H ardly a day passes in the UK and the US without the news that a company is acquired for a hefty premium. The fact that in continental Europe such news is comparatively rare simply reflects a different structure of corporate ownership rather than a lack of interest in corporate control. In continental Europe, the voting majority of most companies is concentrated in a few hands, thanks to a complicated web of cross-shareholdings and voting trusts. As a result, control is generally transferred in classy negotiations at local country clubs rather than in noisy takeover battles under the media’s spotlight. These differences in style notwithstanding, there is one common element throughout the world: investors care about control, which suggests it is valuable. But why is control valuable?
This question, though perhaps a little naive, is not without merit. By their very nature, all common shares have equal rights. Thus a majority shareholder is not entitled to receive a penny more per share than all other shareholders. So why should any investor pay a premium to acquire control if he or she will receive no extra benefits from doing so?
The only possible answer is that, although all shares are created equal, some — like the pigs in George Orwell’s Animal Farm — are more equal than others. What makes controlling shareholders more equal is that they have the right to shape corporate policy. The crucial question, then, becomes how this right translates into higher benefits for the controlling party that are not shared by other shareholders (the so- called private benefits of control). If private benefits of control exist, then it is easy to explain why control is valuable. But what exactly are these private benefits?
The academic literature often identifies private benefits of control as the ‘psychic’ value some shareholders attribute simply to being in control. For example, the Michelins probably would value being in control of the French tyre company founded by their ancestors even if they were not to receive a penny from it. Although this is certainly a factor in some cases, its practical importance is likely to be trivial. Can we really justify premia of multimillions of dollars with the pure pleasure of command?
A second, only slightly more convincing, explanation identifies private benefits of control in the perquisites enjoyed by top executives (and not by their fellow shareholders who pay the tab). There is no lack of examples, as masterfully illustrated in the book Barbarians at the Gate. Many executives enjoy golfing and partying with world celebrities at their company’s expense and use corporate jets to fly friends and family around the country. Yet however outrageous some of these perquisites are, we have to admit that, if this is what private benefits are all about, we do not need to worry too much about the value of control.
In the context of companies worth billions of pounds or dollars, the value of these perquisites is simply too small to matter. Only in the presence of more significant sources of private benefits should the value of control play a prominent role in the theory and practice of finance. The use of a company’s money to pay for perquisites may be the most visible but is not the most important way in which corporate resources can be used to the sole (or main) advantage of the controlling party. A few examples will help illustrate how widespread these opportunities are.
Consider, for example, the value of the information a corporate executive acquires thanks to his or her role in the company. Some of this information pertains directly to the company’s business while some reflects potential opportunities in other more or less related areas. It is fairly easy for a controlling shareholder to choose to exploit these opportunities through another company he or she owns or is associated with, with no advantage for the remaining shareholders. The net present value of these opportunities represents a private benefit of control.
Another source of private benefits is the possibility of internalizing, through other companies controlled by the same party, some of the externalities generated by corporate decisions. Consider, for example, a shareholder who controls 51 per cent of two companies, say A and B, operating in the same market. Suppose there is excess capacity in this market and, thus, some plants need to be closed. In this situation the closure of any plant will reduce over-capacity and so increase the value of all the other plants. If the controlling shareholder closes some plants in company B, he or she will experience an increase in value not only of the B shares but also of the A shares. This increase in A shares is a benefit enjoyed by the controlling party and not by B’s minority shareholders (unless they own the same quantity of A’s shares) and, thus,
represents a private benefit of control. Note that in both previous examples the controlling shareholder receives a benefit denied to the remaining shareholders, even if he or she does not formally receive any larger payment from the company.
A third source of private benefits is associated with the controlling party’s ability to fix transfer prices between a company and its customers and suppliers. A company controlled by its employees, for example, can pay higher wages and benefits to its workforce. Similarly, a bank controlled by one of its borrowers can make larger and cheaper loans to its parent company.
The ability to manipulate transfer prices can be used even in the absence of business dealings between the controlling company and its subsidiary. Imagine that company A owns 50 per cent of company B and 100 per cent of company C. In that case A would find it profitable to transfer B’s assets to C at a below market price. For any pound that B’s assets are underestimated, company A loses 50 pence through its B holdings but gains one pound through its C holdings. A net gain of 50 pence.
Is this legal?
I am sure the reader is now wondering whether most (if not all) of the sources of private benefits that I have described are de facto illegal and, as such, more in the realm of interest of criminal investigators than financial economists. In fact, there is no doubt that in their most extreme forms these strategies are illegal and extremely rare. Nevertheless, there are several reasons why we should expect more moderate versions of these strategies to be more pervasive.
First, in some countries some of these strategies are not illegal. In France, for example, corporate executives do not have a fiduciary obligation to exploit all corporate opportunities in the corporation’s interest. As a result, a controlling party can exploit information acquired qua corporate executive to his or her own personal advantage without breaking the law.
Second, even when a law exists it might be impossible to enforce. Educated economists can legitimately disagree on what is the ‘fair’ transfer price of a certain asset or product. As a result, small deviations from the ‘fair’ transfer price might be difficult or impossible to prove in court. If these small deviations are applied to a large volume trade, however, they can easily generate sizeable private benefits.
Finally, even if these distortions can be proven in court, it is possible that nobody has the incentive to do so. For example, it might be prohibitively expensive for small shareholders to sue the management (especially in countries where contingent fees for lawyers are prohibited).
Unfortunately, it is very difficult to measure the private benefits directly. As argued above, a controlling party would find it possible to subtract corporate resources to his or her benefit only when it is difficult or impossible to prove that this is the case. In other words, if private benefits of control were easily quantifiable, then those benefits would not be private (accruing only to the control group) any longer because outside shareholders would claim them in court. Nevertheless, there are two indirect methods to try to assess empirically the magnitude of these private benefits of control.
Estimates of value of control
The first method, followed by Barclay and Holderness (1989), is simple. Whenever a control block changes hands, they measure the difference between the price per share paid by the acquirer and the price quoted in the market the day after the sale’s
announcement. The market price represents an unbiased estimate of the value of a share for minority shareholders. Any amount paid in excess of it by the acquirer of the control block represents a minimum estimate of the buyer’s willingness to pay for the private benefits of control he or she expects to enjoy. Using a sample of control block transfers in the US, they found that the value of control is about four per cent of the total market value of a company. This method also makes clear why the takeover premium cannot be used by itself as a measure of the private benefits of control. When a takeover is announced the market price incorporates two pieces of information:
• that the company is likely to be run by a different management team
• that somebody is willing to pay a premium for control.
The takeover premium is a combination of these two elements and, in general, it is impossible to separate them. Only when there are two classes of common stock with differential voting rights can we try to disentangle these two components.
This leads to the second method of estimating the value of private benefits of control. By using the price difference between two classes of stock, with similar or identical dividend rights, but different voting rights, one can easily obtain an estimate of the value of a vote. If control is valuable, then corporate votes, which allocate control, should be valuable as well. How valuable?
It depends on how decisive some votes are in allocating control and how valuable control is. If one can find a reasonable proxy for the strategic value of votes in winning control - for example in forming a winning coalition block - then one can infer the value of control from the relationship between the market price of the votes and their strategic role. This is what I do in two articles (see Further Reading). I infer the value of control from the relationship between the value of corporate votes and a synthetic measure of the distribution of voting power called the Shapley value.
Country differences
Interestingly, when I applied this method to a sample of US companies I obtained the same value as Barclay and Holderness (four per cent). By contrast, when I applied it to a sample of Italian companies I estimated the value of control at 30 per cent of the market value of equity. In spite of the magnitude of this estimate, all the evidence I collected indicates that, if- anything, it underestimates the true value of control in Italy. But why should the value of control be so much higher in Italy than in the US? And what should we expect it to be in other countries?
Since the value of control is simply the present value of the private benefits enjoyed by the controlling party, the answer is easy. The magnitude of the private benefits of control, and thus the value of control, depends on the degree of protection offered to minority investors in each country. Without proper disclosure, large investors can more easily hide their abuses and hence find it easier to take advantage of their controlling position. Similarly, lax law enforcement makes it more difficult to detect and punish these abuses, making them more attractive. That small investors are better protected m the US than m Continental Europe is not only consistent with casual empiricism, but has been documented in a systematic way by La Porta and others (1996).
Unfortunately, there is no systematic study of the value of control across countries. However, one can get a rough estimate by looking at the average premium paid to buy voting rather than non-voting stock in different countries. While this measure does not properly control for cross-country differences in the strategic value of votes, it is the only consistent measure available for a (small) cross-section of countries.
Fig.1 Voting prem
Voting premium (%)
100
■■■
1
80
.
60
.. :
40
20
Canada Israel
Italy
Sweden Switzerland UK
Country
Fig.2 Voting pre
Voting premium (%)
Figure 1 presents the level of the average voting premium for the countries for which this measure is available. This premium varies dramatically: in most countries it is between 10-20 per cent, with Israel and Italy being the main exceptions. While the number of observations is clearly too small to undertake any statistical study, it is interesting to see how this measure varies with characteristics within each country that are likely to influence the ability to extract private benefits of control. For example, better disclosure rules should reduce the ability to use some of the strategies described above. Consistent with this hypothesis, Figure 2 shows that the voting premium is inversely related to an index of the quality of accounting standards in each country.
These results are suggestive but, of course, far from conclusive. Countries differ along many dimensions and with few observations it is difficult to identify which effect is driving the results. There is, however, another piece of evidence within the US that agrees with these findings. Even in the US, privately held companies carry large control premia (minority discounts). Interestingly, the reason appraisers adduce for this premium is the lack of protection of minority shareholders in privately held business. So it is not the good nature of Americans that refrains them from abusing their control position, but rather the rigid oversight by the Securities and Exchange
Commission. It is not unusual, for example, for the SEC to investigate large personal expenses that a controlling shareholder bills to his or her company.
us
unti
■PPP
Interestingly, once we admit the existence of sizeable private benefits of control, a lot of the standard finance results break down. For example, the value of a company cannot any longer be estimated simply by multiplying the market price of a share times the number of shares. If one shareholder controls a majority of votes, the market price will simply reflect the value of minority shares and will grossly underestimate the company’s value. By contrast, when two large shareholders are fighting to reach a majority, the market price of a stock will be mainly influenced by the control value and will over-estimate the total value of a company.
More importantly, the efficient working of the financial market may be jeopardized. Large controlling shareholders will be more interested in maximizing the value of their private benefits than the total market value of their company. Consequently, investors,
1 • Value
anticipating this behavior, will shy away from buying the stocks. This is an important lesson for developing countries.
All shares are in theory created equal - but what makes controlling shareholders more equal than others? Luigi Zingales looks at the private benefits of being the main controlling party in a company. Perks and the pure pleasure of command may provide the most visible answer in some cases - but as the author points out there are other potential advantages. These include using information gained from one company for the benefit of another, and the ability to fix transfer prices between a company and its customers and suppliers.
In extreme form these strategies are usually illegal but they are not necessarily outlawed in some countries and they may be pervasive in more moderate versions. There are two indirect methods of empirically assessing the value of private control benefits - measuring the takeover premium and using the price difference between two classes of stock with different voting rights.
Suggested further reading
Barclay, M.J. and Holderness, C.G., (1989), ‘Private benefits of control of public corporations’, Journal of Financial Economics 25, 371-95.
Burrough, B. and Helyar, J., (1991), Barbarians at the gate, Harper Collins, New York.
La Porta, R., Lopez de Silanes Shleifer, F., and Vishny, R., (1996), ‘Law and finance’, NBER Working paper 5661.
La Porta, R., Lopez de Silanes Shleifer, F., and Vishny, R., (1997), ‘Legal determinanats of external finance’, NBER Working paper 5879.
Zingales, L., (1994), ‘The value of the voting right: a study of the Milan Stock Exchange’, Review of Financial Studies 7, 125-148.
Zingales, L., (1995), ‘What determines the value of corporate votes?’, Quarterly Journal of Economics, 1047-1073.
Corporate finance
Contributors
Raghuram Rajan is Professor of Finance at the University of Chicago Graduate School of Business. His research interests include corporate finance and financial intermediation and regulation.
Kjell Nyborg is Associate Professor of Finance at the London Business School. His research interests include corporate finance and information economics.
Luigi Zingales is Associate Professor of Finance at the University of Chicago Graduate School of Business. His research interests include capital structure and corporate control.
Steven N. Kaplan is Professor of Finance at University of Chicago Graduate School of Business. His research interests include mergers and acquisitions, corporate governance and private equity.
Philip G. Berger is an Assistant Professor of Accounting at the Wharton School of the University of Pennsylvania.
Harold Rose is Emeritus Esmee Fairbairn Professor of Finance at London Business School. He was previously first director of LBS’ Institute of Finance and was Group Economic Adviser at Barclays Bank.
Eli Ofek is Assistant Professor of Finance at the Stern School of Business, New York University.
Katherine Schipper is Eli B. and Harriet B. Williams Professor of Accounting at the University of Chicago Graduate School of Business. Her research interests include corporate governance, leveraged buyouts and acquisitions, and the effect of regulation on shareholder wealth.
David Yermack is Assistant Professor of Finance at the Stern School of Business, New York University.
Linda Vincent is Assistant Professor of Accounting at the University of Chicago Graduate School of Business. Her research interests include financial accounting and capital markets.
Richard Brealey is Tokai Bank Professor of Finance and Director of the Institute of Accounting and Finance at London Business School. His research interests include corporate finance and portfolio investment.
Michel Habib is Assistant Professor of Finance at London Business School. His research interests include corporate finance and financial intermediation.
2 ■ Corporate finance