Ownership structure and diversification in a scenario of weak shareholder protection

Abstract

This work examines the influences of ownership concentration and insider ownership on corporate strategies for diversification within a scenario characterized by poor protection of shareholder interests. We find evidence of a quadratic relationship between ownership concentration and diversification, and a cubic relationship between diversification and insider ownership. These results point towards the high probability of both expropriation and entrenchment phenomena, respectively, in this kind of scenario. We also find that concentrated ownership requires high levels of insider ownership, in order to prevent negative externalities of diversification. Another result shows that entrenchment externalities affect diversification before they erode firm value, which suggests that for low levels of diversification, firm value is still not negatively affected. Additionally, our results show that control mechanisms, such as debt, director remuneration and compliance with codes of good practice, are negatively related to the level of diversification. Overall, our results confirm the theoretical relevance of agency theory in explaining managerial attitudes towards corporate strategy, i.e. diversification. Furthermore, companies characterized by deficiencies in shareholder legal protection, concentrated ownership structures and a higher likelihood of managers being entrenched, should focus on the correct functioning of corporate governance mechanisms.

Acknowledgements

Financial support was obtained from DGI (Project SEJ2007-65789), Junta de Castilla y Leon (Project SA069A08) and Junta de Castilla León Grupo de Excelencia de Investigación GR144. We also thank Agencia de Investigación and Banco Santander Central Hispano. We are grateful to Eduardo Melero for helpful suggestions.

Notes

¹ Lane et al. (1998) and Arthus and Busenitz (2003), among others, discuss the limitations of agency theory in describing the relationship between corporate strategy and the value of a firm. This relationship has also been analysed using other competing theories, such as the stewardship theory (Donaldson and Davis, 1991; Fox and Hamilton, 1994) and managerial approaches. Amihud and Lev (1999), Denis et al. (1999) and Kang (2006) support the agency theory approach as the most relevant to analyse this issue.

² Spanish insiders become entrenched when ownership ranges from 35 to 70%, rather than the 5–25% range reported for US firms or the 12 and 41% for UK managers.

³ Graves (1988), Graves and Waddock (1990) and Bethel and Liebeskind (1993) analyse the role played by different kinds of equity owners (e.g. blockholders, institutional owners) in strategic decision making and corporate restructurings.

⁴ Actually, we expect an endogeneity problem between both variables (corporate strategy and executive remuneration), since they are simultaneously determined within the firm. In fact, firm strategy is also one of the factors that helps to determine executive compensation (Balkin and Gomez-Mejia, 1990; David et al., 1998). At the same time, ownership structure is also included among these factors.

⁵ Rose and Shepard (1997) find higher executive remuneration in diversified firms since they are more difficult to run, and thus managers expect a higher premium. Denis et al. (1999) state that the payment of excessive salaries to managers is also an action that runs counter to shareholder interests.

⁶ As given by Miguel et al. (2004), we let this partial derivative equal zero, and thus the breakpoint is OWNCON = −(β ₁/2β ₂). OWNCON is negative and, consequently, β ₁ and β ₂ have opposite signs. Additionally, Hypothesis 1 implies that OWNCON is a minimum, and thus β ₂ > 0 and β ₁ < 0.

⁷ Additionally, for the control variables, we report results similar to those obtained in the ownership concentration framework. The three variables are negatively related to diversification when insider ownership moderates the relationship, but the level of significance of these relationships is less than those obtained when ownership concentration moderates its relationship with diversification.