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Equity Ownership and Firm Value in Emerging Markets

Forthcoming in The Journal of Financial and Quantitative Analysis

First draft: November 20, 1998

This draft: August 5, 2002

Karl V. Lins

David Eccles School of Business

University of Utah

1645 E. Campus Center Dr Rm 109

Salt Lake City, UT 84112-9303

Email: finkvl@business.utah.edu

Phone: (801) 585-3171

Abstract

This paper investigates whether management ownership structures and large non-management

blockholders are related to firm value across a sample of 1433 firms from 18 emerging markets. When a

management group’s control rights exceed its cash flow rights, I find that firm values are lower. I also

find that large non-management control rights blockholdings are positively related to firm value. Both of

these effects are significantly more pronounced in countries with low shareholder protection. One

interpretation of these results is that external shareholder protection mechanisms play a role in restraining

managerial agency costs and that large non-management blockholders can act as a partial substitute for

missing institutional governance mechanisms.

__________________________

I wish to thank Stijn Claessens, Jennifer Conrad, Amy Dittmar, Robert Dittmar, Simeon Djankov, Mustafa Gültekin,

Mark Lang, Mike Lemmon, John McConnell, Henri Servaes, Anil Shivdasani, Marc Zenner, Ingyu Chiou

(discussant) and other participants at the 1999 European Finance Association Conference, and seminar participants

at Arizona State University, Emory University, Southern Methodist University, the University of Georgia, the

University of North Carolina at Chapel Hill, the University of Notre Dame, the University of Pittsburgh, the

University of Utah, the University of Virginia, and Vanderbilt University. I thank an anonymous referee for many

detailed comments and for suggesting additional regression models that have improved the paper substantially. I

thank Stijn Claessens and Simeon Djankov for providing access to the stock market handbooks used in the World

Bank East Asia ownership studies. I am also grateful to Stijn Claessens, Larry Lang, and Mara Faccio for providing

the ownership data used in their studies of East Asia and Western Europe.

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I. Introduction

Recent research shows that large blockholders dominate the ownership structures of firms not

domiciled in the U.S. or a few other developed countries [Shleifer and Vishny (1997), La Porta, Lopez-

de-Silanes, Shleifer, and Vishny (hereafter LLSV) (1998), La Porta, Lopez-de-Silanes, and Shleifer

(1999), Claessens, Djankov, and Lang (2000), and Denis and McConnell (2002)]. This research suggests

that such concentrated ownership coincides with a lack of investor protection because owners who are not

protected from controllers will seek to protect themselves by becoming controllers. When control has

incremental value beyond any cash flow rights associated with equity ownership, shareholders will seek

to obtain control rights that exceed cash flow rights in a given firm. Around the world, control in excess

of proportional ownership is usually achieved through pyramid structures in which one firm is controlled

by another firm, which may itself be controlled by some other entity, and so forth.

The management group (and its family members) is usually the largest blockholder of a firm at

the top of the pyramid and there is significant overlap between the top firm’s management group and the

managers of each firm down the line in the pyramid. Thus, the controlling managers at the top of a

pyramid are generally able to exercise effective control of all the firms in the pyramid, while they bear

relatively less of the cash flow consequences of exercising their control in each firm down the line.

Finally, irrespective of pyramiding, managers of a given firm sometimes issue and own shares with

superior voting rights to achieve control rights that exceed their cash flow rights in the firm [Zingales

(1994), Nenova (2002)]. Taken together, the net result is that a great number of firms around the world

have managers who possess control rights that exceed their cash flow rights in the firm, which,

fundamentally, gives rise to potentially extreme managerial agency problems.

The extent to which managerial agency problems affect firm value is likely to depend on several

factors. If there are cash flow incentives that align managers’ interests with those of outside shareholders,

this should raise firm values. Alternatively, if a management group is insulated from outside shareholder

demands, a situation often referred to as managerial entrenchment, managers might choose to use their

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control to extract corporate resources; this consumption (or expected consumption) of the private benefits

of control should reduce firm values. When managers have control in excess of their proportional

ownership, the consumption of private control benefits is especially likely since this type of ownership

structure both reduces cash flow incentive alignment and increases the potential for managerial

entrenchment. Conversely, if managers act in the best interest of all shareholders, then firm values should

not depend on managerial control rights. Finally, to the extent that management’s control rights are

correlated with its cash flow rights, additional managerial control could result in higher firm values.

Non-management blockholders might also impact firm value. If there are large non-management

shareholders that have both the incentive to monitor management and enough control to influence

management such that cash flow is increased, firm values should be higher because all equity holders

share in this benefit of control. Of course, as with managers, large non-management blockholders might

choose to use their power to extract corporate resources, which would reduce firm values. Finally, all of

these factors are potentially even more important where external shareholder protection is the weakest.

This paper tests the above hypotheses using a sample of 1433 firms from 18 emerging markets.

Emerging markets provide an excellent laboratory to study the valuation effects of ownership

structure for several reasons. First, pyramid ownership structures are prevalent across virtually all

emerging markets. Second, emerging markets generally suffer from a lack of shareholder and creditor

protection and have poorly developed legal systems [LLSV (1998)]. Finally, markets for corporate

control (i.e. the takeover market) are generally underdeveloped in emerging markets [Economist

Intelligence Unit (1998)]. Overall, where external corporate governance is weak and managerial control

often exceeds its proportional ownership, extreme managerial agency problems may arise because the

private benefits of control are large.1 Non-management blockholders may be especially beneficial to

minority shareholders if they help fill the external governance void.

1 Bebchuk, Kraakman, and Triantis (2000) argue that agency problems in emerging markets may be an order of

magnitude larger than those in developed economies.

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LLSV (2002) and Claessens, Djankov, Fan, and Lang (2002) provide some evidence on the

relation between firm value, as measured by Tobin’s Q, and ownership structure across different

economies. Both papers focus exclusively on the ownership characteristics of a firm’s largest

shareholder, which is usually, but not always, the management group and its family. These papers do not

explicitly test how the relation between management/family ownership and firm value could be affected

by other blockholders that are not part of the management/family group. LLSV study the 20 largest firms

in each of 27 wealthy economies and report that the cash flow rights held by the largest blockholder are

positively related to firm value. They find no relation between Q and a separation in the control rights

and cash flow rights held by the largest blockholder.2 Claessens, et al. (2002) study a large set of firms

from eight East Asian emerging economies and also find that the cash flow rights held by the largest

blockholder are positively related to value. Additionally, they find that a difference in the control rights

and cash flow rights held by the largest blockholder is negatively related to firm value.

This paper builds on previous work relating ownership structure to firm value in several ways.

First, in all of my sample firms, I explicitly account for the effect of management group (and its family)

ownership and whether there is a large non-management blockholder present in the ownership structure.

Since it is the management group that actually administers a firm, the reduction in value from potentially

costly agency problems may be even worse when the management group has sufficient control to exploit

minority shareholders and there is no large non-affiliated blockholder to constrain it from doing so.

Backman (1999) details many examples of listed emerging market firms engaging in sometimes

egregious expropriation of minority shareholders through related-party transactions.3 Second, because

not every emerging market has identical external corporate governance features, I test whether any

valuation effects associated with ownership structure are more pronounced when shareholder protections

2 In contrast, Morck, Stangeland, and Yeung (2000) find that family control through pyramids reduces market value

for Canadian companies.

3 My sample contains several of these firms – CAM International, Cheung Kong Holdings, Hyundai Corporation,

Pacific Chemicals, Shangri-La Asia, and Wembley Industries – all of which have the management group as the

largest blockholder and most of which also have pyramid ownership structures.

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are the weakest. Finally, I expand considerably the number of less-developed countries in which

ownership and valuation are studied and use a broad cross-section of firms from each.4

For all of my sample firms, I trace out ultimate ownership, which includes both directly and

indirectly held control and cash flow rights. I employ a broad definition of management group

ownership, consisting of a firm’s officers, directors, and top-level managers, as well as their family

members. I find that management group blockholdings of control (i.e. voting) rights average 30 percent

across my sample. I also group non-management blockholders into various categories. Interestingly, I

find that the control rights blockholdings of other shareholders not affiliated with management average

almost 20 percent, which indicates that large non-management blockholders may play an important

corporate governance role in emerging market firms. Managers and their families are the largest

blockholder in two-thirds of sample firms, consistent with Claessens et al. (2002) and La Porta et al.

(1999). I also find that managers make extensive use of pyramid ownership structures in all sample

countries and that managers of Latin American firms frequently use shares with superior voting rights to

further increase the control rights associated with their cash flow rights.

My valuation analysis contains three sets of tests. The first uses regression models to test the

relation between Tobin’s Q and managerial equity holdings, ignoring the effect of the holdings of non-

management blockholders. This approach facilitates direct comparison with LLSV (2002) and Claessens

et al. (2002). When a management group’s control rights exceed its cash flow rights (because of

pyramiding and/or superior-voting equity), I find that firm values are lower. I also conduct tests using

breakpoints in the level of managerial control and find that managerial control between 5% and 20% is

negatively related to Q, consistent with the U.S. results of Morck, Shleifer, and Vishny (hereafter MSV)

(1988). These results support the managerial entrenchment hypothesis and indicate that the costs of the

private benefits of control are capitalized into share prices in emerging markets. Unlike LLSV (2002) and

Claessens et al. (2002), I find no evidence that increases in managerial cash flow rights affect Tobin’s Q.

4 For some country-specific evidence on ownership concentration and valuation in emerging markets, see Denis and