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Corporate Governance, and the Returns on Investment

Klaus Gugler, Dennis C. Mueller andB. Burcin Yurtoglu

University of Vienna, Department of EconomicsBWZ, Bruennerstr. 72, A-1210, Vienna

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Considerable interest recently in differences in corporate governance systems.

Ten years ago -- German and Japanese systems were thought to be better.

Today, many think US & UK (Anglo-Saxon) systems better.

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Focal point of literature has been on the extent to which corporate governance institutions align the interests of managers and shareholders.

Weak corporate governance systems allow managers to pursue their own goals.

Much of the literature has emphasized the importance of growth or empire building as a managerial goal.

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Previous Tests

Dividend payouts

Tobin‘s q

Both measures of performance have difficulties.

• When investment opportunities differ, so too should optimal dividend payments.

• Tobin‘s q is a measure of average performance.

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Tobin‘s q equals the return on total capital divided by the cost of capital. When testing for the existence of agency problems, one wants to compare the returns on investment to the cost of capital.

Our paper employs such a measure by estimating marginal qs for firms -- ratios of returns on investment to costs of capital.

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In testing for the presence of agency problems, we focus upon two sets of institutions

• The corporate governance structure of a country as defined by its legal system

• The ownership structure of a company

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In our empirical work we measure a firm’s average return on investment (r) as a ratio to its cost of capital (i), a ratio that we define as qm, qm=r/i .

Since the average return on capital should be greater or equal to the marginal return on capital, we predict for a firm, which maximizes shareholder wealth, qm ≥ 1 .

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Main Hypotheses

(1) Legal Institutions and Returns on Investment

A strong corporate governance system aligns managerial and shareholder interests. Managerial and shareholder interests are more likely to be aligned in countries in which it is easy for shareholders to monitor managers, and initiate proxy fights or hostile takeovers.

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We use the LLSV (1997, 1998) categorization of the legal environments of countries as a measure of the strength of a country’s corporate governance system.

Hypothesis 1: For companies located in countries with strong corporate governance systems,qm > 1.

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Weak corporate governance systems allow managers to pursue their own goals at the shareholders’expense. Where corporate governance systems are weak managers pay out less in dividends and retain larger fractions of their cash flows to pursue their own goals and invest too much. This reasoning leads us to expect qms < 1, in countries with weak corporate governance systems.

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Some firms have attractive investment opportunities and limited financial resources. For these companies no conflict between managers and shareholders over dividend and investment policies exists.

Hypothesis 2: For companies with limited investment opportunities that are located in countries with weak corporate governance systems, qm < 1 .

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(2) Legal Institutions, Ownership Structures and Returns on Investment

We define five ownership categories:

• Family-controlled

• Firm-controlled,

• Finance-controlled

• State-controlled

• Dispersed ownership

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Separation of ownership from control

Hypothesis 3: In countries with strong corporate governance systems, companies with widely dispersed shareholdings have lower qms than the other companies in their country group.

Hypothesis 4: In countries with weak corporate governance systems, companies with widely dispersed shareholdings have higher qms than the other companies in their country group.

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No (simple) predictions concerning other ownership categories:

family-control:

• MSV (1988) observe a nonlinear relationship

• in countries with weak protections it may lead to expropriation or over-investment

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Control by a financial or non-financial firm: can have several implications on investment performance:

+ Those in control of any firm A, even if they are empire builders, will want the managers of any firm B that they control to maximize profits

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- Families behind these pyramids are empire builders who sacrifice profits at all levels of the pyramid

- The pyramid’s size makes careful monitoring of lower-level firms difficult

- The performance of lower level firms is sacrificed to benefit the parent firm at the top of the pyramid

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= the ratio of r to i for total investment,

= the ratio of r to i for investment out of cash flow,

= the ratio of r to i for investment out of new debt,

= the ratio of r to i for investment out of new equity.

Iqm

CFqm

Dqm

Eqm

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Hypothesis 5: For companies with qmI > 1 ,

it is also true that qmCF > 1, qmD > 1 ,and qmE > 1 .

Hypothesis 6: In countries with weak capital

market discipline, for companies with qmI < 1,

1 > qmD > qmCF and 1 > qmD > qmE .

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Methodology

It : a firm's investment in period t,

CFt+j: the cash flow this investment generates in t+j,

it: the firm's discount rate in t.The present value of this investment is

( )1

(1)1

t jt

j t

CFPV

i

∞+

=

=+∑

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Define a permanent return, rt, which creates an equivalent present value to that defined by (1).

where qmt = rt / it .

(2)t tt t t

t

I rPV qm Ii

= =

1 1 (3)t t t tt tM M PV Mδ µ− −= + − +

The market value of the firm at the end of period tcan be defined as

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1

1 1 1

(4)t t t t

t t t

M M IqmM M M

µδ−

− − −

−= − + +

I = After tax profits + Decpreciation –Dividends + D + E + R&D + ADV

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The Data

The financial data:

1996-2001 versions of the Global Vantage,

1997 version of the Compustat from S & P's.

We exclude banks and financial companies and some service industries (SICs 6000 through 6999 and above 8100)

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To minimize the weight of outliers, we cap our basic variables at both the 1st and 99th percentiles of each country sample.

After this procedure we are left with 19,010 companies.

Ownership data:

• AMADEUS database for the European companies,

• Compact Disclosure for the USA,

• Asian (Japanese) Company Handbook for Asian companies (Japan).

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10.900.77African Countries4.300.64Transition Countries29.230.59French Origin35.510.74German Origin13.670.78Scandinavian Origin111.341.02English Origin

t-valueLegal System

Estimated qms by Legal Origin

qm

n = 112, 590, Adj.R2 = 0.25

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0.210.040.010.000.020.000.270.20(qm≠1)

631.10Ireland2460.80India1270.78Hong Kong

13310.85Great Britain420.58Cayman Islands

14781.16Canada2150.91Bermuda3460.94Australia

FirmsCountry qmEstimated qms by Country

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85910.001.05USA2430.000.64Thailand1180.721.07South Africa2080.750.97Singapore

460.000.40Pakistan660.050.86New Zealand

3810.000.86Malaysia560.181.27Israel

Firms(qm≠1)Country qm

Estimated qms by Country

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Estimated qms by CountryScandinavian Origin

1560.000.65Sweden1030.631.04Norway

790.690.96Finland1010.000.65Denmark

Firms(qm≠1)Country qm

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1260.011.26Taiwan1600.000.64Switzerland

820.000.70South Korea22190.000.86Japan4250.000.57Germany

820.020.71AustriaFirms(qm≠1)Country

Estimated qms by CountryGerman Origin

qm

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4950.000.57France490.000.54Greece

150.000.43Columbia730.291.24Chile

1330.000.25Brazil790.000.51Belgium240.160.78Argentina

Firms(qm≠1)Country

Estimated qms by CountryFrench Origin

qm

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40.231.25Panama190.171.19Netherl. Antil.

1740.000.69Netherlands810.000.50Mexico120.520.70Luxembourg

1500.000.64Italy1320.060.84IndonesiaFirms(qm≠1)Country qm

Estimated qms by Country

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700.000.45China100.040.58Venezuela290.000.54Turkey

1170.000.54Spain490.000.46Portugal830.981.00Philippines200.000.11Peru

Firms(qm≠1)Country qm

Estimated qms by Country

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Scandinavian Origin

0.796 ≈ 0.7431.014 ≈ 1.045State1.145 > 0.6831.001 ≈ 1.050Dispersed0.718 ≈ 0.7611.058 ≈ 1.041Non-Financial0.561 ≈ 0.8121.002 < 1.061Financial0.773 ≈ 0.7391.082 > 1.019Family

EnglishOrigin

B. The Effects of Ownership Structures

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0.374 < 0.6341.358 > 0.6010.626 ≈ 0.6280.561 ≈ 0.6400.599 ≈ 0.636

European-GermanOrigin

1.322 ≈ 0.880State0.829 ≈ 0.906Dispersed0.896 ≈ 0.863Non-Financial0.869 ≈ 0.882Financial0.977 ≈ 0.872Family

Asian-German Origin

B. The Effects of Ownership Structures

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0.952 > 0.5880.543 ≈ 0.6050.565 ≈ 0.6440.692 > 0.5790.569 ≈ 0.605

French Origin

StateDispersedNon-FinancialFinancialFamily

B. The Effects of Ownership Structures

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C. The Effects of Insider Ownership on qmin the United States

qm risesInsider Ownership > 68 %

qm = 0.92Insider Ownership = 68 %

qm = 1.21Insider Ownership = 22 %

qm = 0.95Insider Ownership = 0

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In Europe: Effects of Pyramiding (P),Cross Shareholdings (C)Voting Rights = Cash Flow Rights (V)

when P = 1, C = 1, V =1 qm = 0.34

when P = 0, C = 0, V = 0qm = 0.80

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Effects of Business Groups: Japan

0.92

1.071985 – 1995

0.570.83Group

0.590.94Independent1996 - 20001985 – 2000

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qm by Source of FundsEnglish Origin

0.630.770.360.5145qm < 1

1.991.351.481.7455qm ≥1

1.371.090.861.09All

∆ Equity∆ DebtCFMedian%Sample

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qm by Source of FundsScandinavian Origin

0.210.860.710.5558qm < 1

1.371.422.291.5642qm ≥1

0.551.081.310.85All

∆ Equity∆ DebtCFMedian%Sample

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qm by Source of FundsGerman Origin

0.550.830.470.5561qm < 1

1.591.271.571.4539qm ≥1

1.090.980.700.84All

∆ Equity∆ DebtCFMedian%Sample

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qm by Source of FundsFrench Origin

0.370.840.460.4662qm < 1

1.101.411.391.6738qm ≥1

0.521.020.640.78All

∆ Equity∆ DebtCFMedian%Sample

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qm by Source of Funds

China

Africa

Transition

-0.461.140.280.648All

1.050.900.450.7117All

1.291.250.390.7678All

∆ Equity∆ DebtCFMedianNo of firms

Sample

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Effects of Accounting StandardsEnglish Origin

0.930.700.68Strongqm <1

0.570.780.37Weakqm < 1

2.391.301.88Strongqm ≥ 1

1.741.471.62Weakqm ≥ 1

1.861.051.32StrongAll

1.071.050.83WeakAll

∆ Equity∆ DebtCFStandardSample

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Effects of Accounting StandardsScandinavian Origin

0.470.760.72Strongqm <1

0.560.991.23Weakqm < 1

2.191.222.38Strongqm ≥ 1

0.691.481.47Weakqm ≥ 1

1.010.971.39StrongAll

0.641.041.28WeakAll

∆ Equity∆ DebtCFStandardSample

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Effects of Accounting StandardsGerman Origin

0.720.720.62Strongqm <1

0.660.890.58Weakqm < 1

1.771.272.01Strongqm ≥ 1

1.581.100.81Weakqm ≥ 1

1.330.951.09StrongAll

1.030.990.59WeakAll

∆ Equity∆ DebtCFStandardSample

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Effects of Accounting StandardsFrench Origin

0.570.790.58Strongqm < 1

0.500.880.51Weakqm < 1

1.451.441.48Strongqm ≥ 1

0.841.441.49Weakqm ≥ 1

0.981.070.89StrongAll

0.651.050.73WeakAll

∆ Equity∆ DebtCFStandardSample

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Effects of Creditors‘ RightsEnglish Origin

0.580.710.78Strongqm < 1

1.060.700.65Weakqm < 1

1.571.342.07Strongqm ≥ 1

2.541.311.87Weakqm ≥ 1

1.061.031.34StrongAll

2.061.051.32WeakAll

∆ Equity∆ DebtCFStandardSample

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Effects of Creditors‘ RightsScandinavian Origin

0.570.991.22Strongqm <1

0.480.760.72Weakqm < 1

0.691.471.46Strongqm ≥ 1

2.191.212.37Weakqm ≥ 1

0.641.041.29StrongAll

1.010.971.40WeakAll

∆ Equity∆ DebtCFStandardSample

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Effects of Creditors‘ RightsGerman Origin

0.660.890.58Strongqm <1

0.720.720.62Weakqm < 1

1.581.100.81Strongqm ≥ 1

1.771.262.01Weakqm ≥ 1

1.030.980.59StrongAll

1.330.941.09WeakAll

∆ Equity∆ DebtCFStandardSample

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Effects of Creditors‘ RightsFrench Origin

0.360.840.41Strongqm <1

0.540.850.55Weakqm < 1

0.301.832.04Strongqm ≥ 1

1.081.411.45Weakqm ≥ 1

0.421.180.85StrongAll

0.781.040.78WeakAll

∆ Equity∆ DebtCFStandardSample

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Robustness Check

Possible problems

1. Efficient capital market

2. Investment endogenous

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Mt = Mt-1 + qmt It - δt Mt-1 + µt (6)

Mt+1 = Mt + qmt+1 It+1 - δt+1 Mt + µt+1 (7)

Mt+1 = Mt-1 + qmt It + qmt+1 It+1 - δt Mt-1 - δt+1 Mt +

+ µ t + µ t+1 (8)

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1 10 0 0

(9)

n n n

t n mt i t i t i t it t ii i i

M M q I Mδ µ+ + + + +− − += = =

= + − +∑ ∑ ∑

0

0

(10)

n

mt i t ii

m n

t ii

q Iq

I

+ +=

+=

=∑

∑

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0

0

11 0 0

0 0 0

(11)

n

m t i t ii

m n

t ii

n n

t i t it it n t i i

n n n

t i t i t ii i i

q Iq

I

MM M

I I I

δ µ

+ +=

+=

+ +− ++ − = =

+ + += = =

= =

−= + −

∑

∑

∑ ∑

∑ ∑ ∑

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Compute for firms with 3 or more observations

(weight by number of firms in country).

smq

ˆ 1.03 ,m mq q= 2 0.98R =

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Table 8 Comparison of Estimated andCalculated Returns on Investment

The table reproduces the estimates of returns on investment by legal system from Table 2 and compares them with means of calculated returns on investment using eq. 11 .

0.620.580.59French Origin0.660.830.74German Origin0.740.870.78Scandinavian Origin1.011.041.02English Origin

Weighted Mean

MeanLegal System

( )ˆmq( )mq

( )ˆmq( )mq

ˆ mqmq

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Conclusions

Corporate governance institutions and ownership structures are important in explaining differences in company returns on investment relative to their costs of capital, qm.

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(1) The origin of a country’s legal system is the most important.

English-origin legal systems provide shareholders with more protection against managers than other systems.

(2) Differences in investment performance related to a country’s legal system dominate differences related to ownership structure.

(3) A hierarchy of finance with respect to the returns on investment

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Accounting standards and rules that protect creditors’rights have significant effects on the returns on investment from new equity and new debt issues, even in countries with generally strong corporate governance systems.

Agency problems exist in all countries and can have significant impacts on the investment performance of companies.

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Agency problems can be mitigated by the institutional structures of a country. Legal institutions that strengthen shareholder rights do bring about superior investment performance. Strengthening external capital market constraints can also increase returns on investments out of externally raised finance.