Friday, November 26, 2004

More evidence that governance matters

Giannetti and Simonov find that some investors are more concerned with corporate governance than others.

Short version: Corporate governance does not affect all shareholders equally. Individual investors and this with no connection to the firm, are more apt to invest if the firm has a strong governance system. On the other hand, insiders apper to either not care or be more apt to invest if there is not a strong governance system in place.

Longer version: Giannetti and Simonov report more evidence that corporate governance does matter. Previous researchers have shown that those firms with strong governance have higher returns—for example see: Cremers and Vinay (2004) and Yermack (2004).

What is new in this paper is convincing evidence that corporate governance does not affect all investors equally. In fact, some investors (those with ties to the firm), may actually seek out poorly governed firms.
As G&S put it:
“We find that all categories of investors who generally enjoy only security benefits (domestic and foreign, institutional and small individual investors) are reluctant to invest in companies with weak corporate governance. In contrast, individuals who are well connected with the local financial community because they are board members or hold large blocks of at least some listed companies behave differently. They seem not to care about the expected extraction of private benefits and even prefer to invest in companies where there is more scope for it.”

(This would suggest that these investors are in a position to use their power to expropriate wealth form other investors).

The authors identify firms where the risk of poor expropriation is high by
1. using a ratio of control to cash flow rights of the main shareholder.
2. a control premium using “the difference between price paid for a control block and the price in the market after the sales announcement”
3. “a dummy variable proxying for the level of control entrenchment”

The authors then use these categories to assess the likelihood of various investor groups investing in the firm. As stated above, they find that investors with no ties to the firm are much more sensitive to the risk of expropriation.

Interestingly, this finding may also be able to help explain home country biases (the finding that investors invest more in their home nation than would appear economically justifiable) as foreign investors are particularly less apt to invest in firms with weak governance. Specifically, ‘a marginal increase in the control/cash flow ratio decreases the probability of investing in a firm by 1.37% for foreign individual investors…the effect is comparable for foreign financial institutions.” (page 16)

Giannetti, Mariassunta and Simonov, Andrei, "Which Investors Fear Expropriation? Evidence from Investors' Portfolio Choices" (June 2004). ECGI - Finance Working Paper No. 54/2004; EFA 2003 Annual Conference Paper No. 715.

© Mariassunta Giannetti and Andrei Simonov 2004. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including
© notice, is given to the source.

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