Abstract
This article analyzes how asymmetric information in corporate management and equity financing distorts corporate investment and how different corporate ownership (government, managerial, and foreign) affects investment distortion in a transitional economy. When managerial entrenchment is sufficiently high, government ownership further distorts investment by biasing downward managers’ net marginal cost of investment; in contrast, managerial and foreign ownership counter the bias and thereby reduce investment distortion. Furthermore, unlike government ownership, managerial and foreign ownership mitigate rather than exacerbate the extent to which high entrenchment distorts investment. An econometric analysis of a large sample of Chinese public firms provides strong evidence in support of these theoretical predictions.
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Notes
For the importance of these three ownerships, see a case study of 29,638 Chinese firms in Zhu et al. (2019). Lin (2012) also reveals that nearly RMB 300 billion was appropriated by controlling shareholders at the expense of minority shareholders’ interest from 2002 to 2003. In addition, despite their appeal to earnings management, minority shareholders have only limited role in external monitoring (Kong 2019).
The existing literature suggests that government ownership tends to exacerbate entrenchment problem and lower corporate efficiency (Zou and Adams 2008; Berkman et al. 2014). Particularly in China, the segregation between voting right and cash-flow right for state ownership causes severe agency problems such as entrenchment, because bureaucrats with ownership lack financial incentives to closely monitor managerial performances (Cull and Xu 2005). In fact, government ownership is often conducive to non-professional management through nepotism in personnel appointments (Fan and Zhang 2007) or corporate empire building that has a government-favored externality impact on job creation and economic growth (Guo et al. 2018). In contrast, foreign ownership often plays an active role in monitoring corporate governance and performance and in raising a firm’s long-term value, see Khanna and Palepu (2000), Douma et al. (2006), Wang and Wang (2015), and Zhu et al. (2019), among others.
See Myers and Majluf (1984) for the pecking order theory.
State-owned banks favor government ownership because of the so-called paternalism (Kornai 1980) and banks’ associated moral hazard, as government interests in borrowing firms are implicitly insured by taxpayers collectively against any possible failures (Firth et al. 2009; Bailey et al. 2011). Banks in general also favor foreign ownership since it means not only improved corporate governance through foreign investors’ monitoring function (Gillan and Starks 2003) but also a better access to the world's capital market (Wang and Wang 2015; Bena and Simintzi 2017).
Specifically, \(\mu (E) = [P(E|r_h)/P(E)]\)×p, where P(E) is the total probability for announcement E, and P(Erh) is the conditional probability that announcement E is made by high-return firms.
Below is the proof for the firm’s expected value V net of new equities E after the investment project pays off: \(\begin{aligned} V - E & = V - \left( {I - F - L} \right) \\ & = \left[ {A + I^{r} - \left( {1 + i} \right)L} \right] - I + F + L \\ & = A + I^{r} - \left[ {1 + i\left( {a_{1} + b_{1} \alpha_{g} + b_{2} \alpha_{f} } \right)} \right]I + F \\ \end{aligned}\)
The positive relationship between the downward net marginal cost bias and government ownership holds if \(\frac{{\alpha }_{m}+{\beta }_{2}{\alpha }_{f}}{1-{\alpha }_{f}}>{\beta }_{1}\), which is true as long as \({\alpha }_{m}+{\beta }_{2}{\alpha }_{f}>{\beta }_{1}\) because \(\frac{{\alpha }_{m}+{\beta }_{2}{\alpha }_{f}}{1-{\alpha }_{f}}>{{\alpha }_{m}+{\beta }_{2}{\alpha }_{f}>\beta }_{1}\). Therefore a reasonable assumption is: as far as managers’ utility maximization is concerned, the marginal utility of managerial ownership plus foreign ownership is greater than the marginal utility that government ownership generates to managers; in particular, when foreign ownership is very small, it boils down to the fact that managers favor their own ownership more than government ownership.
Here we assume that there is no difference in entrenchment between high-return firms and low-return firms.
We use the phrases of investment distortion and investment gap interchangeably in this study.
The intermediate value theorem applies here.
Kumar and Langberg (2009).
With the algebraic values of GAPl and GAPh, Case a and Case b of “Appendix 1” provide the proof of Proposition 5 for the cases of overinvestment and underinvestment respectively, and Case c and Case d of “Appendix 1” supply the proof of Proposition 6 in a similar way. Based on the proof in “Appendix 1”, Eqs. (20) and (21) in the text highlight (for presentation convenience) only the equivalent magnitude change in GAP without making a distinction between GAPl and GAPh.
http://www.wind.com.cn. WIND database developed by Wande Information and Technology Ltd. collects the data of public companies listed in Shanghai and Shenzhen stock exchanges since 2006. The database includes financial and accounting information, ownership structure, corporate governance structure, related party transactions and loan guarantees. The database is derived from listed companies’ annual, semi-annual and quarterly reports, announcements from shareholders’ meeting, companies’ websites and other sources.
http://www.resset.cn RESSET database developed by Beijing Gildata Resset Data Tech Co., Ltd. covers public companies listed in Shanghai and Shenzhen stock exchanges. The database provides the data about independent directors. in addition to other financial and market data. We extract the data of independent directors from RESSET database.
http://www.gtadata.com. CSMAR database developed by Shenzhen GTA Education Tech Ltd. covers public companies listed in Shanghai and Shenzhen stock exchanges. We collect the data of government ownership from CSMAR database.
Originally, the sample has 21,748 observations from 3,029 firms. The sample-size reduction is due to (1) the exclusion of financial sectors (industry code J66, J67, J68, and J69), as financial industries are subject to special restrictions on investing activities; and (2) the loss of one-year observation (year 2007) when computing one-year lagged variables used in the optimal investment model.
Guanxi in Chinese means connection. It represents a wide network of mutually beneficial relationships often featured in an off-business setting but used for securing a business deal.
Although loan guarantees are more likely to do more harm than good for the companies issuing the guarantees, these guarantees were permissible and used by many Chinese listed firms. In June 2000, Chinese regulators prohibited issuance of any new guarantees, but did not require the termination of pre-existing guarantees. With the absence of strong legal enforcement mechanisms, guaranteed loans remain a popular practice (Berkman et al. 2009, 2014; Jiang et al. 2010).
A major type of foreign investors in China’s corporate sector is the so-called Qualified Foreign Institutional Investors (i.e., QFII), and they are mainly foreign mutual funds and hedge funds.
One basis point equals 1/100 percentage points.
Prior research documents the restricted foreign ownership in China, see Tam et al. (2010), for example.
We would like to thank an anonymous referee for the suggestion.
Although Kumar and Langberg (2009) studied both overinvestment and underinvestment in a model with corporate fraud (an extreme version of managerial entrenchment) in the efficient capital markets, their study leaves out the cases of different types of corporate ownership so that the issue of the investment-distortion sensitivity to ownership is unaddressed.
We posit a reasonable assumption in “Appendix 1” that the capital market’s expected return from firm’s investment project is less than 50% (re < 1/2).
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Acknowledgements
The authors are grateful to Dr. Cheng-Few Lee (the Editor-in-Chief) and two anonymous referees of Review of Quantitative Finance and Accounting for their helpful comments on an earlier version of this paper. The authors wish to thank the International Corporate Governance Society (ICGS) and its two anonymous reviewers for nominating this paper for the best paper award at the 2020 ICGS annual conference. The authors have also benefited from discussions with session participants when the earlier versions of this paper were presented at the following conferences: the 86th International Atlantic Economics Society Conference, the 2018 American Accounting Association annual meeting, and the 14th biannual international conference of Western Economic Association International. Any errors or omissions are the sole responsibility of the authors.
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Appendices
Appendix 1. The sensitivity of the distortive entrenchment impact to ownership structures
- Case a:
-
Sensitivity analysis for managerial and foreign ownership in the case of overinvestment.Footnote 27
To show \(\frac{{\partial }^{2}{GAP}_{l}}{\partial {\alpha }_{x}\partial \gamma }\)< 0 in (20) (\({\alpha }_{x}={\alpha }_{m}, {\alpha }_{f})\), we show that the first and second two-term products in (20) are both negative. By (7), \(\frac{\partial {GAP}_{l}}{\partial c}\)< 0, and \(\mathrm{by }(17)\) and (18), \(\frac{{\partial }^{2}c}{\partial {\alpha }_{x}\partial \gamma }>0.\) In addition, \(\frac{\partial c}{\partial \gamma }\)< 0 by (12). Finally, taking derivatives of (13) and (14) with respect to c respectively produces
where Γ1≡ \(\frac{\left({r}_{l}-{\mathrm{r}}_{e}\right)\gamma \left(1-{\alpha }_{f}+{\alpha }_{g}\right)}{\left({r}_{l}-1\right)\left({\mathrm{r}}_{e}-1\right){\left({\alpha }_{m}+{\beta }_{1}{\alpha }_{g}+{\beta }_{2}{\alpha }_{f}\right)}^{2}}\)< 0, and
where Γ2 ≡\(\frac{\left({r}_{l}-{\mathrm{r}}_{e}\right)\left[\gamma \left({\beta }_{2}+{\alpha }_{m}+{\beta }_{2}{\alpha }_{g}+{\beta }_{1}{\alpha }_{s}\right)+{b}_{2}i{\left({\alpha }_{m}+{\beta }_{1}{\alpha }_{g}+{\beta }_{2}{\alpha }_{f}\right)}^{2}\right]}{\left({r}_{l}-1\right)\left({\mathrm{r}}_{e}-1\right){\left({\alpha }_{m}+{\beta }_{1}{\alpha }_{g}+{\beta }_{2}{\alpha }_{f}\right)}^{2}}<0\). □
- Case b:
-
Sensitivity analysis for managerial and foreign ownership in the case of underinvestment
To show \(\frac{{\partial^{2} GAP_{h} }}{{\partial \alpha_{x} \partial \gamma }} > 0\) in (20) \(\left( {\alpha_{x} = \alpha_{m} , \alpha_{f} } \right)\), we show that the first and second two-term products in (20) are both positive. By (7), \(\frac{{\partial GAP_{h} }}{\partial c}\)> 0, and by (17) and (18), \(\frac{{\partial^{2} c}}{{\partial \alpha_{x} \partial \gamma }} > 0.\) In addition, \(\frac{\partial c}{\partial \gamma }\)< 0 by (12). Finally, taking derivatives of (13) and (14) with respect to c respectively produces.
where Γ3≡ \(\frac{{\left( {r_{h} - {\text{r}}_{e} } \right)\gamma \left( {1 - \alpha_{f} + \alpha_{g} } \right)}}{{\left( {r_{l} - 1} \right)\left( {{\text{r}}_{e} - 1} \right)\left( {\alpha_{m} + \beta_{1} \alpha_{g} + \beta_{2} \alpha_{f} } \right)^{2} }}\)>0, and
where Γ4 ≡\(\frac{\left({r}_{h}-{\mathrm{r}}_{e}\right)\left[\gamma \left({\beta }_{2}+{\alpha }_{m}+{\beta }_{2}{\alpha }_{g}+{\beta }_{1}{\alpha }_{s}\right)+{b}_{2}i{\left({\alpha }_{m}+{\beta }_{1}{\alpha }_{g}+{\beta }_{2}{\alpha }_{f}\right)}^{2}\right]}{\left({r}_{h}-1\right)\left({\mathrm{r}}_{e}-1\right){\left({\alpha }_{m}+{\beta }_{1}{\alpha }_{g}+{\beta }_{2}{\alpha }_{f}\right)}^{2}}>0\). □
- Case c:
-
Sensitivity analysis for government ownership in the case of overinvestment with high entrenchment
To show \(\frac{{\partial }^{2}{GAP}_{l}}{\partial {\alpha }_{g}\partial \gamma }\)> 0 in (21), we show that each term in (21) is positive. By (7), \(\frac{\partial {GAP}_{l}}{\partial c}\)< 0, and by (19) \(\frac{{\partial }^{2}c}{\partial {\alpha }_{g}\partial \gamma }<0,\mathrm{ since} \frac{{\alpha }_{m}+{\beta }_{2}{\alpha }_{f}}{1-{\alpha }_{f}}>{\beta }_{1}\). In addition, \(\frac{\partial c}{\partial \gamma }\)< 0 by (12). Finally, taking derivative of (15) with respect to c produces
where Γ5 ≡ \(\frac{\left({r}_{l}-{\mathrm{r}}_{e}\right)\left\{-\gamma \left[{\alpha }_{m}+{\beta }_{2}{\alpha }_{f}-{\beta }_{1}\left(1-{\alpha }_{f}\right)\right]+{b}_{1}i{\left({\alpha }_{m}+{\beta }_{1}{\alpha }_{g}+{\beta }_{2}{\alpha }_{f}\right)}^{2}\right\}}{\left({r}_{l}-1\right)\left({\mathrm{r}}_{e}-1\right){\left({\alpha }_{m}+{\beta }_{1}{\alpha }_{g}+{\beta }_{2}{\alpha }_{f}\right)}^{2}}\)>0 because \(\upgamma >\frac{{{b}_{1}i\left({\alpha }_{m}+{\beta }_{1}{\alpha }_{g}+{\beta }_{2}{\alpha }_{f}\right)}^{2}}{{\alpha }_{m}+{\beta }_{2}{\alpha }_{f}-{\beta }_{1}\left(1-{\alpha }_{f}\right)}\), and \(\frac{{\alpha }_{m}+{\beta }_{2}{\alpha }_{f}}{1-{\alpha }_{f}}>{\beta }_{1}\). □
Case d
Sensitivity analysis for government ownership in the case of underinvestment with high entrenchment
We then show \(\frac{{\partial }^{2}{GAP}_{h}}{\partial {\alpha }_{g}\partial \gamma }\)< 0 in (21) by showing that the first and second two-term products are both negative. By (7), \(\frac{\partial {GAP}_{h}}{\partial c}\)> 0, and by (19), \(\frac{{\partial }^{2}c}{\partial {\alpha }_{g}\partial \gamma }<0,\mathrm{since} \frac{{\alpha }_{m}+{\beta }_{2}{\alpha }_{f}}{1-{\alpha }_{f}}>{\beta }_{1}.\) In addition, \(\frac{\partial c}{\partial \gamma }\)< 0 by (12). Finally, taking derivative of (15) with respect to c produces
where Γ6≡ \(\frac{\left({r}_{h}-{\mathrm{r}}_{e}\right)\left\{\left({\alpha }_{m}+{\beta }_{2}{\alpha }_{f}\right)\left[-\gamma +{b}_{1}i\left({\alpha }_{m}+{\beta }_{2}{\alpha }_{f}\right)\right]+{\beta }_{1}^{2}{b}_{1}i{\alpha }_{g}^{2}+{\beta }_{1}\left[\left(1-{\alpha }_{f}\right)\gamma +2{b}_{1}i\left({\alpha }_{m}+{\beta }_{2}{\alpha }_{f}\right){\alpha }_{g}\right]\right\}}{\left({r}_{h}-1\right)\left({\mathrm{r}}_{e}-1\right){\left({\alpha }_{m}+{\beta }_{1}{\alpha }_{g}+{\beta }_{2}{\alpha }_{f}\right)}^{2}}\)<0 because.
\(\upgamma >\frac{{{b}_{1}i\left({\alpha }_{m}+{\beta }_{1}{\alpha }_{g}+{\beta }_{2}{\alpha }_{f}\right)}^{2}}{{\alpha }_{m}+{\beta }_{2}{\alpha }_{f}-{\beta }_{1}\left(1-{\alpha }_{f}\right)},\) and \(\frac{{\alpha }_{m}+{\beta }_{2}{\alpha }_{f}}{1-{\alpha }_{f}}>{\beta }_{1}\).
Appendix 2. The entrenchment index, its components and their impacts on firm value
Panel A in “Appendix 2” reports the mean values of the entrenchment index (E-Index) and of its components for a sample of 21,748 observations between the period 2007 and 2016. Panel B reports the pooled OLS regressions of firm value, measured as the log of total market value, on the entrenchment index (E-Index) and then on its components. E-Index is the sum of %IndDirector, NumMeeting, NonBig4, CSRCFines, RelatedTrans, and LoanGuarantee. Year Indicators is a vector of indicator variables to capture annual fixed effects. The sample period is between 2007 and 2016. Industry Indicators is a vector of indicator variables to capture industry fixed effects. There are 65 non-financial industries in this regression. The t-statistics are reported in the last column based on Huber-White robust standard errors. ***, **, and * indicate statistical significance at the 0.01, 0.05, and 0.10 level, respectively.
Panel A: The entrenchment index and its components | ||||||||
|---|---|---|---|---|---|---|---|---|
E-Index | %IndDirector | NumMeeting | NonBig4 | CSRCFines | RelatedTrans | LoanGuarantee | ||
2007 | 2.013 | 0.536 | 0.289 | 0.903 | 0.012 | 0.175 | 0.132 | |
2008 | 2.188 | 0.613 | 0.525 | 0.904 | 0.003 | 0.187 | 0.154 | |
2009 | 1.969 | 0.593 | 0.243 | 0.906 | 0.021 | 0.199 | 0.149 | |
2010 | 2.374 | 0.609 | 0.600 | 0.913 | 0.021 | 0.178 | 0.238 | |
2011 | 2.327 | 0.647 | 0.574 | 0.920 | 0.028 | 0.183 | 0.233 | |
2012 | 2.313 | 0.499 | 0.370 | 0.922 | 0.030 | 0.202 | 0.257 | |
2013 | 2.457 | 0.517 | 0.454 | 0.922 | 0.053 | 0.239 | 0.261 | |
2014 | 2.464 | 0.519 | 0.428 | 0.924 | 0.048 | 0.254 | 0.2550 | |
2015 | 2.310 | 0.505 | 0.386 | 0.926 | 0.065 | 0.264 | 0.078 | |
2016 | 2.359 | 0.499 | 0.534 | 0.927 | 0.078 | 0.226 | 0.013 | |
2007–2016 | 2.305 | 0.546 | 0.448 | 0.919 | 0.041 | 0.216 | 0.173 | |
Panel B: The entrenchment index and firm value | ||||
|---|---|---|---|---|
Variable | Dependent variable: LogMV | |||
Coefficient | t-statistics | Coefficient | t-statistics | |
E-Index | − 0.197*** | − 27.21 | ||
%IndDirector | − 0.120*** | − 8.92 | ||
NumMeeting | − 0.113*** | − 8.30 | ||
NonBig4 | − 1.430*** | − 57.95 | ||
CSRCFines | − 0.121*** | − 3.58 | ||
RelatedTrans | − 0.180*** | − 10.94 | ||
LoanGuarante | − 0.363*** | − 20.30 | ||
Industry and Year Indicators | Yes | Yes | ||
Adjusted R2 | 3.22% | 16.37% | ||
N | 21,748 | 21,748 | ||
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Wu, Y., Duong, H.K., Libin, E. et al. The ownership effect on corporate investment distortion in the transitional economies: Mitigating or exacerbating?. Rev Quant Finan Acc 57, 523–555 (2021). https://doi.org/10.1007/s11156-020-00954-1
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DOI: https://doi.org/10.1007/s11156-020-00954-1