Ebook The Principle of Proportional Ownership, Investor Protection and Firm Value in Western Europe
The European Commission has initiated a number of policy proposals directed at affecting the distribution of ownership and control in European companies. A common trend in these initiatives is to promote the so-called “principle of proportional ownership”, which states that it is desirable to have proportional distributions of cash flow and control rights among investors in publicly traded corporations.
According to this principle, it is undesirable to use mechanisms such as dual class shares, pyramidal ownership structures, cross-ownership, golden shares and voting caps that create a wedge between the nominal income rights and the voting rights that the ultimate owners possess. In this paper, we scrutinize the premise of this principle in a sample of more than 4,000 publicly traded corporations from 14 Western European countries.
Prior research has focused on two effects of ownership concentration on the governance of corporations: an incentive effect, which makes the monitoring of management more efficient, and an entrenchment effect, which makes it easier for opportunistic owners to behave in a manner that enriches themselves at the cost of other owners. Starting with Claessens, Djankov, Fan and Lang (2002) a number of studies have empirically established a negative correlation between firm value and disproportional ownership structures. We confirm this value discount in our sample covering most of the publicly traded firms in the Western European countries.
Investigations of the effect of ownership structures on firm value is bound to be plagued by endogeneity problems. The main contribution of the present paper is to provide evidence that is consistent with the interpretation of the value discount being related to incentive and entrenchment effects. In addition, we present additional insights that allows us to address a number of specific endogeneity problems that rule out alternative explanations of the observed relationship between disproportional ownership structure and firm value.
First, we build a simple model based on incentive and entrenchment effects that yields a number of testable and refutable predictions of the relationship between disproportional ownership structures and firm value. The model predicts that corporations with disproportional ownership structures have lower firm value, and that this discount is strictly larger in family firms; firms with dispersed cash flow distribution; and, in firms with a large scope for extraction of private benefits. Moreover, our model provides a channel through which the value discount of disproportional ownership structures intervenes with the degree of legal protection of outside investors.
Second, we investigate these predictions empirically and find that there is a significant value discount of disproportional ownership structures in Western Europe and provide new insight consistent with the theoretical model: The value discount is larger a) in family-controlled firms where the incentive problems are absent; b) in firms with higher amenity value where the scope for entrenchment is larger; and c) when large owners have small cash flow stakes, i.e., where disproportionality provides most added control for the largest owners. Furthermore, we show that the value discount increases in the level of investor protection, which indicates that disproportional ownership structures and legal investor protection are substitute governance mechanisms from the perspective of outside investors.
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