__ April 2014
- What the Paper is about
This study was done by four students from Department of International Business at Schulich School of Business (Bae et al., nd) to test how expropritaion incentives of controlling shareholders impact firm values during a financial crisis and the recovery period.
The results of the expropriation model ran for Asian firms for their 1997 crisis and Latin American firms for the 2001 Argentine economic crisis were aligned with the main hypothesis. The hypothesis called “expropriation hypothesis” posits that the value of firms with weaker corporate governance would significantly drop during a financial crisis, but would rebound higher when the economy recovers. Thus, a firm’s governance has a direct relationship on a firm’s value.
- Significance of the Study
Past researchers have established the link between corporate governance and firm values during economic crisis, which gave rise to the expropriation hypothesis. However, succeeding research studies have provided alternative explanation why firms with poor governance would be greatly be impacted by economic crisis, that have weaken the findings. One study points to poor information about the firms and argues that investors’ awareness is the key to the relationship of corporate governance to the value of the firm (Rajan and Zingales, 1998). Another research cites a firm’s sensitivity to business conditions as the driver, while another suggests investors’ overreaction on the financial crisis as the trigger.
This study aims to further support expropriation hypothesis by extending the simulation of the research model to the period of recovery from the crisis. The purpose is to provide an explanation and correlation on the performance of poorly governed firms after a financial crisis. The results essentially suggest that since firms under poor governance have dropped tremendously compared to well-governed ones, they are forced to use their limited capital to invest only in highly profitable venture during the recovery period. This explains why these firms would bounce better after a crisis than well-governed firms.
- The study’s sample covered:
- 608 Korean firms listed on the Korean Stock Exchange in the pre-and post economic crisis period (1997-1998 and 1998-1999, respectively);
- 598 firms listed on seven Southeast Asian stock market; and
- 302 firms listed on the four Latin American stock market during the Argentine crisis from 2001-2002 and after the crisis in the years 2002-2003.
Relevant data gathered about the firms are: daily stock return, ratio of voting rights to cash flow right, equity/ block ownership, size of the firms, firms’ beta, leverage ratio, ratio of cash flow to total assets, and average ratio of investment to total assets.
- Determinants of firm’s performance during crisis and post-crisis period are:
- Univariate test
- Cross-sectional variation of HPRs
- As control variables for alternative explanations, firms’ beta and prior years’ returns were factored in the regression analysis.
- It also provided proof that impact of bad news is more adverse on well-governed firms than the poor ones;
- Vigorous data checks were conducted using:
- Sensitivity tests on the following:
- Alternative measures of corporate governance
- Alternative choice of shock and recovery periods
- Effects of manager’s decision on profitability
- Endogenous issues and events
- Out-of-sample tests by using:
- Firms in Other Asian countries in the pre- and post-1997 Asian Financial crisis
- Firms in Latin American countries in the pre- and post-2001 Argentine currency crisis.
- Key Variables include:
- Expropriation variables namely, difference between cash flow rights and voting rights of the controlling shareholder. An alternative to the equity ownership variable is a measure of a firm’s diversification.
- Risk and overreaction variables which is mainly the firms’ beta.
- Control variables such as the firm’s size and control of leverage.
- The Model
- The managerial expropriation model is essentially a one-period maximization model where the payoff depends on investment amount and profitability. It is applied separately during the financial crisis and the post-crisis period to the sampled firms in Southeast Asia and Latin America.
- The study mainly assumes:
- Profitability of the firm’s investment is not dependent on the manager but whether or not there is a crisis. This implies that the manager cannot influence profitability;
- Financing is only sourced from previous operations. This requires that available capital in the recovery period comes from cash flow of the same firms during the crisis period and thus, is limited.
- Expropriation of capital is only decided by the manager as the representative of shareholders. Factors that may cause a manager to divert capital are if a firm’s initial capital is large enough (applied on the crisis period) or otherwise, limited (applied on the recovery period).
- The Proposition. During period of crisis, when available capital is still large, managers tend to divert investment than during the post-crises or recovery period, when available capital is scarce. This leads to proving two main predictions as cited:
Prediction #1: During a financial crisis, the change in a firm’s value is negatively related to the manager’s expropriation power, but is positively related to his equity ownership in the firm.
Prediction #2: There is positive relationship between a manager’s expropriation power and a firm’s value during recovery period, but has inverse relationship on his equity ownership in the firm
- Results and Conclusion
The study revealed that firms considered poorly governed are much more adversely affected during economic crisis, but nevertheless, rebounds greater during the recovery period than well-governed firms. The result is consistent for high beta stocks. For the sampled firms, the research model resulted to an estimated market beta with a strong negative correlation between firm-level governance metrics and systemic risk. This implies that poorly governed firms are more sensitive to changes in business environment and react more negatively. Even when isolating the impact of systemic risk and overreaction effects, the result still shows that a firm’s governance has a significant impact on a firm’s value.
On the contrary, the study’s result is inconsistent with prior research which implies that the greater information available to investors leads to the worst performance of poorly governed firms. The findings insinuate that since information available after the crisis period remain the same, then this variable is not correlated to the higher performance of stocks of those firms in that period.
As the study concluded, the findings are relevant in proving how control of shareholder’s incentives to expropriate minority shareholders can be a crucial factor linking corporate governance and a firm’s value during a financial crisis. It provides support on post-crisis advocacies by investors and financial market regulators on providing greater investor protection.