Excess Control and Corporate Diversification Hai-fan LU

2017 2 nd International Conference on Education, Management and Systems Engineering (EMSE 2017) ISBN: 978-1-60595-466-0 Excess Control and Corporate Diversification Hai-fan LU Guangdong University of Foreign Studies, College of Accounting, Guangzhou, 510006, China Keywords: Ultimate controlling shareholder, Excess control, Diversification, Discounts. Abstract. This paper examed the relationship between the ultimate controlling shareholder s excess control and corporate diversification discounts. Excess control is positively related to corporate diversification, because of the purse of benefits by the ultimate controlling shareholder. And the excess control is positively related to corporate diversification discounts, which means when the excess control is stronger the discount is larger, because excess control makes the agency problem worse. Introduction The ultimate controlling shareholder can enhance their control through the pyramid structure, cross shareholdings and the issue of double stock etc.. So they can ues less cash flow rights (ownership) to control more, which results in the separation of control rights and ownership. The ultimate controlling shareholders' control right over the degree of ownership is called excess control. In recent years, studies have shown that the ultimate controlling shareholder's control rights and cash flow rights will lead to the rise of agency costs and decline of performance. Researches showed that the divergence of interests of the ultimate controlling shareholders and other shareholders also is the main contradiction of corporate governance in China. Since the contradiction in corporate governance will affect the company's business practices and economic consequences, and diversification is an important mode of operation of the company, so the contradiction between ultimate controlling shareholders and other shareholders will affect corporate s diversification. Therefore, using A-share listed companies as sample, this paper will investigate the ultimate controlling shareholder effect of excess control on corporate diversification and its economic consequences. Theory Analysis and the Research Hypothesis Since the agent problem in corporate governance will affect the company's strategy and management, so diversification strategy will inevitably be affected by the principal-agent problem and affect the company's performance. Traditional research on corporate governance are mostly based on the point of view that ownership structure is widely dispersed. In this case, the conflict between the manager and the shareholders of the company becomes the core of the agency problem. However, recent studies have shown that the ownership of listed companies in most countries is often concentrated or relatively concentrated. Shleifer and Vishny (1997) found that the ownership structure of the company is not widely dispersed, but relatively concentrated, including the United states. Clifford (2009) study shows that in 96% of the company, the largest shareholder held an average of about 39% of the total shares. Ultimate controlling shareholders control of listed companies through the pyramid ownership structure, cross ownership. So, the core of agency problem is no longer the contradiction between the manager and the external shareholders, but the contradiction between the ultimate controlling shareholder and the minority shareholders. Shleifer and Vishny (1997) pointed out that the controlling shareholders have a motivation to supervise the managers, make suer that they take correct decisions, improve corporate performance; on the other hand controlling shareholders have the motivation to grab the behavior of the company, occupation of the interests of the company, damage the company's performance. The motivation of controlling shareholders to improve the performance of the company is to have sufficient financial incentives to them, thereby reducing their willingness to encroach on minority shareholders. Cash 280

flow rights represents the size of the degree of consistency with the interests of the company, the higher the proportion of cash flow rights, the more controlling shareholders are willing for the normal operation of the company, so as to improve their wealth, reduce the damage of company value to obtain private benefits. This effect is known as the incentive effect, which was tested by La Porta et al (2002) and Yeh (2005) through the establishment of model demonstration. If the controlling power of the controlling shareholder is equivalent to the cash flow right, they have no obvious motive to intentionally damage the value of the company. However, since the ultimate controlling shareholder can enhance the control power in many ways, the control is greater than the cash flow right, which leads to the existence of excess control. Bozec and Laurin (2008) and Ronald et al. (2009) pointed out that due to the non matching of high control and low cash flow rights, the ultimate controlling shareholders have the motivation to transfer resources from the controlled company, to obtain private benefits at the expense of other shareholders. The high control right makes the ultimate controlling shareholders have the ability to encroach on the interests of other shareholders, while the low cash flow rights reduce the loss caused by the grab behavior. Excess control of ultimate controlling shareholder phenomenon has a negative effect on the performance of the company, the greater the degree of excess control, the stronger the negative impact. Diversification can be used to transfer interest. When the ultimate controlling shareholders have high control rights and low cash flow rights, they can use control right to promote diversification, and transfer risk of diversification to the company. If the ultimate controlling shareholders have high cash flow rights in the listed companies, they will have to take more risks of diversification, so they will be more cautious in the decision-making. Therefore, in the case of listed companies, diversification is a means of the ultimate controlling shareholder to ocuppy the interests of small shareholders. Under different degree of ultimate controlling, motivation intensity of ultimate controlling shareholders to achieve appropriation will also differ. If the listed company's excess control degree is high, the expropriation motivation of ultimate controlling shareholder will be strong. They will tend to encourage listed companies to diversify, but the specific circumstances and the diversification may not apply to the company, it may adversely affect the company's value. Accordingly, this paper raises following assumptions: H1: compared with the companies with lower degree of excess control, companies with high degree of excess control will have higher the degree of diversification. H2: compared with the companies with lower degree of excess control, companies with high degree of excess control are more likely to have diversification discount. Empirical Study Design Sample Selection and Data Sources The study is based on the samples from 2010 to 2015 of A-share listed companies.the following companies are eliminated: companies with control right of less than 10%; financial listed company; companies with A, B and H shares; ST, PT companies; companies lack of the related data. Observation are 1862. Sample data are from CSMAR database and Wind database. Model and Variables This paper build model 1 to study the impact of ultimate controlling shareholders excess control on diversification strategy choice and build model 2 to study the impact of ultimate controlling shareholders excess control on diversification performance. div it = δ i + α 1 excess it + α 2 roe it + α 3 lnassets it + α 4 growth it + 15 j= 5 α indus it +ε it (1) j exval it = δ i + α 1 div it + α 2 excess it + α 3 div it excess it + α 4 lnassets it + α 5 debt it 281

18 + α 6 two it + α 7 herf it + α j indus it +ε it (2) j= 8 Diversification (div) is measured by Entropy(S) and the number of industies which income from Pi (kind). Entropy(S) is caculated by S= ln(1/pi), where Pi is the propotion of income from industry i. Excess control (excess) is the degree that ultimate controlling right over the extent of the cash flow rights. This paper use three methods to calculate the excess control extent: excess1=vr-cr; excess2=vr/cr; excess3=(vr-cr)/vr. VR for control, CR for ownership. Excess value (exval) is used to measure the performance of diversification and is caculated as Berger and Ofek(1995).Control variables: company performce(roe), company size(lnassets), growth of company (growth), gearing leve(debt),ceo as chairman(two), ownership concentration(herf), industy(indus). Empirical Results Analysis Descriptive Statistics Table 1 shows the descriptive statistics of every indicators. Table 1. Descriptive statistics. Variables obs mean SD min max S 1862 0.4350 0.4157 0 2.2861 kind 1862 2.7584 1.9752 1 11 excess1 1862 6.0457 8.5862 0 41.5410 excess2 1862 1.6728 1.5542 1 27.0541 excess3 1862 0.1721 0.2487 0 1 exval 1862-0.2674 0.7518-2.0543 4.6412 roe 1862 0.04248 0.3845-12.8728 0.7671 lnassets 1862 21.9815 0.8759 19.4876 26.8123 growth 1862 12.1552 82.5517-52.2576 854.5762 debt 1862 15.8971 24.8792 0.01882 78.8455 two 1862 0.6426 0.6753 0 1 herf 1862 0.2376 0.1536 0.0005 0.7857 Regression Results Impact of Ultimate Controlling Shareholder S Excess Control on Diversification Strategy Table 2 shows that the excess control of ultimate controlling shareholders has a significant positive impact on diversification. When the entropy index (S) is used to measure diversification, whether excess1, excess2 or excess3 is used to measure the degree of excess control of ultimate controlling shareholders, their regression coefficients are positive and significant at 0.01 level. The same results are obtained when the number of business (kind) isused to measure diversification. And the whole model was tested by Wald test, and was significant at 0.01 level, indicating that the model was statistically significant. This result verifies the hypothesis 1, that is, the higher the degree of ultimate controlling shareholder's excess control, the higher the degree of diversification of listed companies. This shows that in the listed companies with high excess control, the ultimate controlling shareholder will be motivated by self-interest to promote diversify business. 282

excess1 excess2 Table 2. Regression results of model 1. Diversification measured by S 0.0080 (5.75) 0.0071 (5.05) Diversification measured by kind 0.0079 (5.75) 0.0069 (5.63) excess3 0.0451 0.0197 (4.97) (4.85) roe -0.4521-0.4632-0.4689-0.6747-0.6617-0.6761 (-18.52) (-18.05) (-17.98) (-8.28) (-8.41) (-8.35) lnassets 0.0048 0.0052 0.0051 0.0612 0.0638 0.0665 (5.35) (5.44) (5.40) (7.78) (7.56) (7.68) growth -7.2E-04-6.8E-04-6.6E-04-7.04E-05-6.4E-05-5.5E-05 (-5.86) (-6.10) (-6.46) (5.35) (-4.98) (-5.45) indus Control Control Control Control Control Control Wald 1371.57 6543.55 6843.54 3545.88 4036.54 4216.57 observations 1862 1862 1862 1862 1862 1862 Adj-R 2 0.0985 0.0901 0.0915 0.0998 0.0986 0.9875 p< 0.01, p< 0.05, p< 0.1. Impact of Ultimate Controlling Shareholder s Excess Control on Diversification Performence Table 3 is the regression result of model 2. The results show that: firstly, there is a negative correlation between the level of diversification and the excess value (exval) when excess is not in the model. There was a negative correlation between S and exval, which was significant at 0.01 level. Kind and exval had a negative correlation, and significantly at the level of 0.01. This shows that the higher the degree of diversification, the lower the value of the company, which means there is a discount in diversification. Secondly, this paper further analyzes the diversification discount when the ultimate controlling shareholder has a high degree of excess control. When excess control is in the modle, S excess was negatively correlated to excess value, and at 0.01 significant level. The same results are obtained when kind is used to measure diversification. Table 3. Regression results of model 2. no excess excess1 excess2 excess3 no excess excess1 excess2 excess3 S -0.3854 (-50.22) -0.3761 (-50.65) -0.2407 (-31.56) -0.2557 (-31.65) Kind -0.0260 (-8.12) -0.0297 (-8.65) -0.0081 (-5.43) -0.0210 (-5.37) excess -0.0005 (-5.35) -0.0175 (-5.35) -0.0168 (-5.78) -0.0003 (-4.56) -0.0354 (-4.65) -0.0342 (-4.73) Sexcess -0.0008 (-5.78) -0.0648 (-5.87) -0.0973 (-5.10) kindexcess -0.0001 (-4.76) -0.0090 (-4.86) -0.0087 (-4.98) lnassets -0.1568 (-45.60) -0.1587 (-45.26) -0.1587 (-46.17) -0.1597 (-40.75) -0.1486 (-30.75) -0.1572 (-31.68) -0.1463 (-30.65) -0.1507 (-30.68) debt 0.0006 (3.75) 0.0005 (3.69) 0.0005 (3.68) 0.0005 (3.78) 0.0006 (4.05) 0.0005 (3.98) 0.0005 (3.78) 0.0005 (3.98) two 0.0152 (1.68) 0.0103 (1.70) 0.0105 (1.67) 0.0106 (1.71) 0.0110 (1.75) 0.0010 (1.68) 0.0095 (1.80) 0.0123 (1.69) herf -0.7645 (-30.81) -0.7354 (-30.76) -0.7688 (-30.87) -0.7065 (-30.50) -0.7657 (-28.37) -0.7245 (-28.72) -0.7685 (-29.05) -0.7684 (-29.66) indus Control Control Control Control Control Control Control Control Wald 19785.68 15083.65 12587.65 18645.85 19863.65 9846.65 15670.55 18430.65 observation 1862 1862 1862 1862 1862 1862 1862 1862 s Adj-R 2 0.2237 0.2289 0.2205 0.2361 0.2155 0.2208 0.2167 0.2267 p< 0.01, p< 0.05, p< 0.1. The regression results indicate diversification is a way of the ultimate controlling shareholder to 283

grab the interests of small shareholders and occupy the interests of the company, and the excess control right of ultimate controlling shareholders enhance their motivation to grab the interests of small shareholders and occupy the interests of the company and damaging the company's value. Therefore, the greater the degree of excess control, the lower the company's excess value. Conclusions The results of this paper showed that excess control of ultimate controlling shareholders has an important impact on corporate diversification strategy: first, when excess control of ultimate controlling shareholders is high, listed companies tend to promote diversification; second, there is diversification discount in Chinese listed company. Compared with the listed companies with a lower degree of control over the ultimate controlling shareholders, the diversification of the listed companies with a higher degree of control will lead to a significant decline in the excess value of listed companies. This result is consistent with the "entrenchment effect". This shows that the diversification of the ultimate controlling shareholder under the control of a large extent is the ultimate controlling shareholder to seek their own interests rather than the normal development of the company's decision-making. References [1] Bozec, Y. and Laurin C. Large shareholder entrenchment and performance: empirical evidence from Canada. Journal of Business Finance & Accounting, 2008, 35(1): 5-49. [2] Claessens S, Djankov S, Lang, HP. The Separation of Ownership and Control in East Asian Corporations. Journal of Financial Economics, 2000, (58):81-112. [3] Clifford G Holderness.The Myth of Diffuse Ownership in the United States. Review of Financial Studies, 2009 (4):1377-1408. [4] Denis David J., Diane Denis, Atulya Sarin. Agency problems, equity ownership and corporate diversification. Journal of Finance, 2002, 1 (52): 135-160. [5] Jensen, M. Agency Costs of Free Cash Flow, Corporate Finance and Takeovers. American Economic Review, 1986(76). [6] Jose M. L., L. M. Nichols, J. L. Steven. Contributions of diversification, promotion, and R&D to the volue of multiproduct firms. Financial Management, 1986, 15(4): 33-42. [7] Krishnaswami, S. and Subramaniam, V. Information Asymmetry, Valuation and the Corporate Spin-off Decision. Journal of Financial Economics, 1999(53). [8] La Porta R, Lopez-De-Silanes F, ShleiferA. Corporate ownership around theworld.journal of Finance, 1999, 54(2):471-517. [9] La Porta R,Lopez-De-Silanes F,Shleifer A,Vishny R. Investor protection and corporate valuation. Journal of Finance, 2002, 57(3):1147-1170. [10] Lang, L. and Stulz, R. Tobin s q, Corporate Diversification, and Firm Performance. Journal of Political Economy, 1994(102). [11] Marchica, M.T. and Mura, R. Direct and Ultimate Ownership Structures in the UK: An Intertemporal Perspective over the Last Decade. Corporate Governance, 2005, 13(1):26-45. [12] Ronald, Cong Wang, Fei Xie. Agency Problems at Dual-Class Companies. The Journal of Finance, 2009(4):1697-1727. [13] Shleifer A, Vishny R. A survey of corporate governance. Journal of Finance, 1997(52): 737-783. 284