Family ownership and the cost of under-diversification

Abstract

We argue that the cost to a family of holding a large block of shares in a company, or under-diversifying, is reflected in the diversification benefits that the family forfeits. These costs can be substantial. For example, given a constant relative risk aversion parameter of 2, the median cost to our sample of families controlling large Swedish firms is 13% of the market value of firm's shares. We find that this cost is reduced by pyramid structures but not by the use of dual class shares.

Notes

¹ Moskovitz and Vissing-Jorgensen (2002) find that households invest about 10% of net worth in own-company public firms. While own-company stock investment for entrepreneurial private equity appears to reflect a controlling owner–manager position, own-company stock investment for public equity simply means that a household member is or has been employed in the firm.

² See, e.g. Hamilton (2000) and Heaton and Lucas (2001).

³ As distinct from widely held firms that employ a manager to run the firm (Mudambi and Nicosia, 1998; Chen et al., 2001; Shaffer, 2002).

⁴ Typically, Swedish firms issue A and B shares. The A-shares are one-share one-vote while the B-shares are one-share 0.1 votes. A pyramid structure exists where an investor controls a large fraction of the voting rights in the public firm X and firm X is the largest shareholder in the public firm Y, for example.

⁵Brennan and Torous (1999) also study the cost of under-diversification of pure equity portfolios, though they work with hypothetical portfolios, not actual portfolios.

⁶ This result is consistent with the view that large shareholders reduce moral hazard problems, adverse selection, and the free rider problem (Jensen and Meckling, 1976; Leland and Pyle, 1977; Shleifer and Vishny, 1986). This result is inconsistent with the expropriation hypothesis (e.g. Fama and Jensen, 1983; Bebchuk et al., 2000).

⁷ We limit our study to these 2 years since these were the two last occasions our source (Affärsvärlden) for estimates of the market value of the largest shareholders’ wealth was published.

⁸ The Affärsvärlden report for wealthy Swedes is equivalent to the Forbes Magazine report for wealthy Americans. However, due to the Swedish ‘Principle of public access to official records’ (Offentlighetsprincipen), more information about individual wealth is part of the public domain than occurs in most other countries (see below).

⁹ Affärsvärlden reports 163 (250) individuals or families with net wealth larger than 100 million SEK in 1988 (1991).

¹⁰ The Offentlighetsprincipen has been part of the Swedish constitution since 1766. Although it has been amended, the basic principles have never been changed. It states that all official records collected by the government must be handled in the following manner (the word paper stands for information, on paper or electronic, and the word agencies include courts): First, a paper arrives into an agency, or a paper is finished by a civil or municipal servant. Second, this constitutes the paper ‘a common public paper’, and as such, it is irrevocably archived for eternity (with exceptions stated in a separate law). Third, the paper's existence is registered. If some part of it is classified (e.g. for national security reasons), that is flagged in the register. Fourth, anyone may, anonymously and without giving any reason, immediately read the paper without any cost, and get copies against a fee ‘without undue delay’. Fifth, the Offentlighetsprincipen is part of the right to print and distribute daily papers; the constitution's extremely clear wording allows a publisher to get a copy of a public paper and print it. No one, not even the government or the parliament or the original author, can stop that printing (Johannison, 1981). With modern data processing techniques the information has become readily available to the general public.

¹¹ Listed firms are of course subject to tougher disclosure rules than nonlisted firms.

¹² The general principle of the wealth tax is that all wealth is taxable, including foreign assets. This means that all stocks, bonds, bank-deposits, cash, cars, boats, machines, animals and real estate are taxable. A special taxable value is assigned to all Swedish real estate. It should represent 75% of the market value with 2 years lag, i.e. taxable value 2004 should represent 75% of the estimated market value in 2002. In 1988 and 1991 listed stocks (in Sweden or abroad) were valued at 75% of the market value. OTC traded stocks were valued at 30% of the market value. Nontraded stocks, private firms and partnerships were valued at book values. Some assets are however, not taxable. Insurance other than life insurance is not taxable. Other examples of assets that are not taxable include art and coin collections (if they are not part of a business’ inventory). Furthermore, furniture, household utensil, works of art, etc., which are intended for a family's own use, are not taxable. Most debt is tax-deductible, i.e. the wealth tax is levied on net wealth. In 1988 (1991), net wealth below 400’000 SEK (800’000 SEK) was not taxable (Bratt et al., 1987; Rabe, 1991).

¹³ The wealth tax creates incentives to hide wealth in offshore accounts. However, hiding wealth in Sweden is illegal and studies have shown that Sweden has a very high rate of tax compliance (La Porta et al., 1999; Dyck and Zingales, 2004).

¹⁴ In Sweden, cross-holdings sometimes occur between firms within institutional spheres, i.e. not among firms controlled by individuals and families. No firm in our sample was involved in major cross-holdings.

¹⁵Faccio and Lang (2002) and Giannetti and Simonov (2006) analyse the ratio of voting rights and cash flow rights. We follow Claessens et al. (2002) and analyse the difference between voting rights and cash flow rights.

¹⁶ In Swedish dual class firms, the A-shares typically constitute roughly 20% of outstanding equity. There are no legal restrictions on the split between number of A and B shares. The maximum vote differential is however 10–1.

¹⁷ In the 29 observations in our sample where dual class shares are used in combination with a pyramid structure, the median controlling family still owns almost 24% of the firm in the second level in the pyramid. Typically, the pyramids only have two levels. Thus, the full potential of dual class and pyramids in terms of separating votes from ownership is not utilized.

¹⁸ These results indicate that consumers appear to choose asset portfolios with the long run in mind (Oiannides, 1992).

¹⁹ Total assets are deflated to 1991 prices using the consumer price index.

²⁰ We thank the reviewer for suggesting the possibility that families that control firms may build up political influence over time and thus, there is an argument for inclusion of firm age as a control in the model. We find support for a firm age effect in later analysis.

²¹ This adjustment does not qualitatively change the results.

²²Hall and Murphy (2002) are aware of this problem and ignore cases when the certainty equivalent value is higher than the Black–Scholes value in their analysis of managerial stock options. With our extensions of the LLV model, negative estimates of the cost of under-diversification are ruled out.

²³ An alternative to assuming a certain investment horizon would be to value the shares in the firm as an option written on the assets of the firm with exercise price equal to the face value of the zero coupon debt by approximating the firm's debt with a zero coupon bond whose maturity and face value equal the firm's debt duration and face value (Galai and Masulis, 1976; Jensen and Meckling, 1976).

²⁴ The median yearly risk premium on the Swedish stock market between 1945 and 1988 was 6.5%. The yearly risk premium is estimated as the yearly return on Affärsvärlden's General Index less than 1 year Treasury bill rate at the beginning of the year. Affärsvärlden's General Index is a value weighted index comprising roughly 95% of the stock market capitalization.

²⁵ The assumed risk-free interest rate roughly corresponds to the Swedish Treasury Bill rate in 1988 and 1991.

²⁶ Lambert et al. (1991), Hall and Murphy (2002) and Kahl et al. (2003) all use 10-year investment horizons.

²⁷ We thank the reviewer for suggesting the analysis of overall difference as well as identifying the impact of dual shares and pyramid structures.

²⁸ We have run all regressions with Tobin's q and investment level (Total investments/Total assets) as alternative proxies for growth opportunities. We have also estimated sales growth as the 3-year average. The results are virtually unchanged.

²⁹ Leverage of course affects equity volatility which in turn is included in our estimation of the cost of under-diversification. To control this problem we run the regressions without leverage. It does not change the other results.