Corporate governance, value and performance of firms: New empirical results on convergence from a large international database Jackie Krafft, Yiping Qu, Francesco Quatraro, Jacques-Laurent Ravix To cite this version: Jackie Krafft, Yiping Qu, Francesco Quatraro, Jacques-Laurent Ravix. Corporate governance, valueandperformanceoffirms: Newempiricalresultsonconvergencefromalargeinternational database. 2013. <halshs-00786763> HAL Id: halshs-00786763 https://halshs.archives-ouvertes.fr/halshs-00786763 Submitted on 10 Feb 2013 HAL is a multi-disciplinary open access L’archive ouverte pluridisciplinaire HAL, est archive for the deposit and dissemination of sci- destin´ee au d´epˆot et `a la diffusion de documents entific research documents, whether they are pub- scientifiques de niveau recherche, publi´es ou non, lished or not. The documents may come from ´emanant des ´etablissements d’enseignement et de teaching and research institutions in France or recherche fran¸cais ou ´etrangers, des laboratoires abroad, or from public or private research centers. publics ou priv´es. Title: Corporate governance, value and performance of firms: New empirical results on convergence from a large international database Authors: Jackie Krafft(1), Yiping Qu(1), Francesco Quatraro(1), and Jacques-Laurent Ravix(1) (1)University of Nice Sophia Antipolis, GREDEG-CNRS, 250 rue Albert Einstein, 06560 Valbonne, France. Contact author: Jackie Krafft E-mail: [email protected] Tel: +33 4 93 95 41 70 Fax: +33 4 93 65 37 98 Acknowledgements: The authors wish to thank the editors and the two anonymous referees for their insightful comments. We wish to acknowledge the support of CNRS and the University of Nice Sophia Antipolis (GREDEG, UMR 7321). This work is related to the PICK ME project (EU FP7, grant n°266959). 1 Corporate governance, value and performance of firms: New empirical results on convergence from a large international database February 2013 Abstract: This paper aims to revisit the link between corporate governance, value, and firm performance by focusing on convergence, understood as the way that non-US firms are adopting US best practice in terms of corporate governance, and the implications of this adoption. We examine theoretical questions related to conventional models (agency theory, transaction cost economics, new property rights theory),which tend to suggest rational adoption of best practice, and contributions that alternatively consider country- and firm-level differences as possible barriers to convergence. We contribute to the empirical literature by using a large international database to show how non-US firms’ adoption of US best practice is having an impact on performance. Keywords: Corporate governance; governance metrics, ratings, rankings and scoring; firm value; firm performance. JEL Codes: G30 2 1. Introduction In the US, corporate governance started to become important for market practitioners in the early 1990s. Today, it is a topic of discussion worldwide. International investors generally regard corporate governance as an important criterion in their investment decisions. According to Global Investor Opinion Survey (McKinsey, 2002), 15% of European institutional investors consider corporate governance to be more important than financial issues such as profit performance or growth potential. Also, 22% of European institutional investors are willing to pay a premium of 19% on average for a well-governed company. More and more countries are tightening the rules and regulation related to governance by adopting new standards inspired largely by US codes of best practice and establishing guidelines for publicly listed companies to try to improve the overall governance of firms. The OECD (2004) Principles of Corporate Governance acknowledge that an effective corporate governance system can lower the cost of capital and encourage firms to use resources more efficiently, thereby promoting growth. These factors implicitly and explicitly support the belief that better corporate governance will result in higher firm value and more profitable firm performance. However, some commentators insist on the importance of the institutional context in which the governance system operates and do not support the idea of convergence towards the US model. They point to a growing co-existence of distinct national models of corporate governance with the US style governance. Up to the mid 1990s, most work on corporate governance was in the context of US firms. However the influential work of La Porta et al. (1997, 1998, 1999, 2000a, 2000b, 2002) has stimulated a large body of work on international comparisons (Levine, 2005; La Porta et al., 2008). Much of this work focuses on differences between countries’ legal systems, and studies how these differences relate to differences in the way that economies and capital markets perform. 3 While research on comparative corporate governance so far has focused mainly on cross-country differences in governance, a substantial body of research on US firms shows that cross-firm differences related to governance have substantial effects on firm value and performance (Gompers et al., 2003; Bebchuk et al., 2008; Core et al., 2006). Much less documented is how non-US firms that adopt US best practice are performing. This paper addresses this issue at the theoretical and empirical levels. At the theoretical level, agency theory identifies several reasons why good corporate governance increases firm value and performance (Shleifer and Vishny, 1997). Basically, good governance involves better monitoring, greater transparency and public disclosure between principal (investor) and agent (manager). This leads to increased investor trust and a decrease in managers’ discretion and expropriation of rents. Well-governed firms are supposed to be less risky, and to have more efficient operations and reduced auditing and monitoring costs. These elements tend to alleviate the cost of capital and generate higher expected cash flow stream, which, in turn, create higher firm valuation and better performance. However, agency theory is based on a well-known set of strict hypotheses which largely neglect the institutional context in which the corporate governance system operates. Thus, it provides a theoretical background to the rational adoption of best practice by firms (US and non-US) irrespective of country-or firm-level differences. This is leading to potential inconclusive results. This paper tries to investigate this area more finely. At the empirical level many strands of work, including studies of some aspects of corporate governance (e.g. board composition, shareholder rights, executive remuneration, insider ownership, takeover defences, see Hermalin and Weisbach, 1998), single country analyses (especially the US, see Gompers et al., 2003; Bebchuk et al., 2008; Core et al., 2006; but also Russia, see Black, 2001 and Black et al., 2006a; Korea, see Black et al., 2006b; Germany, see Drobetz et al., 2004; and Switzerland, 4 see Beiner et al., 2006) and cross sectional analyses(e.g. Drobetz et al., 2004, which uses data from a single year), are providing increasing evidence that US corporate governance leads to higher value and performances in both US and non-US firms. This is supporting the hypotheses of Agency theory and other conventional models. However, we need more robust econometric analysis of corporate governance for the value and performance of firms. This paper provides empirical results based on data from the largest corporate governance data provider, RiskMetrics/Institutional Shareholder Services. Its data have at least three advantages. First, it is the most extensive database in terms of coverage (number of firms, length of time frame) able to generate robust and generalizable quantitative results. Second, it is based on 55 governance factors spanning 8 categories of corporate governance including board of directors, audit committee, charter/bylaws, antitakeover provisions, compensation, progressive practices, ownership, and director’s education. Third, it explicitly considers non-US data, allowing more systematic analysis than has been done so far. We find that claims of convergence, in the sense of the adoption of US best practice by non-US firms, are supported by an economically important and statistically strong correlation between governance, value and performance of these firms. Convergence generates higher performance. However, in our view this should not be the end to discussion on corporate governance. The paper is organized as follows. Section 2 reviews the related theoretical and empirical research and formulates our hypotheses. Section 3 describes our corporate governance data and summarizes the firm-level value and performance variables. Section 4 reports on the relation between corporate governance measures, stock market performance, Tobin’s Q, and operating performance (ROA, NPM). Section 5 concludes. 5 2. Literature review and hypotheses 2.1. Theory From a theoretical point of view, corporate governance issues arise due to the separation of ownership and management. Principal-agent theory is the starting point of most discussions of corporate governance (Shleifer and Vishny, 1997). Agency problems can affect firm value and performance via expected cash flows for investors, and the cost of capital. First, agency problems make investors pessimistic about future cash flows being diverted. Good governance increases investor trust and willingness to pay more and renders managers’ actions costly and expropriation less likely. Good governance means that ‘more of the firm’s profit would come back to (the investors) as interest or dividends as opposed to being expropriated by the entrepreneur who controls the firm’ (La Porta et al. 2002, p. 1147). Risk and expected return are negatively related since riskier stocks have to be compensated by a higher expected rate of return which involves higher costs related to monitoring. Thus investors perceive well-governed firms as less risky and better monitored and tend to apply lower expected rates of return, which leads to a higher firm valuation. Also, as Jensen and Meckling (1976) showed, better governed firms may have more efficient operations, resulting in higher expected future cash-flow streams. Second, the cost of capital is negatively related to measures for protection of shareholder rights, and is positively related to general measures of the quality of the legal institutions (La Porta et al., 2002; Gompers et al., 2003). In this case, good governance will decrease the cost of capital since it reduces shareholder’s monitoring and auditing costs (Drobetz et al. 2004; Lombardo and Pagano, 2000; Errunza and Miller, 2000). Therefore, better corporate governance structure and practice lead to better corporate performance, lower agency costs, and higher stock performance. 6 At the firmlevel of analysis, the division between financing (risk-taking) and managing (controlling) functions leads to conflicts (principal-agent problems) between managers (agent) and shareholders or investors (principal). The problem essentially is to persuade the agent to behave fairly and to act on behalf of the principal, and to avoid any discretionary behaviour. The solution to this agency problem is to hire managers on highly contingent, long term incentive contracts ex ante in order to align their interests with those of their investors (Shleifer and Vishny, 1997). This formalization, which is based on the complete contract hypothesis, provides the essential requirements of corporate governance oriented to shareholder value, in a context of transparency on contractual relations in organizations. These models have three implications: (i) they need strong hypotheses in terms of rationality, based on common knowledge requirements: the principal knows that, according to an optimal remuneration scheme, he can access information hidden by the agent. At the same time, the agent knows that he must deliver his private information to the principal on agreeing to an optimal remuneration contract; (ii) they reduce organization problems to simple incentive misalignment problems: internal organization and business strategies are analysed primarily with respect to the elimination of information asymmetries between principals and agents; (iii) they focus exclusively on the control exerted by the discretionary power of managers: managers generally have private information that promotes manipulative and opportunistic behaviours. Complementary approaches have been developed in relation to transaction costs (Williamson 1988, 2000), and property rights (Hart 1995a) and consider weaker rationality hypotheses and the higher costs of negotiating and writing contracts. This literature relies on notions such incomplete contracts and residual rights of control1rather than agency problems. Nevertheless, the transaction cost economics 1 The asset owner has the residual right to decide how to use the asset in cases where the contract is silent on the 7 and new property rights literatures generally reach the same conclusions as studies of agency theory on the rules of governance of large publicly held companies (Williamson, 1988; Hart 1995b). These rules imply general mechanisms of control which can take various forms (board of directors, proxy fights, hostile takeovers, corporate financial structure), but are oriented always towards monitoring and disciplining management in the interests of shareholders and investors. It follows that a ‘best’ system of corporate governance that realigns managers’ incentives with the interests of shareholders and guarantees high cash flow and low costs of capital, should be diffused to and adopted by all firmson the premise of using resources more efficiently and stimulating further growth. Since the US model of corporate governance was elaborated with these objectives, it should be adopted across the world by US and non-US firms alike. This phenomenon is often studied in the literature in terms of the convergence of corporate systems and regulation (Martynova and Renneboog, 2011; Bebchuk and Weisbach, 2010). It should be noted that convergence can mean different things - from incorporation of a system of corporate governance identified as ‘superior’, to a gradual diffusion of rules and practices that lead to a mix of co-existing systems. In a paper criticizing the convergence of financial systems, Hoelzl (2006) explains why conventional models take no account of the institutional context: in the long run international competition will force firms to minimize costs. Cost minimization requires firms to adopt rules to raise external capital at the lowest cost. Competition is assumed to ensure that all corporate governance systems converge to the most efficient system. Countries that fail to adopt the ‘right’ system will inflict costs on their firms, which will be less able to raise capital, and might migrate from the country if inappropriate corporate rules are adopted. Because of this mechanical relationship between competition and governance, supporters of agency theory and occurrence of some event affecting this use. 8 related models of corporate governance argue that the shareholder value model is based on best practice and intrinsically is superior to other models. However, other arguments have been proposed in the field of corporate governance and there are different hypotheses related to corporate governance which tend to be supported by opposing theories. The stakeholder perspective is the main alternative to the maximization of shareholder value promoted by Agency theory. The stakeholder perspective argues that there are numerous parties that contribute to the firm’s economic performance and value. Consequently, all these stakeholders not just the suppliers of capital must be considered as residual claimants (Blair, 1995; Donaldson and Preston, 1995; Kelly et al., 1997; Zingales, 2000; Hansmann, 1996; Driver and Thompson, 2002). Another strand in the literature proposes that the model of corporate governance – understood as shareholder or stakeholder value oriented – cannot be considered in isolation from the institutional context in which it is to be implemented; it claims also that this institutional context has changed significantly since the early 2000s. It should be remembered that, since 2000, financial markets have become much less stable, investors have become more short-termist, and because of their size and sometimes aggressive strategies, more able to impose their views at the board of directors level (Aglietta and Rebérioux, 2005; Tylecote, 2007; Allen, 2005; Coffee, 2005; Becht et al., 2005; Denis and McConnell, 2003; Aoki, 1984). Finally, some contributions in the economics of innovation show that the model of shareholder value may have increased the ‘ups and downs’ that innovative firms and innovative industries have experienced following the Internet bubble explosion in 2000, and conclude that adopting this model is not neutral and may even be detrimental to the evolution of these firms and industries (Lazonick, 2007; Fransman, 2004; Krafft and Ravix, 2005, 2007; Krafft et al., 2008; Driver and Guedes, 2012; Lhuillery, 2011). These theories suggest that the adoption of the US model in firms is not leading to optimum results because of country-level and/or firm-level differences. 9