest hypothesis. They proposed that when managerial ownership increases the ownermanager s interest converges with shareholders. Morck, Shleifer and Vishny (1988) suggested a non-linear relationship, where increased CEO ownership leads eventually to 9 Jensen and Smith (2000) 10 Adam Smith (1776)

15 increased entrenchments. Fogelberg and Weeks (2002) analysed commercial banks. They suggested that CEO ownership had dominating influence on value of the firm, but not insiders or other managers. EVA rose until 12% ownership was reached and then declined until 67% limit was reached. This relationship offset the Convergence-ofinterest hypothesis suggested by Jensen and Meckling (1976). Large shareholder Small shareholder The conflict between large shareholders and small shareholders are another major type of conflicts within the Corporate Governance framework. In Guglers 11 four quadrants concentrated voting power and concentrated ownership (Quadrant IV) are associated with the possible disadvantages such as potential rent extraction of majority owner and high cost of capital while the advantages would mainly be the benefit of direct monitoring capabilities towards the management. The implications for the company would be weak managers and weak minority while we would have strong majority owners. Gugler asks which are the major conflicts. This probably depends on which country the question is being asked in, relating to the economic environment (financial market structure, investor protection etc.). The minority protection is dealt with in many countries by the laws by implementing protection for them against expropriation of the ruling blockholders, and includes for example articles about takeover provisions and proxy voting. Evidences about this problem are somewhat mixed. Gugler (2001) addresses this problem with by examining many studies that have been conducted in this field. Although that this problem is hindsight, he concludes that large controlling shareholders are in fact beneficial due to its monitoring effects on management. Shareholder creditors Controlling shareholders might want to choose other projects than the creditor that is projects with different expected payoff. The shareholders might want to take greater risk since they are entitled to the residual earning and might therefore have greater incentive to put the company at risk while the creditor might want to choose safer projects with more stable expected cash flow even though the expected payoff is lower. Agency cost 11 Gugler (2001)

16 The agency cost is all cost related to the problem of agency, both direct cost such as the cost of writing contracts and enforcing them, monitoring and disciplining managers or cost for the bonus systems towards managers, and indirect cost such as cost that stems from realised losses due to bad decisions or decisions taken that had other incentives than to increase shareholders wealth. Jensen and Meckling (1976) defined agency cost as the sum of the out-of-pocket costs of structuring, administering, and enforcing contracts (both formal and informal) plus the residual loss. 2.3 Corporate governance The Corporate Governance concept has been used as an umbrella for the many things that constitutes the governing of corporations. In practice, its main building blocks relate to systems used to affect the behaviour of the company: Contractual Incentives o Compensation Structure & Inside Ownership o Debt (Maturity & Covenants) Active Monitoring o Board of Directors o Shareholders (Institutional and other large shareholders) o Creditors (Banks & Large Lenders) External Constraints o Product Market Competition (competitors) o Market for Corporate Control o Need for External Capital o Regulation (laws, regulations and codes) Corporate governance provides a framework that defines the rights, roles, and responsibilities of different groups of stakeholders to the firm and defines the environment the companies operate in. The groups can be divided into management, board, controlling shareowner, and minority or non-controlling shareowner. In the stakeholder view of the company, other groups are added, such as employees, creditors, suppliers, customer, the environment and the community

17 Its definition varies somewhat but two commonly used definitions of the Corporate Governance concept are widely accepted and are helpful in this discussion to explain the concept better. Corporate Governance has been defined in the Cadbury report in 1992 as a system by which companies are directed and controlled or even more narrow like in the Cardon report in 1998, set of rules applicable to the direction and control of a company. The concept has however also been defined in more direct and specific ways; In Denmark the more stakeholder society view is included in the CG definitions, The goals, according to which a company is managed, and the major principles and frameworks which regulate the interaction between the company s managerial bodies, the owners as well as other parties, who are directly influenced by the company s dispositions and business (in this context jointly referred to as the company s stakeholders). Stakeholders include employees, creditors, suppliers, customers and the local community 12. Practitioners however used to define Corporate Governance as a set of mechanism, controls and procedures both internal and external to the company, used to manage and maximise the value of the company. Shleifer and Vishny (1997) Corporate governance deals with the ways in which suppliers of finance to corporation assure themselves of getting a return on their investments. Zingales (1998) defined Corporate governance as the complex set of constraints that shape the ex-post bargaining over the quasi-rents generated by the firm and more precisely, Corporate governance is concerned with the resolution of collective action problems among dispersed investors and the reconciliation of conflicts of interest between various corporate claimholders. Similarly, practitioners have categorised these mechanism (governance controls and procedures) in different ways. Denis and McConnell (2003) classify the mechanism as internal or external to the company. Internal mechanism being The board of directors, Managerial incentives, Capital structure and Bylaw and charter provision. The External governance factors are the Law/Regulation and Markets (for corporate control). The mechanism discussed in this thesis are of both types, but the study mainly relates to the internal governance factors; ownership concentration, identity of owners, board of directors and capital structure. 12 The Nørby Committee s report on Corporate Governance in Denmark (2001), available at

18 2.4 Ownership structure Agency theory states that when ownership and control has been separated there is a risk of management not behaving in the best interest of the shareholders since they may have different utility function than the shareholders. Ownership structure has been one of the primary research fields within the corporate governance research area. The ownership structure of companies can affect the ability of shareholders to monitor management behaviour and provide them with necessary supervision. Several different characteristics of the shareholder group have been researched and supported with evidence. The concentration of ownership is usually believed to potentially reduce the agency problems 13. Greater concentration of shareholdings gives the shareholder greater incentive and ability to monitor management. However, when the largest shareholder controls too large part of the company, either through direct holding or due to the weakness of other shareholders, we may experience a problem where the large shareholders entrenches wealth from the company from the minority shareholders. A common categorization used to define how well the shareholders can monitor managers is to define if a company is management controlled (MC) or ownership controlled (OC). The definition whether company is ownership controlled or management controlled varies but is commonly within the range of 5%-20% 14. The difference can partly be explained by several factors, such as the size of the company, where larger companies usually require smaller ratio held by management to be management controlled and how dispersed ownership of the shareholders is. It is convenient to categorise companies based on the level of concentration in ownership and the level of concentration in voting power. This categorisation is bases on the theoretical framework of the ECGN (European Corporate Governance Network) and companies are split into four quadrants representing mixture of voting power and ownership. The framework presented by ECGN is useful in this discussion and table 1 summarises Guglers findings where he added main implications and pros and cons for each quadrant based on existing literature. 13 See for example Gugler (2001) that compiled a list of studies of which many show relationship between OC-MC firms and performance. 14 See overview of studies in Gugler (2001)

19 Quadrant 1 Dispersed voting power Advantages Diversification opportunities (risk sharing) Low cost of capital Disadvantages Laco of diect monitoring (free riding problem, absenteeism) Implications Strong Managers, Weak Owners Takeovers are possible Management Control or Market Control Quadrant 3 Dispersed voting power Advantages Some protection of small shareholders from voting right restrictions Disadvantages Cash-flow and control incentives misaligned Few means of intervention Low Liquidity Low diversifitation opportunities High cost of capital Implications Mostly disadvantages Strong managers, weak owners Takeovers difficult Table 1 Disperse Ownership Concentrated Ownership Table 1 - Source Gugler (2001) Quadrant 2 Concentrated voting power Advantages Direct monitoring Disadvantages Cash-flow and control incentives misaligned Extraction of private benefits Implications Strong Voting Block-holders, Weak Minority Owners Takeovers impossible/unlikely Quadrant 4 Concentrated voting power Advantages Direct monitoring Cash-flow and control interests aligned Disadvantages Low liquidity Low diversification opportunities High cost of capital Potential rent extraction by majority-owner Implications Weak Managers, Weak Minority Owners Strong majority owners Ownership concentration Ownership of companies is linked to control of the companies through board meetings and the election of board members. Associated with this control is the need to provide management with necessary discipline to think about the shareholders interests. But the monitoring of management has costs involved, thus limiting the interest and ability of small owners to economically monitor managers. It is therefore important that there exists an owner that has large enough share in the company for him to be able and willing to provide that discipline

20 Ownership concentration was thought to be little in the US and UK in the early nineties, but more recent studies however showed that ownership was concentrated. Discussion about the extent and the effects of ownership concentration and of different types of owners in a company emerged. In the midst 1990s several non-us studies came into the daylight, first the German and Japanese situations were examined, and now distinction between the two different systems became more clear, the bank-based system and the market-based system. Megumi Suto (2003) examined Malasian firms in the 1990s before the 97 crisis. He examined shareholdings of the top ten owners as a concentration proxy. He found that firms with concentration of ownership seem to be better disciplined than firms whose ownership is dispersed. The top ten shareholdings are negatively related to debt ratio. Blockholders Denis and McConnell (2003) categorise the benefits associated with the control into shared- and private benefits. Shared being those who benefit all shareholders and private being benefits solely for the controlling shareholder. While there is little strong evidence that blockholders affect the market value of the firms, there are indications that blockholders receive significant private benefits of control. A number of studies support this view and reveal that block trades are priced at a premium, consistent with blockholders expecting benefits that are not available to other shareholders. Dyck and Zingales (2004) quantify the value of the private benefits of control by examining the privately negotiated price per share for the controlling block and compare it against the price per share prevailing in the market after the transaction and find on average value of control to be 14%. An interesting observation in the study is that the value of corporate control is highest in countries with least protection for the investors (and the blockholder is therefore more willing or able to extract the private benefits). Also, companies with dual class shares usually trade at a premium, meaning that the voting right actually has value. In the midst 1990s studies revealed that concentrated ownership was more common in Europe than diffused distributed ownership as initially thought to be the majority in UK and the US, which later studies showed also to be more concentrated Denis and McConnell (2003)

21 This has however increased the focus on country differences with respect to degree of ownership concentration and the identities of blockholders or the largest owners. In bankcentred economies, blockholders are important, in Japan financial institutions are very important but in Germany other companies are most important, followed by family holding being the second most important. The German banks however have more voting power due to proxy voting. However, Mehran (1995) finds no significant relations between firm performance and the holdings of a variety of different types of blockholders. Owners with greater control than cash flow rights Share ownership gives the owner certain cash flow rights. Owner of shares can have greater control in the company than he has cash flow rights to (especially in companies with dual class shares). Such owner may have more valuable shares than other shareholders. The higher of those shares can be explained by any private benefits they may offer and thus be valued differently than ordinary shares in the company. Such unbalanced situation may cause conflicts between shareholders and may cause the higher controlling shareholder to extract some private benefits of control for his premium part of the company (such shares usually trades at a premium in the market). What about looking at this the other way and say that the un-controlling shares are sold at a discount rather than the controlling shares at a premium? This does not change the fact that the different pricing methods indicate that the increased control rights do have a price. Pyramid structures - Consolidation of control This situation can emerge from shares having different voting rights, from pyramid ownership structures or by cross-holdings. In Guglers Quadrants, companies subject to pyramid structures among the ownership group (Quadrant II) may suffer from extraction of private benefits of control, but may benefit from direct monitoring towards management. International evidence shows that separation of ownership and control reduces the market value of the firm. The existence of concentration of control is quite common and Group ownership structure is quite common in the countries. In Japan we have the keiretsu, in Korea chaebols and in Russia, India, Italy and Brazil. The Group ownership

22 structure is often originated from the founding family of the company, allowing them to control the individual firm, despite having only minority cash flow investment in the firm. Lins and Lemmons (2001) examined 800 East Asian companies during the Asian crisis and found out that where separation between cash flow and control rights. Lins and Servaes (2002) state that diversification (of control) discount is only when firms belong to industrial group or when management ownership is in the 10-30% range. Joh (2000) also find out that firms belonging to business groups are less profitable overall, and that controlling blockholders are more effective when they have high cash flow ownership Identity of owners The identity of owners has also been researched. The focus has often been on insider holdings 16, but here we will look in general at the identity of the controlling authority. Studies of the identity of owners have focused on if there is different effect on performance of a company depending on the type of owners. Shareholders can be categorised in different ways, but most common categories that have been examined are banks, institutional investors, state, families and households, foreign holdings and non financial business. Many studies exist on this topic and many of them show similar results although one may always find studies that contradict previous results. In particular, the holdings of institutional investors has been discussed and examined whereas institutional investors are believed to be able to monitor management more efficiently than other shareholders. Studies do not agree on results, some show positive effects, some negative and some show no effects on the firm performance. Studies have also focused on other aspects of the affects of the firms, such as profitability, CEO turnover etc. The identity also receiving much attention is the insider ownership, due to its alignment effects with shareholders interests, and the block holder ownership due to its monitoring capabilities on the company s operations. Different types of blockholders have also been identified and examined. From the many possible categorizations the 16 See Böhren and Ödegaard (2001)

23 ownership of foreign owners and institutional investors has been thought to be the most important. Management ownership is the most discussed type of insider ownership. The effect of management ownership has received special attention due to its alignment of interest effects between management and shareholders. The tradeoffs between the alignment effects and the entrenchment effects are supported on some studies. The entrenchment effect has been studied and is supposed to begin at the 12% in the UK 17 and at 5% in the US 18. The difference is supposed to lie in the difference in takeover defences and the surveillance systems where better surveillance in UK and less ability to mount takeover defence by the UK managers (they are therefore forced to do better and not to allow themselves to entrench the company for their own good). Lemmon and Lins (2003) find that ownership structure can be a determinant on the expropriation of insiders towards minority shareholders. In their survey of Asian companies in the Asian crisis they found out that the equity rate of return was lower in firms where insiders had controlling stake, different from their cash flow rights. This supports the view that ownership structure determines the risk of expropriation by controlling shareholders. Some studies look at management ownership and their effects in firms with highly diversified ownership, or, some studies look at how the interaction between managerial ownership and diversification affect on firm value. Gugler defines companies as either Management controlled or ownership controlled, depending on the level of concentration of holding of largest shareholders in the company. Results show that firms with low management ownership have negative relationship between diversification and firm value. That is when managers don t own much themselves then high diversification reduces the firm value. 19 Jensen and Meckling 1976 proposed that with increasing management ownership was increased convergence with shareholders interests. Mock, Shleifer and Vishny (1988) proposed a non linear model where the possibility of management entrenchment was introduced. This non-linear model was explained in the way that as the management ownership increased the disciplinary mechanism of the 17 Short & Keasey (1999) 18 Morck Shleifer and Vishny (1998) 19 Chen and Ho (2000)

24 market (external equity) was diminished and the manager would seek to maximize his own welfare instead of all shareholders interests. State owned companies and privatization Privatizations offer the opportunity to examine the change throughout a privatization process, giving the examiner opportunity to look at the results of a dramatic change in ownership structure. A common question is whether the change in ownership structure increases the firm value. This is an interesting question, but usually the firm goes through more dramatic changes and even changes its focus dramatically and therefore it is hard to give all the credit to the ownership structure, given that there is a change in the firm value. Overall the studies show that privately owned companies are more profitable than state owned companies. Some variations in results are present however, such as Dewenter and Malatesta (2001) that observe that firms became profitable prior to the privatization, indicating that governments choose to privatize companies that became profitable. Alternative theory was that future privatization may enforce the company to improve performance prior to the privatisation. Foreign Ownership A number of studies address the relationship between performance and foreign ownership and ownership by insiders. Makhija and Spiro (2000) find positive relationship between those two, and similar results can be read in Hingorani and Makhija s (1997), a work that concludes that the agency problem might be mitigated by inside and foreign ownership. Problems in the above surveys are present however, and say that the empirics suffer from bad data, lack of data, omitted variabled, endogeneity and selection bias. The comparison of state vs. private ownership needs appropriate benchmark, which without it could be hard to identify Board of directors The board of a company is an essential disciplinary authority on the management. The broad view of the boards effectiveness states that in order for the board to be effective it must be independent from the management team and must have sufficient knowledge of 20 Megginson and Netter (2001)

25 the operation. The optimal size of the board may differ according to the size and complexity of the operation the company engages in. The corporate governance codes usually state the requirements, but leave out expressing what the optimal size might be. Jensen (1993) states that increased board size may destroy value because of the board s inability to communicate efficiently and monitor management efficiently. In another study conducted on Fortune 500 companies Yermack (2004) found out that incentives/disincentives received by outside directors rose as the market capitalisation of the respective firm rose and in contrast when firms performed poorly, personal financial gains suffered and the probability of loss of directorship increased. 2.5 Corporate structure Some corporate structure characteristics have been identified in the literature as a possible governance mechanism within corporations. Here the corporate structure refers to the characteristics of the company, its capital structure, voting mechanism (including different voting rights of shares) Capital structure The different types of financial instruments available for corporations have different effects in the running of the companies. The selling of new shares can provide the company with operational capital and capital for special investments such as growth and investments. The repayment of wealth to shareholders is however not scheduled. It only gives the investors the right to the residual income after the company has paid all fixed expenditures, including payment of loans. Debt ratio The issuance of corporate bonds gives the investor the rights to a pre-determined cash flow, but not much more. If the company cannot fulfil its commitments to the bond owner, the shareholders have to give up their rights to the company and the bondholders take over the company. Today s situation also shows that when access to borrowed money is difficult the lenders have more control over the firms activities than the shareholders

26 Companies with higher leverage (debt equity ratio) are required to pay more of its cash flow from operations to the creditors than they are required to pay to its equity holders. This is however far from describing the expected payoff to these two different groups, but only identifies how much fixed payoff the company has to deliver despite how well the company is doing. High debt ratio will put the managers in tighter position with regards with their abilities to expropriate wealth from the company for themselves or to projects that they have a personal interest in, but lesser importance for the company profit. The observation of the debt-equity ratio may indicate to which extent the managers have the opportunity to entrench the providers of capital. The debt equity ratio can however differ across industries. Companies with greater investments in material assets may be in better position to take on debt, while investments in R&D, and growth, may need to be financed with equity due to uncertain cash flow from that investments. The difference between industries is therefore needed in order to compare the debt-equity ratio between companies and may even be explanatory variable for the ratio. Dividend Similar to fixed payoff from debt, dividend policy of the company also enforces management to pay the owners of capital (equity), thus leaving them with less ability to entrench the companies funds. Companies might therefore seek to have strict dividend policy that enforces the management to pay out portion of retained earnings from the operations Industry The industry of company may affect how the capital structure of the company is. Companies investing more in fixed assets than intangible assets (eg. manufacturing companies vs. companies that invest in intangible assets (e.g. knowledge) may be able to have higher ratio of debt than equity. Should manufacturing companies therefore have better corporate governance and therefore higher Tobins q? Not necessarily. During the past one or two decades the landscape of companies in the financial market has changed radically. This can be

27 observed from the growth of the IT and multimedia companies. Companies that invest in intangible assets such as IT have experienced high growth and the growth is usually valued, thus reflected in the Tobin s q of the company. In order to mitigate for these effects in the thesis, we will look at potential industrial difference in the Tobin s q of companies and try to correct for potential industry effects on how we interpret the corporate governance benefits of those companies Age of company and lifecycle According to life cycle theory younger companies may experience higher growth than older companies that have reached their optimal size. Higher growth in younger companies can affect what form of finance companies choose. 2.6 Hypotheses for the study The objective here is to evaluate the corporate governance concepts and identify how they affect the company s performance in different way and the intention is to reveal if and how corporate governance effects firm value. Underlying this findings are several assumption and deviations about each of the factors. Following hypothesis will be tested in the study: Based on the agency problems between management and shareholders I suggest that there is positive relationship if a company is ownership controlled rather than if it is management controlled. H 0 1: When companies are classified into MC- and OC-category differences in performance are documented. OC (+) Majority of studies show that large shareholders are beneficial. I suggest there is a positive relationship between ownership concentration and performance