As Indian capital markets have increasingly looked to attract foreign investors, capital from abroad has become an important source of financing for local Indian firms. However, poor corporate governance is one reason foreign institutional investors may be reluctant to invest in many Indian companies. According to a recent study titled “Do Foreigners Invest Less in Poorly Governed Firms?” that was published in The Review of Financial Studies*, which is one of the three elite journals in finance, foreigners are wary of investing in a firm in which the managers are also its controlling shareholders since foreign investors fear that these “insiders” may not act in the investors’ best interest.
As witnessed in the recent stock price declines of companies embroiled in the 2G scandal, the price of a firm’s stock reflects the consequences of weak corporate governance since investors protect themselves by lowering the price they are willing to pay to ensure that they obtain a fair return. However, since domestic investors may possess more information about the local business environment compared to foreigners, the price of the firm’s stock will reflect primarily what the locals know. The stock price will not reflect the cost that foreigners would have to incur in figuring out whether to invest in a company. In other words, the share price will not be low enough to adequately compensate foreign investors.
Locals have the upper hand in unravelling the activities of corporate insiders, which puts foreign investors at a significant disadvantage. In emerging markets like India, where many businesses are controlled by families, for instance, local investors have a better chance of understanding the complex and often opaque nature of political and business connections, banking relations, and other social and institutional factors that can affect the quality of corporate governance. Locals have a better sense of whether families run their companies in a way that benefits everybody or engage in transactions that harm outside investors. For foreigners who are thousands of miles away, it is much harder to make such assessments. As a result, foreign investors may shy away from companies with weak governance.
Foreign institutional investors need to understand insider relationships and the quality of corporate governance in a firm, particularly when the firm operates in a country where investors are poorly protected. Furthermore, developing such an understanding becomes more costly in countries where firms do not provide information transparently. The authors of this study analyse the impact of corporate governance on foreign holdings of US institutional investors for a large sample of firms across many countries. They measure governance as the extent to which managers and their families control their companies. A high level of control implies that it would be easier for insiders to take advantage of small investors because their decisions cannot be challenged by any other large group of shareholders. Although the presence of powerful insiders is not always bad, its implications are difficult for foreigners to figure out.
The study finds strong evidence that US investors hold significantly fewer shares in a firm where insiders exert substantial control if the firm is located in a country where disclosure requirements are weak, securities regulations are lax, and outside shareholders are weakly protected by law. In contrast, if a similar firm (i.e. one where inside shareholders exert managerial control) is located in a country that provides strong protection to investors and requires more transparent disclosure by firms, these firms do not experience less foreign investment.
In fact, the study shows that its findings do not simply depend on a country’s economic development but appear to be directly related to its legal institutions and rules on disclosure and investor protection. To find out if poor information is indeed at the centre of the study’s results, the authors look at the impact of “earnings management” on foreigners’ decisions to invest abroad. Under this practice, managers use their discretion in financial reporting. Managers can abuse their discretion to manipulate earnings in order to give the impression of a healthier bottom line. Foreigners may stay away from firms that manage earnings if they feel the practice substantially reduces transparency. In fact, the study finds that investors hold fewer foreign stocks if there is evidence of earnings management, especially if the firm is located in a country with weak disclosure requirements and investor protection.
The incentive to manipulate earnings is naturally higher in firms where the ownership structure makes this easier to do so, such as when managers and their families control a company.
To fully understand the mechanism behind the relationship between corporate governance and foreign investment, the authors analyse the combined impact on foreign holdings if firms frequently practice earnings management and if the company has a weak governance structure.
The authors find that in countries with little investor protection, foreigners avoid investing abroad when earnings management is prevalent and when there is a high level of insider control. This combined effect is more significant than the impact on foreign holdings of insider control alone, which is expected since not all family-run companies deliberately hide information from investors. These results confirm the authors’ prediction that inadequate transparency associated with poor corporate governance is what prevents foreigners from investing abroad.
The authors find a substantial economic effect of corporate governance on US institutional investors’ inclination to provide capital to a foreign firm. In a country where the transparency of corporate disclosures is low, US institutional investors do not mind investing in firms till the inflection point of 28% ownership by family/management is reached. However, beyond this inflection point, any increase in ownership by family/management increases US institutional investors’ reluctance to investing in such firms. This inflection point is quite plausible in the Indian context since 28% ownership is usually sufficient for insiders to be effectively in control of the firm.
* “Do Foreigners Invest Less in Poorly Governed Firms?” Christian Leuz, Karl V Lins and Francis E Warnock. Review of Financial Studies, August 2009.
The author is a PhD in finance from the University of Chicago and is currently a faculty in finance at the Indian School of Business