Concentrated Ownership

Nino Papiashvili

Institute of Finance

Ulm University

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Introduction

In widely held corporations since the manager has only an attenuated interest in the profits generated by the firm it is probable that he will act not to maximize firm profits but rather to maximize his own private utility

One way to reduce the conflicts of interest between the shareholders and the managers is to increase the proportion of shares in the hands of controlling shareholders

However, as ownership becomes more concentrated an overall reduction of agency costs will not necessarily result. Large shareholders may engage in undesirable behavior at the expense of minority shareholders if the private benefits exceed the private costs of doing soWidely held firms may face agency costs because of rogue managers, while more narrowly

held firms may face agency costs because of rogue controlling shareholders2

How prevalent is concentrated ownership?

In most countries, the typical listed company has concentrated rather than dispersed ownership

La Porta et al. (1998,99) find that:• For the sample of 49 countries, the mean ownership of the three largest shareholders is 46% • At 10% cut-off ownership rate the sample of world’s 27 richest countries show that 52% of

medium firms are owned by individuals or families (as opposed to 10% dispersed ownership)

The common argument: investors are willing to take minority positions and finance companies in countries where legal rules are extensive and well enforced. By contrast, where the legal framework fails to provide sufficient protection, investors compensate by taking large positions in firms

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How prevalent is concentrated ownership?

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La Porta et al. (1998,99)

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96% of these firms have at least 1 blockholder (who owns 5% of the firm’s stock)

As a group, blockholders, directors, and officers own 43% of the common stock

Even in the United States according to Holderness (2009)

Ownership is not less concentrated than elsewhere

The results of hand-collected data on randomly selected sample of 375 Compustat- and CRSP-listed firms in 1995 shows that:

On average the large shareholders in a firm collectively own 39% of the voting power of the common stock.

The ownership of Insiders (directors and officers) averages to 24%

In firms with at least 1 blockholder the average size of the largest block is 26%

What motivates concentrated ownership?

What motivates some individuals and organizations to forgo the benefits of diversification by concentrating much of their wealth in the stock of a single firm?

The shared benefits of control - superior management or monitoring that can result from the substantial decision rights

=> To the extent that the subsequent higher cash flows are shared with minority shareholders, they constitute shared benefits of control

The private benefits of control - incentive to use their voting power to consume corporate resources or to enjoy corporate benefits that are not shared with minority shareholders

=>Private benefits can also be negative if blockholders incur personal costs from monitoring or from possible lawsuits

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What motivates concentrated ownership?Private benefits of control can take many forms:

• Large blockholders - impose their personal preferences even if those preferences run contrary to those of the minority shareholders Suboptimal investment decisions, such as overexpansion through mergers and acquisitions

• The controlling shareholder can exploit business relations between the company and other firms that he wholly owns in order to expropriate minority shareholders

• If the controlling shareholder is also a manager or a director of the company he can pay high salaries to himself

• If the manager is also a dominant shareholder, he will try to entrench himself and/or block every attempt at a hostile takeover expropriation takes the form of agency costs that affect firm's performance

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What motivates concentrated ownership?

Summary:

The greater are the control rights of the controlling shareholder the greater is his ability to influence the way the company is run, and hence the greater is his ability to obtain private benefits of control at minority shareholders’ expense

For firms with a controlling shareholder, the key conflict of interest in corporate governance is the one between the controlling shareholder and minority shareholders - When controlling shareholder realizes a disproportionate share of the private benefits of rent seeking, while the costs are shared with the firm’s other shareholders

However, the greater are the cash-flow rights of a controlling shareholder – the fraction of the firm’s profits to which he is entitled – the more closely are her incentives aligned with those of the minority shareholders, and hence the lower are her incentives to pursue costly policies which divert profits from minority shareholders

=>Thus the extent of the conflict of interest between controlling and minority shareholders is predicted to depend on the extent to which the former’s control rights exceed her cash-flow rights

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Ownership is endogenous

When owners of a privately held company decide to sell shares, and when shareholders of a publicly held corporation agree to a new secondary distribution, they are, in effect, deciding to alter the ownership structure of their firms and, with high probability, to make that structure more diffuse

In these ways, a firm’s ownership structure reflects decisions made by those who own or who would own shares

The finding that ownership structure is endogenous and plausibly determined, must be taken into account when seeking the relation between ownership and performance. Failing to do so is bound to yield biased regression estimates

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Ownership is endogenousThe magnitude of the shared and private benefits of control are likely to vary with certain firm characteristics.

The concentration of ownership should therefore vary systematically across firms depending on the characteristics of each firm

Research has identified several firm characteristics that affect the level of private and shared benefits and thus the level of ownership concentration:

Firm size – for large firms the market value of a given fraction of ownership is also large The higher price of a given fraction of the firm reduces the degree to which ownership is concentrated

Regulation - regulatory agencies serve to monitor the management which partially substitutes for shareholder monitoring the shared as well as private benefits of control are likely to be lower

Market Environment – firms that transact in markets characterized by stable prices, technology, market shares etc. are firms in which managerial performance can be monitored at relatively low cost. The noisier a firm's environment, the greater the payoff to owners in maintaining tighter control noisier environments should give rise to more concentrated ownership structures

Legal Environment - ownership concentration occurs as a natural response to high managerial agency costs and emerges as the best way to control agency costs and ensure the protection of shareholder rights

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Ownership concentration and firm value

There are several possible alternative explanations that are consistent with empirical findings of positive relationship:

• Firm value is higher because blockholders monitor better (and managers work harder) as their fractional stake increases when they get to keep more of the fruits of their labor

• Unobserved heterogeneity problem - there are systematic differences between firms with dispersed and concentrated ownership, and it is these differences—not the level of ownership concentration—that are causing the difference in firm value

• Reverse-causation problem - individuals accumulate blocks in high-value firms, perhaps because such firms offer greater private benefits of control

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Ownership Concentration and Firm Value

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Several researchers have found all types of relationships between ownership and firm value -Positive, negative, insignificant, nonlinear, reverse

Those studies that treat ownership as endogenousin one way or another arrive at a similar conclusion of no significant relationship (Panel-FE, Instrumental Vars)

Other studies that fail to account for the endogeneityof ownership structure are the ones that have yielded evidence of a statistically significant effect of ownership structure on performance.

Private Benefits of Control

Difficult to measure:

If large-block shareholders (by using their voting power) anticipate to secure positive benefits that do not accrue to smaller shareholders, then blocks should trade at a premium to the exchange price

However, if blockholders expect to bear net private costs (lack of diversification, costs of monitoring, costs of legal liabilities), then blocks should trade at a discount to the exchange price

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Measuring private benefits of control

1. The price per share for controlling block reflects the cash flow benefits and private benefits stemming from the controlling position in the firm

Market price of the shares following the change in control reflects only the cash flow benefits of non-controlling shareholders (to be expected under the new management)

The difference between the two prices should reflect the differential payoff accruing to the controlling shareholder=private benefits of controlWhenever the control block changes hands, measure the difference

2. Compare the price of multiple (Dual) classes of stock with differential voting but similar cash flow rights Dual class shares not allowed in many countries

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Data

Transactions involving control sale of stock for publicly traded companies in 1990-2000:

• Purchases of blocks larger or equal to 10%• Transactions that result in the increase of acquirers share from lower than

20% to higher than 20%

Sample: 393 transactions from 39 countries

Control Premium=(price per share of block acquisition-value of equity)/value of equity)*% of Cash Flow Rights

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The average control premium of private benefits is 14% of the equity

10 countries have control premiums of more that 25% of the equity price

14 countries have control premiums of less than 3% of the equity price

Example: A bought 53% of shares of B for the price of 508 units per share. 2 days after the change of control share price decreased to 363 units.Control Premium = = (508-363)/363*53% = 21%

Differences in Deal and Firm Characteristics

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27% of transactions involve sales of blocks that exceed 50%=> an absolute majority of votes increases the value of controlling block by 9.5%

If the company is in financial distress (EPS<=0) the seller is more likely to be forced to sell=>control premium is 5.4% lower

Companies acquired by foreigners face more competition. Bargaining power of the seller is bigger=>foreign buyers pay a premium of 6.9%

Alternative Interpretations

1. Control Premiums arise from systematic overpayment=Winner’s Curse acquiring firm should experience negative returns at the announcement of the transaction (the results show

that CARs are slightly positive and insignificant) buyer’s announcement returns should be negatively related to the size of the control premium (negative but

insignificant results)

2. Buyer has superior information and there is a delay in incorporating it into the prices (especially in underdeveloped markets) re-estimate private benefits using market price 30 days after the announcement (no significant effects found)

3. Selective non-disclosure – controlling parties are more fearsome to disclose control premiums (especially in countries with more investor protection) 33% of deals were dropped because of non-disclosure of terms, countries with higher premiums tend to have

higher % of deals not disclosed Using antidirector rights it turns out that in countries with more investor protection provide greater % of deals

whose terms are disclosed

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Efficiency of private benefits of control

Are the private benefits of control more or less efficient?

Do they affect the development of financial markets?

• Where controlling party can appropriate the value – entrepreneurs will be less likely to take the company public the size of equity market relative to GDP should be smaller

• When control value is high – selling majority in the market is discouraged – small shareholders are not willing to pay proper value for their atomistic (non-controlling) shares% of companies widely held will be smaller

• It will be more profitable to sell control in private negotiationsprivatizations are executed through private transactions as opposed to public offerings

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Higher the private benefits of control=> more the ownership concentration and private placement of assets as opposed to public share offerings

Higher the private benefits of control=> Capital markets are less developed: less IPOs, less number of company listings, less the size of the equity market

What curbs private benefits of control?

Legal Institutions:

• Legal Environment – the probability of being sued discourages the controlling party to appropriate some of the valuemeasure of investor protection - Antidirector Index (La Porta et al. 1997)

• Disclosure standards – information available to non-controlling shareholders more accurate the disclosures the less the degree of appropriation by controlling party

• Law Enforcement – speedy and predictable enforcement of legal protectionsstrength of countries Law & Order. Country risk rating agency – International Country Risk

index (scaled from zero to 10)

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What curbs private benefits of control?Extra-legal Institutions:

Product market competition. Under more competition: i) survival of the firm is more challenged by extracting private benefits; ii) prices are more verifiable - difficult to tunnel out resources through transfer prices

Control for industry type; Use the survey of World Competitiveness Report (“Competition Laws prevent unfair competition in your country?”)

Public opinion pressures. Concern for reputation and public humiliation.

The existence of independence press: circulation of daily newspapers normalized by population as a measure of importance of public opinion and the credibility of newspapers (less credible newspapers will sell less)

Internal moral norms

Violent Crime Rates (World Competitiveness Yearbook) and Use of Religion (primary orientation) as proxy for cultural norms

Labor as monitor. Labor is privy in insider information on customers and suppliers and can hold up the controlling shareholder by threatening to withhold services and sometimes through the position of boards of directors

Measure used is the Degree of employee protection – extent of potential labor power, available for OECD countries

Government as monitor – a minority shareholder that is common to everyone. Is able to discipline through tax code and better tax enforcement

Measure the Level of Tax Compliance (not the level of tax rates) Index by World Competitiveness Report (scale form 0 to 6) 22

What curbs private benefits of control?

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Countries with better accounting standards, better investor protection and better enforcement of law have lower private benefits of control

Countries with more competitive product markets, higher diffusion of newspapers and higher degree of tax compliance have lower private benefits of control

Summary

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Extraction of private benefits by controlling shareholders is a very real phenomenon that can be consistently measured

The negative effect of private benefits of control on financial development can be identified. In countries where private benefits of control are large:Ownership is more concentratedPrivatizations are less likely to take place as public offeringsCapital markets are less developed

Private benefits of control are effectively constrained by strong legal and extra-legal institutions

References:

*Dyck, A., & Zingales, L. (2004). Private benefits of control: An international comparison. The Journal of Finance, 59(2), 537-600.

*Holderness, C. G. (2003). A survey of blockholders and corporate control. Economic policy review, 9(1), 51-64.

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Optional Readings/Presentations:

Li, D., Moshirian, F., Pham, P. K., & Zein, J. (2006). When financial institutions are large shareholders: The role of macro corporate governance environments. The Journal of Finance, 61(6), 2975-3007.

Claessens, S., Djankov, S., Fan, J. P., & Lang, L. H. (2002). Disentangling the incentive and entrenchment effects of large shareholdings. The Journal of Finance, 57(6), 2741-2771.

Barclay, M. J., & Holderness, C. G. (1989). Private benefits from control of public corporations. Journal of financial Economics, 25(2), 371-395.

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