The power of control: the acquisition decisions of newly public dual-class firms

Many private firms that go public opt for a dual-class share structure which gives insiders stronger voting power, at the expense of shareholder democracy. We examine how the dual-class structure influences the merger decisions of newly public firms, which have a notable appetite for acquisitions. Specifically, we compare acquisition activity, method of payment choice, and the long-run value implications of acquisitions by newly public single-class and dual-class US companies. Our results show that dual-class IPO firms make relatively more acquisitions in innovative industries and are less likely to pay with stock as compared to single-class IPO firms. The reluctance of dual-class firms to pay with stock is positively related to the wedge between the insiders’ voting rights and cash-flow rights. We also find that newly-public dual-class acquirers perform better in the long-run than newly-public single-class acquirers, mainly due to dual-class acquisitions in innovative industries. Our multivariate analysis shows that these findings hold after controlling for relevant risk factors associated with industry, deal, and firm specific characteristics. These results suggest that the dual class structure may enable newly-public firms to make better M&A decisions after going public.     

Innovation Success and Capital Structure

This paper analyzes the relationship between firms’ innovation success and their capital structures. I hypothesize that firms’ innovation success reduces the extent of information asymmetry facing them in the equity market, leading to a greater propensity of firms to issue equity rather than debt to raise external financing. Supporting these hypotheses, I show empirically that firms with higher levels of innovation success have lower leverage ratios and a greater propensity to issue equity rather than debt. Further, these firms face a lower extent of information asymmetry in the equity market. I establish causality using instrumental variable analyses, instrumenting for patent grants with patent examiner leniency.     

Performance of Cross Listed Dual-Class Firms: Evidence from Chinese Firms Cross Listed on US Exchanges

We compare operating and market performance of Chinese single- and dual-class firms cross listed on US exchanges. We find evidence in line with researchers who argue that a dual-class structure allows insiders to invest in long-term value-enhancing projects. We find that dual-class firms underperform prior to their initial public offering (IPO) and then improve and have better operating performance than single-class firms in the second year after IPO. We find that dual-class firms also have better market performance than single-class firms beginning in the initial year, which is contrary to the finding in most other studies. The reason for this might be that firms that list on US exchanges show a credible commitment to shareholder rights.     

Investment efficiency: Dual-class vs. Single-class firms

This study examines the effects of a dual-class structure on investment efficiency. Agency theory suggests that a dual-class structure exacerbates agency problems, leading to under- or overinvestment, but another view posits that the dual-class structure insulates managers from the pressure of the marketplace or activist investors seeking short-term profits. We find that dual-class firms invest more efficiently than single-class peers. This effect is more pronounced among firms with less transparent investments such as R&D. Our findings are robust to a propensity score matching approach and a setting where single-class firms recapitalize with dual-class shares. Furthermore, we find that among firms most at risk of overinvestment, dual-class firms have higher future accounting profitability and less volatile future returns.     

Access to Capital, Capital Structure, and the Funding of the Firm

Based upon a large data set of public and private firms in the United Kingdom, I find that compared to their public counterparts, private firms rely almost exclusively on debt financing, have higher leverage ratios, and tend to avoid external capital markets, leading to a greater sensitivity of their capital structures to fluctuations in performance. I argue that these differences are due to private equity being more costly than public equity. I further examine the private firms subsample to show that private equity is more costly than its public counterpart due to information asymmetry and the desire to maintain control.     

External financing and earnings management: Evidence from international data

Corporate financing conditions in the external capital market are significantly affected by information asymmetry, while internal financing is not. Given that earnings information influences market perceptions regarding firms’ quality, firms relying on external financing should have incentives to manage earnings to improve their financing conditions. This study investigates the effect of corporate external financing behavior on earnings management. Using a sample comprising 75,790 observations of 12,874 firms in 43 countries, we find that accrual-based and real earnings management are positively associated with firms’ reliance on external financing. This positive relationship holds especially true for firms that rely on equity rather than debt financing. We argue that reliance on external financing (especially equity financing), which is subject to problems arising from information asymmetry, generates a motive for earnings management.     

Corporate payout policy in dual-class firms

We examine corporate payout policy in dual-class firms. The expropriation hypothesis predicts that dual-class firms pay out less to shareholders because entrenched managers want to maximize the value of assets under control and the associated private benefits. The pre-commitment hypothesis predicts that dual-class firms pay out more to shareholders because firms use corporate payouts as a pre-commitment device to mitigate agency costs. Our results support the pre-commitment hypothesis. Dual-class firms have higher cash dividend payments and total payouts, and they use more regular cash dividends rather than special dividends or repurchases, compared to their propensity-matched single-class firms. Dual-class firms with severe free cash flow-related agency problems and few growth opportunities rely even more on corporate payouts as a pre-commitment mechanism. We also rule out the alternative explanation that dual-class firms pay out more because super-voting shareholders lack the ability to generate home-made dividends by selling shares since super-voting shares are often non-tradable or very illiquid.     

Information asymmetry and firms’ credit market access: Evidence from Moody's credit rating format refinement

I exploit Moody's 1982 credit rating refinement to examine its effects on firms’ credit market access, financing decisions, and investment policies. While firms’ ex ante yield spread can partially predict the direction of refinement changes, firms with refinement upgrades experience an additional decrease in their ex post borrowing cost compared with firms with downgrades. The former subsequently also issue more debt and rely more on debt financing over equity than the latter. Lastly, upgraded firms have more capital investments, less cash accumulation, and faster asset growth than downgraded firms. These findings show that credit market information asymmetry significantly affects firms’ real outcomes.     

The effect of securities litigation on external financing

Using a comprehensive sample of securities litigation, we examine the effect of financial fraud on the subsequent use of external financing. We find that firms with a recent history of securities litigation, particularly more severe litigation, are less likely to seek external debt and equity financing. This negative relationship between prior litigation and external financing is stronger for firms with high information asymmetry. Furthermore, firms significantly reduce their investments in capital expenditures and research and development during the three years following a litigation filing. Thus, the reduction in the availability of external financing due to allegations of financial fraud can have a tangible impact upon the investment opportunities of the firm.     

Resolving Information Asymmetry Through Contractual Risk Sharing: The Case of Private Firm Acquisitions

When private firms are acquired, buyers commonly rely on seller financing and earnouts. Using a novel database of private acquisitions, I find that seller financing and earnouts become more common as information asymmetry increases between the acquirer and the target. Financial statement audits of the targets attenuate these results, which suggests that audits decrease information asymmetry in firm acquisitions. Seller-financed acquisitions also close faster and at higher prices, reducing the private firm discount. These findings suggest that these contract structures are an important channel through which privately held firms mitigate adverse selection that arises from information asymmetry.     

Growth opportunities,short-term market pressure,and dual-class share structure

We test the hypothesis that dual-class shares can help managers focus on the implementation of long-term projects while avoiding short-term market pressure. Consistent with this idea, we find that dual-class firms face lower short-term market pressure (fewer transient or short-term institutional holdings, a lower probability of being taken over, and lower analyst coverage) than propensity-matched single-class firms. Dual-class firms also tend to have more growth opportunities (higher sales growth and R&D intensity). The dual-class share structure increases the market valuation of high growth firms, in contrast to the finding in the literature that dual-class firms trade at lower valuations. To address endogeneity concerns, we evaluate a sample of dual-class share unifications and find that growth opportunities decline while short-term market pressure increases after share unifications.     

Information Asymmetry and Corporate Investment Decisions: A Dynamic Approach

This paper develops a dynamic model of the financing and operating decisions of firms in the presence of information asymmetry. When the value of growth opportunities is not fully recognized, securities are undervalued, thus influencing the financing and investment decisions. The agency‐based underinvestment problem is re‐examined under information asymmetry. For firms with greater growth opportunities, the investment distortion resulting from information asymmetry is especially significant. Information asymmetry also increases the expected bankruptcy cost. The cost of information asymmetry in terms of both the firm value and the information spread under the optimal capital structure could be substantial.     

Investment financing: evidence from Korea

This study examines the relative importance of various forms of capital in financing investments by Korean firms. Our results from the seemingly unrelated regression (SUR) method indicate that, unlike U.S. firms, Korean firms rely substantially on cash holdings to finance investments. These results also suggest that Korean firms use long‐term debt more actively than equity issuance to finance investments. Subgroup analyses show that large firms and Chaebol‐affiliated firms use more long‐term debt but less equity issuance than comparison firms do, suggesting that debt capacity allows firms to reduce the use of equity issuance. However, there is little evidence that financing decisions are driven by information asymmetry. The results from the quantile regression (QR) method suggest that Korean firms tend to use debt capital more than they do equity capital at low and medium levels of investments, while their reliance on equity capital increases at high levels of investments.     

When Does Information Asymmetry Affect the Cost of Capital?

This paper examines when information asymmetry among investors affects the cost of capital in excess of standard risk factors. When equity markets are perfectly competitive, information asymmetry has no separate effect on the cost of capital. When markets are imperfect, information asymmetry can have a separate effect on firms’ cost of capital. Consistent with our prediction, we find that information asymmetry has a positive relation with firms’ cost of capital in excess of standard risk factors when markets are imperfect and no relation when markets approximate perfect competition. Overall, our results show that the degree of market competition is an important conditioning variable to consider when examining the relation between information asymmetry and cost of capital.     

Weakened outside shareholder rights in dual-class firms and timely loss reporting

In this paper, we examine timely loss reporting for U.S. firms with a dual-class share structure, i.e., firms characterized by a divergence (wedge) between insiders’ voting rights and cash flow rights. In our primary analysis, we find compelling evidence that the wedge (quantified by excess voting rights) is associated with less timely loss reporting for these firms. In our secondary analysis, in which we match our sample of dual-class share observations with a sample of single-class share observations, we find similar results. Our paper informs public policy by showing that weakened outside shareholder rights matter, even in the U.S., where, despite a strong investor protection environment, dual-class firms are less timely in recognizing bad news in reported earnings.     

The Real Effects of Financial Shocks: Evidence from Exogenous Changes in Analyst Coverage

We study the causal effects of analyst coverage on corporate investment and financing policies. We hypothesize that a decrease in analyst coverage increases information asymmetry and thus increases the cost of capital; as a result, firms decrease their investment and financing. We use broker closures and broker mergers to identify changes in analyst coverage that are exogenous to corporate policies. Using a difference‐in‐differences approach, we find that firms that lose an analyst decrease their investment and financing by 1.9% and 2.0% of total assets, respectively, compared to similar firms that do not lose an analyst.     

Exploitation of the internal capital market and the avoidance of outside monitoring

Internal capital markets (ICMs) provide firms an alternative to costly external financing; however, they also provide an avenue to avoid the monitoring associated with issuing external capital. We argue that firms operating inefficient internal capital markets will avoid outside financing. Consistent with this view, conglomerates that cross-subsidize divisions or engage in value-destroying investment avoid external capital market oversight by refraining from issuing both debt and equity. We further show that firms issuing bonds while engaging in value-destroying investment experience yield spreads that are, on average, 46 basis points higher than those of other diversified firms. They similarly experience yield spreads that are 18 basis points higher when they issue syndicated loans. Value-destroying conglomerates also witness SEO announcement returns that are, on average, 1% more negative than firms operating more efficient internal capital markets.     

Dual-class share structure and innovation

Using a sample of dual-class firms matched with single-class firms possessing similar antitakeover protection, we find a positive association between disproportionate insider control and patent output, quality, creativity, research and development efficiency, and chief executive officer innovative risk taking. We also find, however, that the positive effects of disproportionate control on innovation are concentrated in financially constrained firms and firms in highly competitive industries, and that the positive effects dissipate within 10 years after the initial public offering. Most important, the positive effect of dual-class structures for innovation is conditional on the presence of innovative insiders in the firm. These findings imply that entrenchment through concentrated control in the hands of uniquely innovative corporate insiders provides a positive environment for innovativeness beyond the entrenchment effects of alternative antitakeover measures.     

Conglomerate investment under various capital market conditions

This paper studies the investment of diversified and focused firms under various capital market conditions. When external capital becomes more costly at the aggregate level, investment declines in focused firms but remains unchanged in diversified firms. This investment advantage enjoyed by diversified firms could attribute to both their easy access to external capital and their ability to substitute internal capital markets for costly external markets. Consistent with the internal capital market argument, our findings show that the investment advantage exists for diversified firms even after we control for their easy access to external markets. We also find that the role of internal markets in financing investment is more important for diversified firms that are more financially constrained in external markets. Finally, we find that the segment-level investment becomes more efficient in conglomerates’ internal capital markets under depressed external capital market conditions. Overall, our findings suggest that internal capital allocation functions as a valuable and efficient substitute for diversified firms in a tightened external capital market.     

Access to financing and firm growth

Why do some firms grow faster than others? Although various observed and unobserved aspects of firms have been suggested as potential drivers of firm heterogeneity, economists disagree sharply on the role of financial structure in influencing firm growth. In this paper, I use a sample of quoted and unquoted firms to show that the effect of financial structure on firm growth is statistically significant and quantitatively important. In the presence of external financing constraints, firms rely more on internal funds to finance growth, but the effect of internal financing on firm growth decreases with an increase in the firm’s access to an external bank credit facility. As the external financing constraint is alleviated, the firm relies less on internal funds and switches to external financing as the primary source of financing for its growth. This pattern of transition between internal and external financing is particularly pronounced in small unquoted firms (conditional on their survival). These results suggest a real effect of financial structure on growth via the channel of an external financing constraint.