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Social Capital, Informal Governance, and Post-IPO Firm Performance: A Study of Chinese Entrepreneurial Firms

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Abstract

Social capital can serve as informal governance in weak investor-protection regimes. Using hand-collected data on entrepreneurs’ political connections and firm ownership, we construct several original measures of social capital and examine their effect on the performance of entrepreneurial firms in China after their initial public offerings. Political connections or a high percentage of external investors tend to enhance firm performance, but intragroup related-party transactions commonly lead to performance decline. These forms of social capital have a strong influence on the performance of Chinese firms, whereas formal governance variables such as board size or board independence have little effect. Although social capital may serve as an informal governance mechanism and effectively substitute for formal governance mechanisms in an emerging market, this role of social capital raises several ethical concerns, notably the development of rent-seeking and crony capitalism.

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Notes

  1. In contrast to the agency problem known to exist when ownership is diffused, the main conflict in China is between controlling and minority shareholders, because the controlling shareholders have highly concentrated ownership (Shleifer and Vishny 1997). According to Bae et al. (2012), controlling shareholders’ expropriation of minority shareholder investments is the key channel through which corporate governance affects firm value.

  2. Peng and Heath (1996) find that it is informal constraints rather than formal institutions that play the more important role in regulating emerging markets. Peng (2002) emphasizes the importance of interactions between formal and informal constraints for organizations in emerging markets such as Asia.

  3. Khanna and Palepu (2000) explain that when institutions intended to enhance the efficiency of input and output markets are underdeveloped, family firms and business groups can act as substitutes for the inefficient external capital and labor markets.

  4. ‘Mainland stocks become world giants after defying global rout’, South China Morning Post, August 15, 2007, p. B20.

  5. As the Chinese stock market was not doing well during the period 2002–2006, the whole process took four or even 5 years for some firms in our sample.

  6. For details, see the literature review by Ritter and Welch (2002, p. 1796) and the CFO survey by Brau and Fawcett (2006).

  7. In Chinese entrepreneurial companies, most founders are actively involved in the management of their firms. Of the 82 sample companies that have political bridging social capital, there are only five in which the founding entrepreneurs do not occupy any management position. Even for these five firms, it could be argued that the firms still reflect the entrepreneur’s efforts to build political bridging social capital by engaging managers with such social capital.

  8. Tian et al. (2008) present a comprehensive study on how Chinese private entrepreneurs participate in politics.

  9. The application of year fixed effects is very necessary, since our sample period includes the Split Share Structure Reform period in China between 2005 and 2006, which terminated trading constraints on restricted shares in China and also threatened the price premium on their freely traded counterparts. The literature documents that this reform brought about profound changes in the power balance between large and small shareholders, as well as in large shareholders’ incentives vis-à-vis the firm’s accounting and market performances (Hou and Lee 2013; Cumming and Hou 2014).

  10. Of these 32 firms, eight had political bridging social capital prior to their IPO.

  11. When both the pre- and post-IPO connections are loaded in Column 5, the significance bounces back.

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Acknowledgments

The authors would like to thank Douglas Cumming, Wenxuan Hou, Edward Lee (editors) and one anonymous reviewer, the participants at the European Accounting Association Annual Meeting (Ljubljana, Slovenia, May 2012), the 2012 Asian Finance Association (AsianFA) Annual Meeting (Taipei, July 2012), and the Conference on Sustainable and Ethical Entrepreneurship, Corporate Finance and Governance, and Institutional Reform in China (Beijing, April 2013) for their helpful comments and advice. The authors acknowledge financial support from the CEIBS Research Fund. The research assistance to Yvonne Yuan, Sophie Xiao, and Yuanyang Song is greatly appreciated. The authors also thank Ann Gallon for her much appreciated editorial help.

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  1. Singapore Management University, Singapore, Singapore

    Jerry X. Cao

  2. China Europe International Business School (CEIBS), Shanghai, China

    Yuan Ding & Hua Zhang

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  1. Jerry X. Cao
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Correspondence to Hua Zhang.

Appendix: Definition of Variables and Sources of Data

Appendix: Definition of Variables and Sources of Data

Variables

Definition

Data sources

Change in ROA

The difference between a sample firm’s three-year average ROA after the IPO and the three-year average ROA before the IPO. ROA is the ratio of net income over total assets

Pre-IPO data are hand-collected from the firm’s prospectus, and post-IPO data are collected from the Wind database

Change in ROE

The difference between a sample firm’s three-year average ROE after the IPO and the three-year average ROE before the IPO. ROE is the ratio of net income over equity

Pre-IPO data are hand-collected from the firm’s prospectus, and post-IPO data are collected from the Wind database

Post-IPO three-year stock abnormal return

A sample firm’s stock return during the period of 3 years starting from the next trading day after the IPO, net of the market return. Market return is the arithmetic mean of return for all stocks outstanding on the market during the same period

Individual stock return and market return are both collected from the CSMAR database

Change in sales as percentage of pre-IPO sales

The difference between a sample firm’s three-year average sales after the IPO and the three-year average sales before the IPO as a percentage of three-year average sales before the IPO

Pre-IPO data are hand-collected from the firm’s prospectus, and post-IPO data are collected from the Wind database

Change in asset turnover

The difference between a sample firm’s three-year average asset turnover after the IPO and the three-year average asset turnover before the IPO. Asset turnover is the ratio of a firm’s sales revenue over total assets

Pre-IPO data are hand-collected from the firm’s prospectus, and post-IPO data are collected from the Wind database

Political bridging social capital

Dummy variable that equals one if the entrepreneur or a management team member has political connections, which is defined as having past working experience in government or SOEs, being a member of the National People’s Congress or National Political Consultative Conference, or a Chairman of a National Industry Association

Pre-IPO data are hand-collected from the firm’s prospectus, and post-IPO data are hand-collected from the firm’s annual report

Pre-IPO Political bridging social capital

Dummy variable that equals one if the firm has developed political connections before the IPO. Having political connections is defined as having an entrepreneur or management team member who has past working experience in government or SOEs, is a member of the National People’s Congress or National Political Consultative Conference, or a Chairman of a National Industry Association

Relevant data are hand-collected from the firm’s prospectus

Post-IPO political bridging social capital

Dummy variable that equals one if the firm has no political connections before the IPO, and has developed political connections only after the IPO. Having political connections is defined as having an entrepreneur or management team member who has past working experience in government or SOEs, is a member of the National People’s Congress or National Political Consultative Conference, or a Chairman of a National Industry Association

Hand-collected from the firm’s annual report

External investor bridging social capital

Percentage of new shares floated to the public in the IPO

Hand-collected from the firm’s prospectus

Intragroup bonding social capital

The ratio of total related-party transactions in the three post-IPO years over total sales in the three post-IPO years

Collected from the Wind database

Proceeds raised

Amount of IPO proceeds as a percentage of the firm’s equity for the year before the IPO

Collected from the Wind database

Ln (total assets)

Arithmetic mean of total assets for the three consecutive years before the IPO year (in natural log form)

Hand-collected from the firm’s prospectus

Ln (market value)

Arithmetic mean of post-IPO market value (in natural log form) for three consecutive year-ends (last trading day of the year)

Collected from the Wind database

If CEO is chairman

Dummy variable that equals one if the chairman of the board is also the CEO in the year before the IPO, and zero otherwise

Hand-collected from the firm’s prospectus

Board size

Natural log of number of board directors in the year before the IPO

Hand-collected from the firm’s prospectus

Board independence

Ratio of number of independent directors over total number of board directors in the year before IPO

Hand-collected from the firm’s prospectus

IPO first-day return (firm)

The sample firm’s IPO first-day return, which is the difference between the IPO first-day closing price and the IPO offering price divided by the offering price

Collected from the Wind database

IPO first-day return (market)

The average IPO first-day return of all companies conducting an IPO in the same month our sample firm went public. A firm’s IPO first-day return is the difference between the IPO first-day closing price and the IPO offering price divided by the offering price

Collected from the Wind database

Firm/year dummies

Dummy variables based on IPO year of the sample companies

Collected from the Wind database

Industry dummies

Dummy variables based on 4-digit industry classifications

Collected from the Wind database

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Cao, J.X., Ding, Y. & Zhang, H. Social Capital, Informal Governance, and Post-IPO Firm Performance: A Study of Chinese Entrepreneurial Firms. J Bus Ethics 134, 529–551 (2016). https://doi.org/10.1007/s10551-014-2383-5

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