The controlling shareholder's personal leverage and firm performance

Abstract

This article examines the relationship between firm performance and its controlling shareholder's personal loans. We present a model that allows the controlling shareholder to finance company projects through personal loans. Using personal loans, however, will create an incentive for controlling shareholders to pursue risky projects. We test our predictions using a sample of companies from Taiwan and find supporting evidence. We find that firms with a higher personal loan will have a higher risk and worse performance in the future. We also find that the positive relation between risk and personal leverage is time varying: the relation gets stronger in bad times.

Notes

¹ For now, we do not consider the possibility that the stock loan becomes due because the market value of the entrepreneur's shares falls below F. For more discussion on this issue, please see the last paragraph of this section.

² The present value of the risky project is higher than that of the safe one if and only if pR + (1 − p)r ≥ 1, which is equivalent to (1).

³ Note that by the assumption , the optimal contract must satisfy α(1 − D) − F > 0, otherwise the entrepreneur will always choose the risky project since his payoff for choosing the safe project is zero. From this result, we know that the optimal p ₁ is strictly larger than zero.

⁴ Since new securities and the stock loan are fairly priced, the entrepreneur has to suffer a loss when V(α, D, F) < 1. As a result, the entrepreneur undertakes the investment opportunity only when V(α, D, F) ≥ 1.

⁵ When the stock loan is risky, the entrepreneur's payoff is zero if he chooses the risky project and the realized return is r. As a result, a decrease in ε reduces the entrepreneur's payoff for choosing the risky project only when the project yields R. Therefore, given p the entrepreneur's payoff for choosing the risky project is reduced by pΔ.

⁶ By (2), (3), and (4), D and F affect p ₁, V, and v ⁰ through αD + F. When α and αD + F are fixed, adjusting the values of D and F will not change either the amount of money the entrepreneur raises or his project choice.

⁷ When the corporate debt is risk free, corporate debt financing dominates stock loan financing because the latter forces the entrepreneur to bear the risk of stock market crashes.

⁸ If the probability of a stock market crash is low and a corporate bankruptcy is very costly for the entrepreneur, then he will turn to stock loan financing once the firm's capacity to issue risk free debt is exhausted.

⁹ The Taiwan Economic Journal collects the reported data.

¹⁰ As earlier, we also include in the regression fixed effects for company and calendar month to remove possible incidental effects.

¹¹ The simple t-test ignores the autocorrelation introduced by overlapping annual data at a quarterly frequency. The autocorrelation will be dealt with later in the multivariate regression.

¹² Tables 3 and 4 use two lags to calculate standard deviations. We have also tried 3 lags and got similar, results.

¹³ Although in the ROE and RET regressions, firm leverage (DEBT) is the most important variable. Its importance is likely due to the mechanical connection between equity risk and firm leverage.

¹⁴ We have also tried to define the bad time based on quarterly ROA (the quarter t is bad if the ROA in quarter t + 1 is below the median over 12 quarters) and got similar results.