EFFECT OF OWNERSHIP STRUCTURES & CORPORATE GOVERNANCE ATTITUDES ON FIRM PERFORMANCE IN CENTRAL & EASTERN EUROPE

February 2011

Michal Bartek

Presentation structure Background to CEE privatisation and

equity markets Topic of my research Relevant theories, literature and

research methods Research progress so far Next stage – transactions between

dominant shareholders and their companies.

Introduction - governance in Central & Eastern Europe

Background to governance in CEE Early privatisation steps – differing

strategies Preliminary results Key questions asked in the 1990s Any answers ? What can be analysed now

Differing approaches to privatisation (I)

Transition starting around 1990. Approach to privatisation of large companies differs significantly.

Key problem : Insufficient domestic savings, limited transparency, direct political influence.

Poland prefers gradual process that includes participation of employees and domestic investment funds. Process started with 512 companies. 60% of equity stakes given to 15 NFI (National Investment Funds), 33% to one NFI and the rest proportionally split. 33% was the upper ownership limit allowed. NFI managerial functions given to banks and consultants, domestic and foreign. The resulting ownership structure was a compromise between concentration and dispersed ownership. Co’s had owners, but not too dominant.

Shareholders received 1 share in each of the 15 funds. 29m people entitled to participate – 26m did take part. The Funds themselves were floated on the Warsaw Stock Exchange in 1997.

Czech government chooses the most rapid method – launching voucher method that distributes shares in 1,700 enterprises to the population for little initial payment. Speed took priority over concerns about the emergence of specific ownership structures.

Differing approaches to privatisation (II)

Hungarian approach puts greater emphasis on direct sales to foreign partners.

Uniquely, reforms started during the1980’s (JVs made possible, small private businesses allowed, relaxed price and wage regulations, 2/3 of companies as self-governing bodies). Restructuring started well before 1990 but was a failure.

Mass-privatization methods played a marginal role. Instead used employee and management buyouts on pref. terms – 400 transactions. But bulk was sold through direct sales and auctions to local/foreign investors (60% of proceeds, 30% of all assets) or though the stock exchange. Has gone further than many Western European countries at that time.

Differing approaches to privatisation (III)

Russia launched ‘voucher’ privatisation (1992-1994), distributing shares to the population, hoping the public would exercise control over the companies.

Shares soon ended up in the hands of the management who gained control of the companies.

Second stage of privatisation – ‘loans for shares’ launched in 1995 and involved the sale through non-transparent auctions.

Dozens of very large enterprises were de-facto sold for fraction of their real value.

Russia made very little use of direct/auction sales to foreign companies.

Privatization steps in Poland

Need to act quickly – due to chaos and 650% inflation. Established Securities Commission and Stock Exchange in 1991 along with disclosure requirements.

Creation of typically 6 member supervisory boards. Initially state was the only shareholder and appointed the members, while employees appointed a third. The duties of the SBs gradually widened.

60% of equity stakes given to 15 NFI (National Investment Funds), 33% to one NFI and the rest proportionally split. 33% was the upper ownership limit allowed. NFI managerial functions given to banks and consultants, domestic and foreign. The resulting ownership structure was a compromised between concentration and dispersed ownership. Co’s had owners, but not too dominant.

Shareholders received 1 share in each of the 15 funds. 29m people entitled to participate – 26m did take part. The Funds themselves were floated on the Warsaw Stock Exchange in 1997.

1997 saw the introduction of legislation the domestic pension funds. Launched in 1999.

Bank were given the option to convert debt into equity but they failed to do that.

CEE equity markets in 2011 Poland seen as a success story. Poland’s stock market development

showed little progress until 2002-2003 at which point the number of IPOs started growing. Unlike in Russia, Polish companies chose to list domestically and continue to do so. Domestic pension funds grew in importance and now account for a substantial share of daily volumes and free float.

Of the 400 companies presently listed, a large proportion (>50% ?) were established after 1990.

The Russian equity market is seeing an increase in the number of listed companies but faces strong competition from the London Stock Exchange – the exchange of choice for most new IPOs.

Only17 stocks listed in Hungary and the market is not actively used. Only 13 stocks listed in Prague – little domestic institutional support

and few IPOs in the pipeline. Several Czech and Hungarian firms are listed in Warsaw.

What CG metrics/features are present ?

The key CG characteristics differ little from what is common in the developed markets :

Functioning Boards of Directors and Supervisory Boards. Independent directors on the Board and their roles defined. Extensive and timely disclosures of accounting information and other material

information Disclosure of related party entities and transactions exceeding a specific

threshold. Management incentives schemes. Regular AGMs and timely disclosures of agenda, time, access of media to

AGMs. Rules on tender offers.

What is different compared to the developed markets is the enforcement of the above rules.

CEE markets in numbers (I)

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CEE markets in numbers (II)

Number of listed companies : Hungary

Russia (includes fixed income instruments)

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Czech Republic (MSCI index – US$)

CEE market performance

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Key questions posed in 1990s Why this topic ? Why Corporate Governance ? Research analyst covering emerging Europe Markets subject to 2 significant problems : i) Entrenched management/dispersed shareholders –

lack of accountability and poor financial performance. ii) Dominant or influential shareholders –

expropriating the minorities. Extensive use of related party transactions. Poor disclosure and rules in place were not enforced.

No universal solution – some argued for further concentration, others suggested the opposite.

The scandals led to introduction of series of measures in all regions as well as greater emphasis on enforcement.

Theories Berle & Means, ‘The Modern Corporation and Private Property’,

1932 - launched the corporate governance debate – with focus on the

separation of ownership from control - most subsequent literature focused on the Anglo-Saxon system of

dispersed ownership and systems designed to deal with the ‘agency problem’

La Porta, Schleifer and Vishny in their numerous studies in late 1990s argued that the above ‘common law’ system is superior.

Gompers, Ishii, Metrick (2003) measured the impact of CG on equity prices using an index now called the GIM G-index (24 CG rules).

Ownership structures & performance theories - 3 streams of literature

1. Companies with dominant ownership should outperform

Following the theoretical foundations laid by Berle and Means in the 1930’s, several studies published since the 1980s argue that the predominant ownership structures are the most efficient within their institutional context

Block ownership is necessary to protect minorities (despite the extraction of private benefits of control threat)

Bebchuk and Roe (1999) and Roe (2003)

Theories - 3 streams of literature

2. Companies with dispersed ownership should outperform

Ownership structures are path-dependent. They reflect vested interests. (Coffee 1999, Zingales and Rajan 2003).

The current ownership structures may not be the most efficient and may not be the best performing one.

Entrenched families/dominant owners are reluctant to divest or reduce their stakes for a variety of reasons despite the possibility of an uplift in firm value in case of a move to more diversified shareholder structure.

They impose ‘sub-optimal preferences on corporate strategy’ (Thomsen and Pedersen 2000, 2004)

Kirchamier and Grant (2006)

Theories - 3 streams of literature

3. Ownership structure makes no difference – ownership structures are endogenous

Ownership structures adjust to the point that produces the optimal corporate strategy, level of monitoring and minimises PCB extraction.

Supporters of the theory argue that ownership structure is endogenous – i.e. is dependent on other factors such as firm performance. OS therefore cannot be treated as an independent variable.

Supported by empirical studies primarily on the US market. Theory developed by Demsetz & Lehn (1985). Empirical studies followed. Demsetz & Villalonga (2001).

Research questions ‘What is the effect of ownership structure on corporate performance in

emerging Europe ?’ Are ownership structures a function of corporate performance in earlier

time-periods ? ‘What is the association between ownership structure and the stock

price ?’

Do different types of controlling shareholders use the profit seizing tools to expropriate value from minorities ? What do they use ?

What kind of RPTs are most likely to be detrimental to the minorities ? Does belonging to a larger group actually bring benefits to the enterprise ? Do markets systematically undervalue businesses that are majority controlled by

the government, domestic or foreign controlling groups ? Do the markets overreact to announcements of significant related party

transactions ?

Methodology (1) The methodology I employ stems from those typically used in

academic literature. The studies measuring the impact of corporate governance

characteristics on performance are quantitative and rely on multiple regression.

By performance they mean accounting profitability, rather than stock market absolute or relative performance.

Hence the dependent variable is usually the ROE, ROA, ROCE or Tobin’s Q.

The core explanatory variable will be ownership concentration I plan to control for size, leverage and industry type.

Methodology (2) Data set of up to 400 companies in Poland and 350 in Russia.

For each company collect data on: Accounting measures of ROCE, ROE, Sales, EBITDA, operating

profit, net earnings, assets, leverage Past and present ownership data (concentration vs. free float,

categorise into type of ownership, foreign/domestic). May use concentration index- Herfindahl.

Related party transactions (size and categories) Other variables to be collected while completing the above :

Corporate governance attributes (board size, non-exec. Directors, Chairman/CEO role split)

Executive compensation and executive ownership in the business.

Methodology (3) Run multivariate regression (for each of the past 10 years)

with ROCE as the dependent variable and ownership concentration as the independent variable. Control for size, leverage and industry category.

Then do the same for each year with share price return as the dependent variable.

Having done this for a number of years one could carry out longitudinal observations of how the ownership structures change and how the behaviour of dominant shareholders and minority investors is changing over time.

Sources of data & other issues Annual reports, press releases, SEC filings, Stock Exchange

disclosures Datastream, Bloomberg, Thomson databases, Compustat

Data availability issues: I have done random checks on the levels of disclosure – but

there may be large gaps in what is easily obtainable from public sources. I may need to contact the relevant companies

Adjusting data - Use reported profitability data or adjusted ones ? Exclude one-off write-offs ?

Stock pricing – ADRs/GDRs often trade at a premium to the domestic shares

Other issues include the availability of all the documents in English

Findings so far : List of Polish companies obtained, ROCE etc. obtained for the past few

years. Current ownership structures now analysed. Findings descriptive in nature: Ownership structures stable. Too early to draw conclusions from the dataset as it stands. Current

data set confirms the expectation of highly concentrated ownership in the region and presence of dominant shareholders.

Emergent themes ? The data may reveal that many dominant shareholders do not abuse

their position and do not expropriate minority investors (as measured by ROE not lagging sector average). Many RPTs are carried out on fair terms and companies may actually benefit from belonging to groups.

Potential conclusion is that the market overreacts to the news of RPTs and consistently and unfairly undervalues the companies affected.

Initial findings in pictures (Poland) :

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Core shareholding vs. '07 ROCE

The next step : RPTs The literature addressing (and confirming) the risk of

expropriation of minorities : Gordon, Henry and Palia (2004) - produced a study of

the US market in 2000 and 2001 Chen and Chien (2007) focus on the Taiwanese market Tai, Liu & Liu (2007) focus on the Chinese stock

market and empirically analyse the relationship between the magnitude of RPTs, corporate performance and corporate governance mechanism

Cheung, Qi, Rau and Stouraitis (2008) examined related party and arms’ length acquisitions and sales of assets in Hong Kong

The next step - RPTs Use company disclosures to identify key transactions with related entities Put them in categories and express as a % of assets or turnover Identify factors that drive their use Study relationship between RPTs and corporate performance – i.e. does

frequency & size of RPT have an impact on company performance ? Possible findings –

i) confirmation of expropriation ii) Companies may actually benefit (from belonging to a larger group) Iii) Transactions make no difference

Issues/problems :Although the disclosure is compulsory (from a certain threshold), one cannot

exclude the possibility of companies ‘splitting’ the transactions into many small ones that don’t exceed the disclosure threshold and therefore go unreported.

Another issue is the impossibility of quantifying the expropriation of corporate opportunities.

Further studies Other possibilities : Do a survey of executives in the region / surveys of investors and analysts

who focus on the region. Triangulate ? Do a comparison of private equity returns with the above-examined

ownership structures. Carry out an event study to see the impact of RPT announcement on the

share price. This would require collection of additional data – specifically press

releases related to the disclosure of each transaction. I would then establish an ‘event window’ and monitor the share price 5

or 10 days prior to the announcement, and then 5 or 10 days following the disclosure

This would indicate whether or not there is a pattern in how the market reacts.

The key independent variable is in most cases a corporate governance index such as GIM’s governance measure – an equally-weighted index of 24 c.g. provisions compiled by the Investor Responsibility Research Center (IRRC), such as poison pills, golden parachutes, staggered boards, etc.

Appendix (1) Ownership categories : Dispersed – with no major shareholders Government controlled Controlled by domestic listed group Controlled by domestic unlisted group Controlled by foreign listed group Controlled by foreign private group

References Atanasov, V.; B. S. Black, C. S. Ciccotello, ‘Unbundling and Measuring Tunneling’ 2008,

University of Texas Law, Law and Econ Research Paper No. 117 ECGI - Finance Working Paper

Atanasov V.; B. S. Black, C. S. Ciccotello , S. B. Gyoshev, 2006 ‘How Does Law Affect Finance? An Examination of Equity Tunneling in Bulgaria’ Journal of Financial Economics (JFE), Forthcoming ECGI - Finance Working Paper No. 123/2006

Berkman H., R. Cole, J.L. Fu, ‘Expropriation Through Loan Guarantees to Related Parties : Evidence from China’, Journal of Banking and Finance, Vol. 33, No. 1, 2009.

Berle, A.,G. Means, ‘The Modern Corporation and Private Property’, 1932, New York : Macmillan

Black B., R. Kraakman, A. Tarassova, ‘Russian privatization and corporate governance : What went wrong’. Stanford Law review 52. 2000

Black, B. The Corporate Governance Behavior and Market Value of Russian Firms, Emerging Markets Review, 2, 89-108, 2001a

Chen, Yu-Mei, Chu-Yang Chien, ‘Monitoring Mechanism, Corporate Governance and Related Party Transactions’, Working paper, September 2007

Cheung, Y. , Y. Qi, P. Rau, A. Stouraitis; ‘Buy High, sell low : How listed firms price asset transfers in related party transactions’, working paper, September 2008

References (continued) Gower and Davies, Principles of Modern Company Law, Eight edition, 2008, Sweet & Maxwell Gordon E., E. Henry and D. Palia 2004a; ‘Related Party Transactions: and Corporate Governance’,

Advances in Financial Economics, Vol. 9 pp1-27. Gordon E., E. Henry and D. Palia 2004b; ‘Related Party Transactions: Associations with Corporate

Governance and Firm Value’, EFA 2004 Maastricht Meetings Paper no. 4377 Gilson, R. , Controlling Shareholders and corporate Governance : Complicating the Comparative

Taxonomy, Harvard Law Review, 2006 Gilson, R., J. Gordon, ‘Controlling Controlling Shareholders’, Columbia Law School, The Center for Law

and Economic Studies, Working paper no. 228, Stanford Law School, John M. Olin Program in Law and Economics, Working paper no. 262

Gompers, P. , J. Ishii and A. Metrick , ‘Corporate Governance and equity prices’ , Feb. 2003, Quarterly Journal of Economics, 118 (1)

Hansmann, H, and R. Kraakman, ‘The End of History for Corporate law’, 2000, Yale Law School Working Paper no. 235

Holderness, C. ‘The role of majority shareholders in publicly held corporations : An exploratory analysis’, 1988, Journal of Financial Economics 20, 317-346

Holderness, C., M. Barclay ‘Private benefits from control of public corporations’, Journal of Financial Economics, Volume 25, Issue 2, December 1989, p. 371-395

Holderness, C.G. ‘A Survey of Blockholders and Corporate Control’ FRBNY Economic Policy Review April 2003

References (continued) Johnson, S. , R. La Porta, F. Lopez-de-Silanes, A. Shleifer, 2000. ‘Tunneling’. American Economic

Review 90, 22-27 Kershaw D. – Company Law in Context, 2009, Oxford University Press Kirchmaier, T. , J. Grant, ‘Corporate Ownership Structure and Performance in Europe’, July 2006, CEP

Discussion Paper No. 0631 Kohlbeck, M. , B. Mayhew, ‘Agency Costs, Contracting and Related Party Transactions’, Working

paper, Dec 2004 Kraakman, R. et al, ‘The Anatomy of Corporate Law’, Second Edition, 2009 Oxford University Press La Porta, Rafael and Florencio Lopez-de-Silanes & Andrei Shleifer, ‘Corporate Ownership Around the

World’, April 1999, The Journal of Finance La Porta, Rafael and Florencio Lopez-de-Silanes , Robert Vishny & Andrei Shleifer, Dec 1998, ‘Law

and Finance’, Journal of Political Economy La Porta, Rafael and Florencio Lopez-de-Silanes , Robert Vishny & Andrei Shleifer, 1997, ‘Legal

Determinants of external finance’, The Journal of Finance Megginson & Netter 2001 Ryngaert, M, S. Thomas, ‘Related Party Transactions : Their Origins and Wealth Effects’, Working

paper, Sept. 20th 2007 Tai, B. Y. , X. Liu, J. M. Liu , ‘Related-party transactions, corporate performance, and the effectiveness

of corporate governance mechanism: evidence from the Chinese stock market’ , Journal of International Business and Economics, May 2007

References (continued) Tharenou, P. , R. Donohue, B. Cooper, ‘Management Research Methods’,

2007, Cambridge University Press Zingales, L. ‘The Value of the Voting Right : A Study of the Milan Stock

Exchange’ 1994, Review of Financial Studies 7, no. 1: 124-48 Zingales, L. , A. Dyck, ‘Private Benefits of Control : An International

Comparison’. The Journal of Finance , Vol LIX , No.2, April 2004

Appendix : Types of RPT

RPTs fall into a number of categories: Buying services or inputs from related (group or parent) companies Selling output through related parties Buying assets from or selling assets to related parties Management fees paid to the parent company Parent’s loans guaranteed by the subsidiary’s assets Buying minority stakes from different minority share-s at different prices. Expropriation of corporate opportunities

The ones exceeding certain threshold have been disclosed in recent years Once announcement is made most investors try to sell the stock in

question – sharp price falls follow But not all transactions with related parties are necessarily detrimental No studies re. the eventual impact on corporate performance Share prices may in fact overreact and may do so consistently due to the

initial fear among investors Conclusions ? Maybe concentrated ownership is better – as it deals with

the agency problem. What type of ownership is superior ? Government or private sector ?

Appendix : Russia – additional rules

Typical principles adopted in Russia in 2002 in responses to the abuses of 1990s :

Early notification of AGMs and EGM – min. 20 days notice. Clarity on agenda and right to pose questions

Requirement for 25% of directors to be independent (although clarity on ‘independence’ is lacking) & formation of committees made up of independent directors.