Pyramidal Ownership Structure, Overinvestment, and Firm Performance in China

Pyramidal Ownership Pyramidal Ownership Structure, Overinvestment, Structure, Overinvestment,

and Firm Performance in and Firm Performance in ChinaChina

Chao ChenChao ChenFudan UniversityFudan University

Donglin XiaDonglin XiaTsinghua UniversityTsinghua University

Song ZhuSong ZhuBeijing Normal UniversityBeijing Normal University

Motivations Motivations

• Business groups organized by Business groups organized by corporate pyramids enable the corporate pyramids enable the ultimate shareholders to control a ultimate shareholders to control a portfolio of firms with less cash portfolio of firms with less cash requirement. requirement.

• It alleviates restrictions on external It alleviates restrictions on external financing and reduces financing cost. financing and reduces financing cost.

MotivationsMotivations

• In China, governments and In China, governments and entrepreneurs control a large entrepreneurs control a large number of listed firms through the number of listed firms through the pyramidal ownership structure. pyramidal ownership structure.

• SOEs and NSOEs have different SOEs and NSOEs have different incentives for creating this pyramid incentives for creating this pyramid structure within their organizations structure within their organizations (Fan et al., 2005; Zhu, 2006). (Fan et al., 2005; Zhu, 2006).

Motivations Motivations

• SOEs utilize the pyramidal ownership SOEs utilize the pyramidal ownership structure to mitigate government structure to mitigate government intervention on listed firms and allow intervention on listed firms and allow them more flexibility in operation. them more flexibility in operation.

• For NOSEs, ultimate shareholders use the For NOSEs, ultimate shareholders use the pyramid to control their portfolio firms pyramid to control their portfolio firms with less cash flows and therefore create with less cash flows and therefore create an internal capital market within the an internal capital market within the pyramid (Bianco and Casavola, 1999; Attig pyramid (Bianco and Casavola, 1999; Attig et al., 2003; Fan et al., 2005). et al., 2003; Fan et al., 2005).

MotivationsMotivations

• This study examines (1) the This study examines (1) the relationship between corporate relationship between corporate pyramids and over investment, and pyramids and over investment, and (2) the influence of corporate (2) the influence of corporate pyramid and overinvestment on firm pyramid and overinvestment on firm performance.performance.

Literature ReivewLiterature Reivew

• The external capital market contents The external capital market contents ““lemonlemon”” premium due to asymmetric premium due to asymmetric information (Myers and Majluf, 1984).information (Myers and Majluf, 1984).

• The external financing is much costly The external financing is much costly than that of internal capital financing than that of internal capital financing due to market fictions (Brennan and due to market fictions (Brennan and Subrahmanyam, 1996; Easley and Subrahmanyam, 1996; Easley and OO’’Hara, 2004). Hara, 2004).

2. Literature Review 2. Literature Review

• Bertrand and Mullainathan (2003), Bertrand Bertrand and Mullainathan (2003), Bertrand et al. (2003) and Bebchuk et al. (2000) et al. (2003) and Bebchuk et al. (2000) argue that pyramids provide controlling argue that pyramids provide controlling shareholders the ability (due to high control shareholders the ability (due to high control rights) and incentive (due to low cash flow rights) and incentive (due to low cash flow rights) to tunnel corporate resources from rights) to tunnel corporate resources from the lower end of the pyramid to the higher the lower end of the pyramid to the higher end where they have higher cash flow end where they have higher cash flow rights. rights.

• Woojin Kim (2007)Woojin Kim (2007)

• Bebchuk et al. (2000) Bebchuk et al. (2000)

2. Literature Review 2. Literature Review

• Bertrand and Mullainathan (2003)Bertrand and Mullainathan (2003)

• Bertrand et al. (2003)Bertrand et al. (2003)

• Stein (1997): Using a pyramid structure Stein (1997): Using a pyramid structure to build an internal capital market may to build an internal capital market may mitigate the reliance on external mitigate the reliance on external financing.financing.

• Almeida and Wolfenzon (2006): When Almeida and Wolfenzon (2006): When the external financing market has the external financing market has greater constraints, the internal capital greater constraints, the internal capital market becomes more convenient. market becomes more convenient.

2. Literature Review2. Literature Review

Holmen and Hogfeldt (2005):Holmen and Hogfeldt (2005):

The overinvestment hypothesis for The overinvestment hypothesis for pyramids argues that discounts are pyramids argues that discounts are primarily for inefficient investment primarily for inefficient investment decisions due to leveraged control decisions due to leveraged control over firmsover firms’’ internal cash flows. internal cash flows.

2. Literature Review2. Literature Review

Richardson (2006) uses accounting information to Richardson (2006) uses accounting information to measure overinvestment of free cash flows. He finds measure overinvestment of free cash flows. He finds a positive relationship between overinvestment and a positive relationship between overinvestment and free cash flow for firms with positive free cash flow. free cash flow for firms with positive free cash flow. Specifically, he documents that the average of firm Specifically, he documents that the average of firm with positive cash flow overinvest 20% of its cash with positive cash flow overinvest 20% of its cash

flow.flow.

HypothesesHypotheses

• Concerning the influence of Concerning the influence of corporate pyramid on capital corporate pyramid on capital investment, longer layers in the investment, longer layers in the pyramid may restrict the pyramid may restrict the overinvestment of listed firm. Thus, overinvestment of listed firm. Thus, increasing layers in the pyramid increasing layers in the pyramid mitigate the likelihood of mitigate the likelihood of overinvestment for both SOEs and overinvestment for both SOEs and NSOEs. NSOEs.


• For SOEs, shorter layers in the pyramid means more direct For SOEs, shorter layers in the pyramid means more direct intervention from the government. intervention from the government.

• The executives of listed SOEs are more likely to be appointed The executives of listed SOEs are more likely to be appointed by the government. For meeting their political performance by the government. For meeting their political performance and avoiding their future political career in jeopardy, those and avoiding their future political career in jeopardy, those government officers-executives have incentives to build and government officers-executives have incentives to build and expand their empires, which may lead to overinvestment.expand their empires, which may lead to overinvestment.

• If the purpose of creating a pyramid is to reduce the influence If the purpose of creating a pyramid is to reduce the influence by the government and increase the managerial control of the by the government and increase the managerial control of the firm, the incentive for creating an empire is much lower than firm, the incentive for creating an empire is much lower than that of the executive directly appointed by the government. that of the executive directly appointed by the government. Therefore, as the increase of pyramid in SOEs, capital Therefore, as the increase of pyramid in SOEs, capital investment tends to be lower and is less likely to be investment tends to be lower and is less likely to be overinvested. overinvested.


• For NOSEs, creating a pyramid aims For NOSEs, creating a pyramid aims to create an internal capital market to to create an internal capital market to reduce the reliance on external reduce the reliance on external financing (Stein, 1997). The internal financing (Stein, 1997). The internal capital market is convenient for capital market is convenient for resource and capital transfers among resource and capital transfers among those portfolio firms to meet the those portfolio firms to meet the requirement of strategic development requirement of strategic development of the ultimate shareholder.of the ultimate shareholder.


• The decision for NSOEs, to build an empire The decision for NSOEs, to build an empire is not under the control by the management is not under the control by the management of the listed firm. Thus, the listed firm of the listed firm. Thus, the listed firm cannot expand its size through an internal cannot expand its size through an internal capital market. The ultimate shareholders capital market. The ultimate shareholders may deprive resources from their listed firm may deprive resources from their listed firm whenever they need capital. This behavior whenever they need capital. This behavior is known as is known as ““tunnelingtunneling””. Thus, investments . Thus, investments in listed firms are restricted by the need of in listed firms are restricted by the need of ultimate shareholders. Overinvestment is ultimate shareholders. Overinvestment is easier to control through longer layers in easier to control through longer layers in the corporate pyramid. the corporate pyramid.

Hypothesis 1Hypothesis 1

• The Pyramid will restrict the The Pyramid will restrict the capital investment of listed firms capital investment of listed firms and reduce the overinvestment and reduce the overinvestment for both SOEs and NSOEs.for both SOEs and NSOEs.


• Overinvestment Overinvestment (underinvestment) will lower the (underinvestment) will lower the accounting performance.accounting performance.


• For SOEs, pyramid is positively For SOEs, pyramid is positively related to performance, while for related to performance, while for NSOEs, the relation is negative.NSOEs, the relation is negative.

Variable Variable –– Pyramidal Pyramidal Ownership StructureOwnership Structure• The pyramidal ownership structure The pyramidal ownership structure

(CHAIN) is the number of layers (CHAIN) is the number of layers between the listed company and the between the listed company and the ultimate shareholder.ultimate shareholder.

Variable Variable –– Capital Capital InvestmentInvestment• Capital investment is a proxy using the Capital investment is a proxy using the

following two different measures: following two different measures:

• I1I1 is the increase of long term assets is the increase of long term assets standardized by the beginning assets. standardized by the beginning assets.

• I2I2 is the cash purchase in long-term equity is the cash purchase in long-term equity investment, debt investment, fixed assets, investment, debt investment, fixed assets, intangible assets and other assets, then minus intangible assets and other assets, then minus the cash flow from selling of fixed assets, the cash flow from selling of fixed assets, intangible assets and other assets intangible assets and other assets standardized by the beginning assets.standardized by the beginning assets.

Variable Variable –– Firm Performance Firm Performance• Performance is the accounting performance Performance is the accounting performance

measured by the net income and income measured by the net income and income before extraordinary items. ROE is the net before extraordinary items. ROE is the net income divided by the ending of period income divided by the ending of period equity. AveROE is the net income divided by equity. AveROE is the net income divided by the average equity. EXBIOE is the income the average equity. EXBIOE is the income before extraordinary items divided by the before extraordinary items divided by the ending of period equity, and AveEBXIOE is ending of period equity, and AveEBXIOE is the income before extraordinary items the income before extraordinary items divided by the average equity.divided by the average equity.

Control VariablesControl Variables

• IIt-1t-1 is the capital investment of the prior year; is the capital investment of the prior year;

• CF is the beginning cash flow from operation divided by CF is the beginning cash flow from operation divided by beginning assets;beginning assets;

• LEV, the debt ratio at the beginning of year; LEV, the debt ratio at the beginning of year;

• Size is the nature log of beginning assets. Size is the nature log of beginning assets.

• Q is prior year end TobinQ is prior year end Tobin’’s Q, which is calculated as the s Q, which is calculated as the market value of assets divided by book; market value of assets divided by book;

• Sale is the prior yearSale is the prior year’’s sales revenue divided by s sales revenue divided by beginning assets;beginning assets;

• Ret is the prior yearRet is the prior year’’s market return; s market return;

• Age is the time span from IPO year;Age is the time span from IPO year;


• State, dummy variable, 1 = SOE and 0 State, dummy variable, 1 = SOE and 0 otherwise;otherwise;

• V, the total voting rights of the ultimate V, the total voting rights of the ultimate shareholder in the listed company; shareholder in the listed company;

• CV is the deviation of cash flow right from CV is the deviation of cash flow right from voting right, measured by the cash flow right voting right, measured by the cash flow right divided by voting right; divided by voting right;

• Years is year dummy (5 yearly dummies); Years is year dummy (5 yearly dummies);

• Inds is the industry dummy (11 industrial Inds is the industry dummy (11 industrial dummies).dummies).


• FCF, the free cash flow, equals to FCF, the free cash flow, equals to prior year’s cash flow from operation prior year’s cash flow from operation minus expected capital investment minus expected capital investment derived from Richardson (2006) derived from Richardson (2006) expected investment model; expected investment model;

Cash flow-investment Cash flow-investment sensitivitysensitivity

Expected Capital Expected Capital InvestmentInvestment

Overinvestment:Overinvestment:1( )OverI

Residual Investment Residual Investment

Data and SamplesData and Samples

• We choose all listed firms in ChinaWe choose all listed firms in China’’s A-s A-share market from 2001 to 2006. Then, we share market from 2001 to 2006. Then, we exclude those firms (1) without the exclude those firms (1) without the information of ultimate shareholders, (2) in information of ultimate shareholders, (2) in finance industry, (3) not listed yet in the finance industry, (3) not listed yet in the previous year, (4) issued other kind of previous year, (4) issued other kind of shares, like B/H/S/ADR, (5) with leverage shares, like B/H/S/ADR, (5) with leverage ratio greater than 5 in the previous year. ratio greater than 5 in the previous year.

• Finally, we have 6213 firm-year Finally, we have 6213 firm-year observations. observations.

Data and SamplesData and Samples• In order to avoid the influence of In order to avoid the influence of

outliers, we winsorize observations of outliers, we winsorize observations of the top and bottom 1% for capital the top and bottom 1% for capital investment, I1 and I2, and top and investment, I1 and I2, and top and bottom 2% for accounting bottom 2% for accounting performance, ROE, AveROE, ROA, performance, ROE, AveROE, ROA, and AveROA. and AveROA.

Cash flow-investment sensitivityCash flow-investment sensitivity

Cash flow-investment sensitivity-Robust Cash flow-investment sensitivity-Robust TestsTests

Overinvestment MeasureOverinvestment Measure

Pyramid, Investment and Firm PerformancePyramid, Investment and Firm Performance

Different Ultimate ShareholderDifferent Ultimate Shareholder

Robust test-cash capital investment and Robust test-cash capital investment and other performance proxiesother performance proxies

ConclusionsConclusions

• We investigate the relationships among We investigate the relationships among capital investment, firm performance, and capital investment, firm performance, and pyramidal ownership structure in China. pyramidal ownership structure in China.

• Longer layers in the pyramid reduce the Longer layers in the pyramid reduce the likelihood of overinvestment. The negative likelihood of overinvestment. The negative relations between pyramidal ownership relations between pyramidal ownership structure and overinvestment exist for structure and overinvestment exist for SOEs and NSOEs. SOEs and NSOEs.


• Different incentives for creating a pyramid Different incentives for creating a pyramid structure may induce different effects on structure may induce different effects on performance for SOEs and NSOEs. performance for SOEs and NSOEs.

• For SOEs, the creation of corporate pyramid For SOEs, the creation of corporate pyramid results in less government interferences and results in less government interferences and offers more freedom for firms to operate in offers more freedom for firms to operate in a free market. Therefore, pyramiding may a free market. Therefore, pyramiding may enhance the profitability of SOEs. enhance the profitability of SOEs.


• While for NSOEs, although corporate While for NSOEs, although corporate pyramid may impose more pyramid may impose more restrictions on overinvestment, restrictions on overinvestment, higher agency costs dominate the higher agency costs dominate the positive effect of pyramid on positive effect of pyramid on overinvestment and lead to lower overinvestment and lead to lower accounting performance for NSOEs. accounting performance for NSOEs.

Pyramidal Ownership Structure, Overinvestment, and Firm Performance in China

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