1 governance and value: evidence from emerging markets
TRANSCRIPT
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GOVERNANCE AND VALUE: EVIDENCE FROM
EMERGING MARKETS
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Questions
Can companies compensate for poor laws by practicing good governance?
do you believe standards of governance should be required through legal mandate or adopted at the discretion of the company based on recommended best practices and pressure from shareholders?
do all firms in weak legal regimes suffer from poor corporate governance and do firms in strong legal regimes practice uniformly high-quality governance?
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if so, is there a systematic pattern in which firms choose their quality of governance?
what are the relevant firm attributes and how are they related to the observed governance practices?
is the quality of governance priced in stock markets, and if so, should corporate decision makers take notice?
Questions
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Risk neutral controlling shareholder with ownership Interest rate = 0 measures investment profitability for firm iEndowment:
F
jj 1)(1
jj
1
1
*j
D
Simple models
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Quality of Governance Practices: 1 – d, where
d = the proportion of cash flows that the controlling shareholder diverts for private benefits includes outright stealing, shirking, perks, tunneling
high d = bad corporate governance low d = good corporate governance
Simple model
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( ( ))1 1 j c
c = cost of diversion = PV of legal costs/penalties and costs of diverting and converting corporate resources into cash equivalents
fines, jail term, loss of reputation, bribes
- high c in the U.S.- low c in Russia, China, India, Brazil
The controlling shareholder will invest if:
personal benefits from investment > net benefits from diversion
Simple model
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Investment opportunities
In strong legal regimes, firms divert less and practice higher quality governance.
Good rules and effective enforcement reduce thievery.
Controlling shareholders of firms with more profitable investment opportunities divert less for private gains and practice higher-quality governance.
One is less likely to commit crime if one has something valuable to lose
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The impact of profitable investment opportunities on corporate governance is greater in weaker legal regimes.
Good governance driven by private incentives becomes a more important complement to regulation when regulation is less effective.
Investment opportunities
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Controlling shareholder’s payoff as a function of diversion d
DcMV )1(
Russiafor 3.0
for U.S. 6.0
c
Payoff =
Sensitivity of d* w.r.t. is smaller in the U.S. than in Russia
prof.high 2.2
prof. low 0.2
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diversion d
RUSSIA, LOW PROF.
RUSSIA, HIGH PROF.
US, LOW PROF
US, HIGH PROF.
dHRUS dL
RUS
dHUS dL
US
DdUS=dHUS-dL
US
DdRUS=dHRUS-dL
RUS
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Controlling shareholders of firms with higher cash flow ownership practice higher quality of governance.
One does not steal from oneself
The impact of ownership on governance is stronger in weaker legal regimes.
Concentrated ownership becomes a more important tool to resolve agency conflict between controlling and minority shareholders in weaker legal regimes
Ownership
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External Financing
For a given level of profitable investment opportunities, controlling shareholders of firms with greater dependence on external financing practice better governance.
One does not spit into the well one drinks from
The relation between reliance on external financing and governance is stronger in weaker legal environment.
Firms in weak legal regimes have greater incentive to improve their governance practice to overcome the deleterious effects of poor legal protection on their
ability to raise external financing.
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Valuation
Firms with better governance are valued higher.
The effect of governance on valuation is stronger in weaker legal regimes.
Good corporate governance is valued higher where it is scarce
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1. 2.Standard&Poor’s
Governance Scores
CLSA has lost quite a bit of corporate financebusiness. with companies that were assigned the worst corporate governance scores and that.
CLSA may stop compiling the scores.
- South China Morning Post: Hong Kong; Nov 2, 2001
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CLSA Corporate Governance Scores in 2000
494 companies across 24 emerging marketsBased on 57 questions in 7 categories
Managerial Discipline (0-100)E.g., incentives towards a higher share price
Transparency (0-100)E.g., timely release of annual reports
Board Independence (0-100)E.g., Chairman who is independent from management
Board Accountability (0-100)E.g., foreign nationals are present on the board
Responsibility (0-100)E.g., share trading by managers is transparent
Fairness (minority shareholders protection), PROTECT, (0-100)
Measures to protect minority shareholdersComposite score, COMP, (0-90)
Social awareness (0-100)child labor practices, political legitimacy, environmental responsibility,
equal opportunity employment policy
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S&P Transparency Ranking in 2000573 companies across 16 emerging markets and 3
developed countries
Transparency and disclosure Ownership structure and investor relations (0-22)
Financial transparency and information disclosure (0-34)
Board and management structure and process (0-35)
Aggregate, TRAN, (0-91)
Comparing across the two data sets
CLSA = 0.16S&P + country and industry dummies
[0.05]
Governance scores
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How reliable are CLSA scores? Is it just legal environment + noise?Look for governance scandals for 84 firms from 14 countries with at least 11 firmsLexis-Nexis, news search
• assets expropriation, accounting misreporting, share dilution, insider trading, undertaking illegal projects
• manually checked 29,320 articles• 49 scandals
Correlation between CLSA’s COMP and SCAND is -0.36 (p-val = 0.00)
Control for legal environment, # of newspapers per capita (NEWS), and media attention(TOTAL)
SCAND = -0.017 COMP – 0.015 LEGAL + 0.017 * NEWS + 0.088 TOTAL
Governance scandals
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Firms with more profitable investment opportunities and greater reliance on external financing practice higher quality governance and the relations are stronger in weaker legal regimes
*** significant at 1%** 5%* 10%
CORP GOV INV OPP EXT F IN LEGAL INV OPP LEGAL EXT F IN LEGAL
Z d
jc
jc
jc c
jc c
jc c
k k jc
k
K
ii
I
jc
_ _ _ _ * _
,
1 2 1 2 3
1 1
1
CLSA COMPOSITE CLSA PROTECT CLSA SOCIAL S&P TRAN
INV_OPP 14.089*** 21.270** 6.421 35.737***EXT_FIN 4.363* 16.223*** -9.900* 9.154LEGAL 0.490*** 1.013*** -0.091 0.352***INV_OPP* LEGAL -0.525*** -0.579* -0.466 -1.125***EXT_FIN* LEGAL -0.083 -0.443** 0.258 -0.302
SIZE 0.879* -3.325*** 1.137 1.235***R&D 19.874 -22.812 139.853** 12.503EXPORT -6.240* 0.943 9.981 -13.629***ADR DUMMY 6.668*** 2.576 2.142 0.553CONSOL. DUMMY 6.420*** 4.333 -12.992*** 3.653**
R 2 24.00% 22.40% 13.70% 23.10%Number of Companies 439344
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Firms with more concentrated cash flow ownership practice higher quality of governance and the relation is stronger in weaker legal regimes
CLSA COMPOSITE CLSA PROTECT CLSA SOCIAL S&P TRAN
OWN_CASH 0.575** 1.691*** -0.595 0.192(OWN_CASH)^2 -0.005** -0.015*** 0.005 -0.001WEDGE -0.829 -8.640* 1.371 -0.803LEGAL 0.864*** 1.447*** -0.220 0.599***OWN_CASH* LEGAL -0.010 -0.030* -0.017 -0.005
SIZE 1.085 -1.973 1.804 0.411R&D -92.774 -546.453 -71.505 22.817EXPORT -0.388 13.545 6.594 -24.857***ADR DUMMY 4.515 -8.561 11.907 -1.962CONSOL. DUMMY 2.442 4.567 -8.333 0.238
R 2 44.20% 32.60% 11.80% 34.40%Companies 240173
*** significant at 1%** 5%* 10%
CORP GOV OWN CASH OWN CASH WEDGE LEGAL
OWN CASH LEGAL Z d
jc
jc
jc
jc c
jc c
k k jc
k
K
ii
I
jc
_ _ ( _ )
_ ,
1 22
3 1
21 1
1
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Firms with better of governance are valued higher and the relation is stronger in weaker legal regimes
*** significant at 1%** 5%* 10%
CORPORATE GOV 1.950* 1.711** 0.436 0.905**LEGAL 0.010 0.005 0.001 0.016CORP.GOV.* LEGAL -0.026* -0.012 0.030 -0.006***
INV_OPP 0.820*** 0.840*** 0.888** 0.843***SIZE -0.104** -0.074 -0.098*** -0.113***R&D 5.711* 6.371* 4.292 5.071***EXPORT 1.795*** 1.629*** 1.479*** 1.226***ADR DUMMY -0.137 -0.081 -0.044 -0.037CONSOL. DUMMY -0.513*** -0.422*** -0.228 0.104R 2 34.40% 32.80% 36.10% 28.20%Companies 438344
CLSA COMPOSITE CLSA SOCIAL
Q CORP GOV LEGAL CORP GOV LEGAL Z djc
jc c
jc c
kk
K
k jc
ii
I
jc
1 1 21 1
1
_ _ * ,
CLSA PROTECT S&P TRAN
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Economic significance
On average, a one standard deviation increase in CLSA composite score increases Q by 9%
the relation between corporate governance and performance is stronger in weaker legal regime countries
Mexico, LEGAL = 1 (de jure) * 3.33 (enforcement) =
3.33 increase in Q is 13.2%
Hong Kong, LEGAL = 5 (de jure) * 8.33 (enforcement) =
41.65 increase in Q is 4.6%
May explain the previous mixed findings on U.S. data
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Policy implicationsFor policymakers to give the controlling shareholders greater incentives to improve
governance practices• pro-growth policies vs. re-distributive policies
Convergence in governance with increasing globalization of trade, national boundaries and
legal structures become less effective in defining corporate policy any debate over convergence must also consider firm-specific
factors
Social awareness is neither related to firm-specific factors, nor is it valued by investors.