lauantai 11. kesäkuuta 2011

Corporate Ownership, Capital Structure and Investment: a Theory and Empirical Evidence

Lately I have read dissertations on ownership in order to get theoretical material for my own dissertation. Luckily I noticed that some Finns have taken this path already before me and have made their contribution to the theory of ownership. Mika Ihamuotila's dissertation titled Corporate Ownership, Capital Structure and Investment: a Theory and Empirical Evidence is one of these early studies in this field. It is an article collection of three articles. Here is a brief summary of my notes.

Mika Ihamuotila (Picture: Talouselämä)

As you might know Dr Ihamuotila didn't end up having an academic career, instead he has made a remarkable job in investment banking and is at the moment the CEO and major owner of Marimekko, a publicly listed fashion company, which he bought from Kirsti Paakkanen. Definately, Ihamuotila has taken his theories into action by being the largest shareholder of Marimekko. I highly respect his merits both in academia and business.

Corporate Ownership, Capital Structure and Investment: a Theory and Empirical Evidence

The study on corporate ownership has been centered around the belief that the separation of ownership from control decreases the value of the firm. Management’s objectives are assumed to be partially contrary to those of the shareholders, and monitoring by large shareholders is believed to diminish this problem. However, in the light of empirical evidence, firms with a concentrated ownership structure are no more profitable than firms that have only small, atomistic shareholders. (p. 8)

Mainly due to the developments in the agency theory the discussion has shifted from the value of the firm to firm-risk and capital structure. The agency theory has turned out to be well applicable to the relationship between management and shareholders and between shareholders and debtholders, and perhaps the most relevant difference between preferences of these parties arises from the different attitudes towards risk and leverage. However, empirical evidence is puzzling in this field. From the standpoint of risk exposure it may be suggested that firms that have a large shareholder are less risky than firms with a dispersed ownership structure: A large equity stake in a firm usually prevents diversification, and thus it may be argued that a large shareholder may require safer projects than what is preferred by well-diversified, atomistic shareholders. Empirical evidence is opposite to this view: ownership concentration is positively related to firm-risk. The current interpretation to this relation is that returns to monitoring are greatest in a volatile industry, because managerial performance is difficult to monitor a volatile environment. Hence, ownership is the more concentrated the more risky the firm. However, this interpretation raises many questions. First, we do not know whether firms in volatile environment are closely monitored or is monitored firms volatile in each environment. In other words, we are unable to say whether firm risk is a cause or a consequence of ownership concentration. Second, we do not know why shareholders would monitor risky firms, since empirical evidence suggest that monitoring does not increase the value of the firm. (p. 9)

Another confusing area in the literature is the relationship between corporate ownership and leverage. Agency theories and theories that are based to asymmetrically distributed information have been relatively successful in explaining the firm’s capital structure decisions. Intuitive extensions of these models suggest that ownership concentration is negatively related to the debt level of the firm. For example, if debt is argued to discipline management, then shareholder monitoring should be seen as a substitute for debt. On the other hand, if debt is argued to serve as a signal to the capital market, then firms with a concentrated ownership structure needs less debt for this purpose, since large shareholders are better informed than the markets on average. However, empirical evidence suggests the opposite: Ownership concentration is positively related to the debt level of the firm. (p. 9)

The common feature in the theoretical and empirical literature is that large shareholders are considered homogenous. This is clearly not a realistic view, since large shareholders not only monitor management but also control firms according to their own preferences, and these preferences seem to vary much. One reason for the fact that ownership concentration has not been able to explain the firm behavior is that ownership concentration only enables to excert control, but the result of this control depends on the preferences of the large shareholders. For example, ownership concentration may increase profitability if the large shareholders are of a particular type, but in another case, ownership concentration can be of the harm for the value of the firm. (p. 10)

Many family-held firms appear to avoid debt, and the business press often concludes that this is due to the dominant shareholders’ aversion to control shift that may be followed by a financial distress. However, some Scandinavian firms that are monitored by control-oriented families that hold stakes in many firms are known to bear a high leverage. This suggests that if control benefits are received in many firms, the threat of a financial distress brought by debt may be low. (p.11)

Investors face a tradeoff between control and diversification, and a high initial wealth enables an investor to simultaneously control firms and receive benefits from partial diversification. The issuance of debt allows further diversification, but it also brings a higher probability to lose control benefits in case of financial distress. (p. 12)

Ownership concentration is found where there is a high level of debt. If there are no large shareholders, managers will not choose a high level of debt, because they are averse to the control shift in case of a poor firm performance and they are unable to diversify their human capital. If the firm is controlled by a shareholder the choice of the capital structure depends on the shareholder’s diversification and valuation of control. (.14)

Managerial theories suggest that owner controlled firms should be more profitable than management controlled firms, because management has less freedom to pursue its own objectives if it is monitored by shareholders. This claim inspired a vast range of empirical work, that does not support the theories: no relation between the ownership structure and the performance of the firm is found. (p. 21)

The literature has so far been unable to explain why close monitoring that is related to a high return variances does not induce higher returns. This raises the question of why do some investors bother to monitor, because monitoring as such can be costly. In addition, a monitoring position usually requires a large relative stake of shares, which leads to an imperfectly diversified portfolio, which in turn should be compensated to the monitor. One reason for this could be that large shareholders receive private benefits from control. The literature suggests that the private benefits can be derived from perquisites, dilution of funds for private benefit, synergies with other assets held by the shareholder, or direct valuation of control. Empirical evidence supports the existence of these benefits, since shares with superior voting rights are systematically valued more highly than other shares. The literature appears unable to explain why investors hold large stakes in firms in the absence of private benefits derived from control. Most theories are based on the assumption that there are returns to monitoring, but empirical evidence can give only weak support to this assumption. (p. 33)

Modigliani and Miller show that in a perfect competitive capital market the value of the firm is not related to the firm’s capital structure. Counter to Modigliani and Miller, Jensen and Meckling propose that an optimal capital structure exists. It is the one that minimizes all agency costs, and some of which arise from the conflicts of interests between different providers of capital. Jensen and Meckling recognize debt not only as a solution to managerial agency problems but also as a source of agency problems between shareholders and debtholders. (p. 34)

1. A Theory of the Impact of Ownership Characteristics on the Capital Structure and Investments of Firms

If shareholder does not value control highly, she will diversify. (p. 61)

Demsetz and Lehn (1985) argue that if the firm operates in a stable industry, managerial performance can be monitored at low cost. Hence, the returns to shareholders from monitoring management should be greater the more volatile the firm’s environment. Indeed, Desetz and Lehn (1985), Bergström and Rydqvist (1990) and Prowse (1992) find a positive relation between firm risk and ownership concentration. (p. 63)

Control benefits can serve as a substitute for a higher expected return. (p. 80)

Investors can choose among many alternative strategies. They may:

  • Control their initial endowment and not invest in the project
  • Invest in the project and finance it by:

a. Issuing debt

b. Issuing outside equity

c. Using their initial wealth

d. Any combination of the above

  • Invest in the capital market
  • Any combination of the above

The conclusions of the first paper

1) Ownership concentration and shareholder diversification increase the firm risk and debt level.

2) Wealthy investors are likely to exert control even if they value control only marginally.

3) Whether a large shareholder is valuable for the firm or not depends on diversification and control-orientation by the shareholder: Ownership concentration increases profitability or Tobin’s q if the large shareholders has diversified well and/or does not value control very highly.

4) Firms that are controlled by less wealthy investors value control highly (=family held firms) behave in the following way: They prefer equity over debt, they have stable earnings, they invest less than the average, and their investment is more sensitive to internal revenue than that of other firms.

5) Firms that are controlled by a shareholder that does not value control highly and/or that is well diversified issue debt on less favorable terms than other firms. By contrast, they issue equity on more favorable terms.

2. The Effect of Ownership Concentration and Shareholder Diversification on Firm Risk and Capital Structure: Evidence from Finland

There are four types of firms:

MN: Firms monitored by a nondiversified principal shareholder

MD: Firms monitored by a diversified principal shareholder

N: Firms not monitored and the principal shareholder has not diversified

D: Firms not monitored and the principal shareholder has diversified

Firms by Ownership Characteristics by Ihamuotila

If there are no other managerial agency problems than managers’ aversion to risk and debt, there is no reason for risk averse shareholders to hold a large, nondiversified stake in a firm. This is because only monitoring by well-diversified shareholders leads to an increase in firm value. However, in reality, we also observe poorly diversified investors monitoring firms. (p. 111)

We assume that ownership has an influence on firm risk. (p. 113)

Conclusions of the second paper

The most fruitful theoretical developments within agency theory center around the apparent real-life differences in risk preferences between different parties. This in the essence of conflicting interests of creditors and shareholders, and it is prevalent in e.g. contracting between managers and shareholders – whether the agents wish to maximize their wealth or reputation. (p. 138)

Managers appear more averse to high levels of debt and risk than large shareholders on average. The paper provides a new view on the role of large shareholders as monitors by using variable that measures the diversification of the largest shareholder. The paper finds that shareholder diversification increases corporate leverage and riskiness, and that this impact is more significant the more control the shareholders have over the firm. If the largest shareholder holds a large nondiversified stake in a firm, the interest of the managers and the shareholders coincide over the capital structure choice. The preference of a large shareholder decreases variance of accounting returns if the shareholder holds poorly diversified portfolio. Similarly, monitoring by shareholders increases leverage only if the largest shareholder has diversified well. The evidence suggest further that ownership is a cause rather than a consequence of risk. The results raise doubts about the relevance of examining the impact of equity concentration without distinguishing between the preferences of the shareholders.

Based on this study, one would expect that firms that are monitored by a well-diversified large shareholder exhibit the highest earnings expectations, are the most profitable firms, are the least diversified, and offer contracts with highest risk incentives to the management. An increase in shareholder diversification or monitoring is related to a significant increase in the collateral sensitivity of differences in risk incentives, but it also suggests that “safe” ownership can serve as a substitute for credit-monitoring or collateral requirements.

3. Ownership Concentration, Shareholder Diversification and Asset Structure: When are Creditors Worried?

There is general agreement in the literature on some regularities between ownership of equity and corporate investment. Even though we know a great deal about the interaction of investment and finance, we understand very little about how providers of finance really anticipate the differing investment incentives of firms that differ in the way ownership of equity is organized. (p. 146)

This paper argues that since ownership characteristics of firms are adequate for explaining differences in firm riskiness, differences in the cost of debt capital can be explained by ownership of equity. (p. 146)

Hypothesis 1: An increase in concentration of equity ownership increases the agency costs of debt.

Hypothesis 2: An increase in diversification by monitoring shareholder increases the agency costs of debt.


Creditors use ownership information when evaluating the risk in borrowing to different firms. This has real implications as regards as the optimal ownership of a particular asset structure. Three empirical contributions with Finnish data are provided:

1) Debt financing of firms that have large investors is more sensitive to collateral than that of firms with a dispersed ownership structure.

2) Debt financing of firms with a poorly diversified largest shareholder is independent from collateral, which is not the case if the largest investors has diversified well. These results may reflect that creditors regard shareholders riskier on average than managers and well-diversified investors riskier than poorly diversified investors.

3) Large investors that monitor intangible assets hold more firm-specific risk than those that monitor tangible assets. This finding may be justified by the claim that firm-specific risk of large investors can serve as a substitute for collateral. Hence, firms with poorly diversified shareholders may be able to raise inexpensive debt to finance investment in intangible assets that do not create collateral.

This analysis suggests that it may not be primarily the actions of managers or poorly diversified shareholders that give rise to agency costs of debt. If those who control the firm have much of their interests tied to the firm, there is less likely to be severe conflicts of interest between creditors and the firm. The results encourage closer study of the relationship between corporate control characteristics and debt contracts. Similarly, it would be interesting to apply the analysis in the examination of outside equity. Following the above logic, the holders of dispersed outside equity could afford to compensate (in line with Shleifer and Vishny 1986) the costly monitoring of well-diversified investor but not necessarily that of a poorly diversified investor. These considerations imply that pricing of securities and the reaction of stock price to issuance of different securities depend on the ownership structure and the type of the monitor.

Finally, the value collateral and observability of the use of assets depends on corporate control characteristics. It might prove worthwhile to treat corporate assets structure and ownership structure as being interrelated when examining their role in the financial decisions of a firm. A particular ownership structure may function as a substitute for financial intermediation. (p. 175)

Total conclusions

The dissertation builds a theoretical model in which investors differ in their initial wealth and the extent to which they derive benefits from controlling a firm. Since all investors are risk averse they prefer the benefits of a diversified portfolio unless they value control highly. However, wealthy investors are able to combine partial diversification and control benefits by controlling several firms. In the model, ownership structure determines control over the firm and diversification and control-orientation of the controlling shareholders determine their preferences over the firm’s investment and financing. The model provides several new implications that are widely consistent with anecdotal evidence and that may enlighten related puzzling empirical work. For example, it suggests that ownership structure is not necessarily sufficient to explain the riskiness of the capital structure of the firm. However, a particular combination of shareholder diversification and valuation of control by large shareholders may determine the firm’s willingness to bear a particular level of risk and debt. This, on the other hand, determines the value of the controlling shareholder to the firm.

The empirical tests of Finnish data give strong support to the theoretical model. For example, the more the largest shareholder has diversified the more risky and the more highly leveraged the firm. In addition, ownership structure may be rather the cause than a consequence of firm risk, which is opposite to Demsetz and Lehn (1986). Furthermore, creditors require the higher level of collateral for a given amount of debt the more the shareholders have control over the firm and the more the largest shareholders has diversified. This may reflect an anticipation of shareholders incentives to substitute assets.

Only a large stake in a firm brings control, and due to limited wealth, a large stake is connected to a nondiversified portfolio and thus to ineffective monitoring. However, control and sufficient diversification can be combined. Examples of this are venture capital funds and some wealthy European family-controlled industrial groups. There is also clear evidence on that U.S. pension funds and other institutional investors are concentrating their stock portfolios in order to monitor management.

Why do investors pay for the votes in a firm and why are so many investors willing to hold a nondiversified stake in a firm – despite monitoring does not seem to increase the value of the firm? The empirical results appear puzzling if all investors need to be compensated monetarily for monitoring. If investors value control per se then it has to have implications on firm-risk and financial decisions. One way to estimate the valuation of control by large shareholder is to look at the fraction of votes per fraction of equity held by the shareholder.

The results also suggest to go deeper in the empirical research on the relationship between ownership structure and profitability or Tobin q. If it is so that management is overly averse to risk and debt and that particular combinations of shareholder diversification and valuation of control increase the level of risk and debt in a firm then these combinations ought to increase the value of the firm. Similarily the results suggest that these characteristics in the monitoring shareholder have an effect on how e.g. debtholders evaluate their claims in the firm. For example, if particular shareholder characteristics serve as a substitute for financial intermediations this should be taken into account in the literature. (p. 182)


Mika Ihamuotila (1994): Corporate Ownership, Capital Structure and Investment: a Theory and Empirical Evidence. Helsinki School of Economics and Business Administration. Acta Universitatis Oeconomicae Helsingiensis.

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