Reexamining the determinants of managerial ownership and the link between ownership and firm performance

Transcription

1 Master Thesis Finance Reexamining the determinants of managerial ownership and the link between ownership and firm performance Name: N.T. van Vlerken Student number: Faculty: School of Economics and Management Department: Finance Thesis supervisor: Dr. F. Feriozzi Second reader: Prof. Dr. V.P. Ioannidou

2 Master Thesis Finance Reexamining the determinants of managerial ownership and the link between ownership and firm performance I am grateful for the helpful comments and support of my supervisor Dr. F. Feriozzi and for the remarks of J.C. Dekker and P.M.M. Maas that have significantly improved this master thesis.

3 Abstract This master thesis examines the determinants of managerial ownership and the link between managerial ownership and firm performance by replicating the study of Himmelberg, Hubbard, and Palia (1999) with more recent data. However, several authors have argued that, in addition to managerial ownership, other internal and external governance mechanisms can also force managers to pursue a shareholder wealth maximization goal. Therefore, I extend the specification of Himmelberg et al. (1999) and examine whether or not internal and external governance mechanisms can function as a substitute to managerial ownership in mitigating agency problems. Although I do not find evidence that managerial ownership is influenced by the strength of internal or external governance mechanisms, my findings suggest that the link between managerial ownership and firm performance depends crucially on the strength of various governance mechanisms. Only when companies have a low leverage ratio, pay no dividends, have high market power, or institutional ownership concentration is low, I observe a hump shaped relation. Therefore, my findings suggest that, at low levels of managerial ownership, strong internal and external governance mechanisms can function as an effective substitute to managerial ownership in mitigating agency problems. Furthermore, strong governance seems to help to alleviate the entrenchment effect of managerial ownership at high ownership levels. Finally, I observe a hump shaped relation between managerial ownership and firm performance only when companies adopt few anti-takeover provisions. Therefore, this finding suggests that only when the entrenchment index is low, managerial ownership does function as an effective governance mechanism to realign the interest of managers with those of shareholders. Keywords: managerial ownership, firm performance, corporate governance

4 Table of contents 1. Introduction Literature review... 8 A. Theories on the relation between managerial ownership and firm performance... 9 A.1. The convergence-of-interests and managerial entrenchment theory... 9 A.2. The optimal contracting theory B. Empirical findings Methodology A. The determinants of managerial ownership A.1. Measuring managerial ownership A.2. Pooled-OLS and fixed effect regressions B. The link between managerial ownership and firm performance B.1. Measuring firm performance B.2. Measuring managerial ownership B.3. Pooled-OLS and fixed effects regressions Observable firm characteristics A. Himmelberg et al. (1999) specification B. Proxies for the strength of internal and external governance mechanisms Data collection and summary statistics A. Data collection B. Summary statistics C. Correlations... 33

5 Table of contents - Continued 6. Determinants of managerial ownership: Empirical evidence A. Evidence B. The effect of managerial turnover, firm performance, and the share class system C. Robustness tests The link between managerial ownership and firm performance: Empirical evidence A. Evidence B. The effect of governance mechanisms on the link between ownership and firm performance C. Robustness tests Conclusion Limitations and recommendations References Appendix A: Supplementary data... 60

6 1. Introduction Examples of the consumption of outrageous private benefits by corporate managers are quite common in history. While CEO of Hollinger, Conrad Black acquired presidential papers and other memorabilia about former U.S. President Franklin D. Roosevelt after paying millions of dollars with the corporation s funds. Although paid for by Hollinger, the documents were stored at Black s residences and used to complete his biography about the former president. When asked about the reason he used corporate assets for the acquisition of the collection, Black argued that the money was not something he was prepared to spend personally (MacLeans, September 1, 2003). Alternatively, founding CEO John Rigas of Adelphia Communications used a corporate jet to transfer a Christmas tree to his daughter in New York City in However, the tree was perceived to be too short and was therefore returned to Adelphia s headquarters. Subsequently, Mr. Rigas ordered a second corporate jet to transport a taller tree to his daughter. According to the manager of the aviation department of Adelphia, the total costs of the two flights amounted to over $6,000. Although these two cases are extreme examples, the use of corporate assets by managers to consume private benefits 2 is common practice in business (Benos and Weisbach (2004)). Corporate scandals like the Hollinger and Adelphia case have raised the question how to protect minority shareholders against non-value-maximizing behavior by managers. Jensen and Meckling (1976) argue that the consumption of private benefits by managers can be limited by establishing appropriate managerial incentives. One way to create these incentives is by providing managers with equity stakes in the firm. Therefore, one would expect that firms with higher levels of managerial ownership perform better. However, prior empirical research has been ambiguous about the effect of managerial ownership on firm performance. While Mørck, Shleiffer, and Vishny (1988), McConnel and Servaes (1990), Hermalin and Weisbach (1991), Davies, Hillier, and McColgan (2005), Benson and Davidson (2009), Kim and Lu (2011) and Zhang (2011) find that managerial ownership is positively related to firm performance at low levels of managerial ownership (convergence-of-interests effect 3 ) and negative at high ownership levels (managerial entrenchment effect 3 ), Demsetz and Lehn (1985), Cho (1998), Himmelberg et al. (1999), and Demsetz and Villalonga (2001), find no significant ownership firm performance relationship. In this master thesis, I will replicate the study of Himmelberg et al. (1999) with a more recent unbalanced panel dataset covering the pre-crisis FY1997 to FY2006 period, and including public U.S. firms listed on the S&P500, S&P Midcap 400, or S&P Smallcap 600. By making use of panel data, I am able to control for time-invariant unobserved heterogeneity which is an important source of the crosssectional variation in managerial ownership levels according to Himmelberg et al. (1999). 2 These managerial benefits concern the consumption of perquisites and shirking behavior, but also include other non-valuemaximizing pursuits like empire building and sales growth (Mørk, Shleiffer, and Vishny, 1988). 3 I will further elaborate on the convergence-of-interests and managerial entrenchment hypotheses in section 2.A. 5

7 However, when compared to the study of Himmelberg et al. (1999) my study differs in two ways. First, Himmelberg et al. (1999) apply the aggregate shareholdings of corporate insiders as their managerial ownership measure. According to Kim and Lu (2011) this managerial ownership measure is inappropriate. Therefore, I follow Benson and Davidson (2009), Kim and Lu (2011) and Zhang (2011) and measure managerial ownership by the shareholdings of the firm s CEO. Second, several authors have argued that, in addition to managerial ownership, other internal and external governance mechanisms like product market competition (Hart, 1983), leverage (Jensen, 1986), dividends (Jensen, 1986), and institutional ownership (Pound, 1988), can also force managers to pursue a shareholder wealth maximization goal. Himmelberg et al. (1999) do not take these ownership substitutes into account in their specification. Therefore, I extend their framework and examine whether or not internal and external governance mechanisms can function as a substitute to managerial ownership in mitigating agency problems. Furthermore, I assess the impact of the strength of these governance mechanisms on the link between managerial ownership and firm performance in this master thesis. To proxy for the strength of internal governance mechanisms, I use leverage, a company s dividend policy, and the entrenchment index (Bebchuk, Cohen, and Ferrel (2009)). Furthermore, I use the industry concentration ratio, the company s relative market share, and institutional ownership concentration as proxies for the strength of external governance mechanisms. While Kim and Lu (2011) also studied the interactive effect of the industry concentration ratio and institutional ownership concentration with managerial ownership, and Zhang (2011) studied the interacting effect of the entrenchment index, to my knowledge no earlier paper has studied the effect of leverage, dividends, and the company s relative market share on the link between managerial ownership and firm performance. This master thesis consists out of two parts. In the first part, I examine the determinants of managerial ownership and study whether or not other internal or external governance mechanisms can function as a substitute to managerial ownership. Following Himmelberg et al. (1999), I control for unobserved heterogeneity by including firm fixed effects in my regressions. Additionally, I control for the effect of managerial turnover on managerial ownership argued for by Denis and Sarin (1999), by including executive fixed effects, following Benson and Davidson (2009), or by including a turnover dummy. The second part of this master thesis examines the link between managerial ownership and firm performance. First, I study my entire dataset and examine whether or not changes in managerial ownership levels are associated with changes in firm performance. Finally, I divide my dataset into subsamples based on the strength of the various internal and external governance mechanisms to study how these governance mechanisms interact with managerial ownership in mitigating agency problems. After controlling for firm fixed effects, I find that the industry concentration ratio, institutional ownership concentration, leverage, the entrenchment index, and the dividend dummy are statistically 6

8 insignificant in the regressions. Although this finding suggests that these governance mechanisms do not function as an effective substitute to managerial ownership, the insignificant coefficients might be driven by too low within firm variation in those variables. For example, Brook, Charlton, and Hendershott (1998) and Allen, Bernardo, and Welch (2000) argue that a company s dividend policy is sticky, suggesting that it is highly persistent over time. Because firm fixed effects models rely on this within firm variation, these models might be unable to detect a relation between managerial ownership and persistent firm characteristics even if such relation does exist. Next, I find that including firm or executive fixed effects increase the adjusted R 2 value of my models tremendously. This finding suggests that unobserved heterogeneity is an important source of the cross-sectional variation in managerial ownership and is in line with previous findings by Himmelberg et al. (1999). Furthermore, after controlling for unobserved heterogeneity at the firm level, I find that managerial ownership is negatively and significantly associated with firm size, managerial turnover, and R&D expenditures, and positively and significantly associated with firm performance, idiosyncratic risk, and the profit margin. My results are robust to using the shareholdings of the top 5 managers as an alternative managerial ownership measure. When examining the link between managerial ownership and firm performance I observe a hump shaped relation supporting the converge-of-interest and managerial entrenchment hypotheses after controlling for unobserved heterogeneity at the firm level and after controlling for managerial turnover. Furthermore, I find that the link between managerial ownership and firm performance crucially depends upon the strength of internal and external governance mechanisms adopted by the company. Only when the industry concentration ratio is low, the company s relative market share is high, the company does not pay dividends, or industry-adjusted leverage is low, I observe a hump shaped relation between managerial ownership and firm performance. This finding suggests that these governance mechanisms can function as an effective substitute to managerial ownership at low levels of managerial ownership in mitigating agency problems. Furthermore, strong internal or external governance seems to alleviate the entrenchment effect of managerial ownership at high levels of ownership. In addition, my findings only lend support to the convergence-of-interests and entrenchment hypotheses when the entrenchment index is low. This finding suggests that for managers who are already highly entrenched within a firm through the adoption of many anti-takeover provisions, managerial ownership does not function as an effective governance mechanism to realign the interest of managers with those of shareholders. Finally, although the findings presented in this master thesis do not provide irrefutable evidence of a causal relationship running from managerial ownership to firm performance, it is unlikely that the differences I observe between subsamples are the results of compensation plans or insider trading. Therefore, my results strongly suggest that managerial ownership affects firm performance. The remainder of this master thesis is organized as follows. Section 2 describes the current state of 7

9 related literature, while section 3 addresses the methodology used to research the determinants of managerial ownership and the link between ownership and firm performance. Section 4 describes the observable firm characteristics and their expected effect on managerial ownership. Section 5 addresses data collection procedures and includes summary statistics. In section 6 and 7, respectively, I present empirical findings on the determinants of managerial ownership and on the link between managerial ownership and firm performance. Section 8 concludes this master thesis. Finally, section 9 discusses the limitations of this master thesis, and provides fruitful area s for further research. 2. Literature review During the previous decades many researchers have tried to uncover the relation between ownership structures and firm performance. The theoretical debate started with the Berle and Means (1932) thesis identifying the separation of ownership from control in many large corporations: The separation of ownership from control produces a condition where the interests of owner and ultimate manager may, and often do, diverge, and where many of the checks which formerly operated to limit the use of power disappear [Berle and Means 1932, pp. 6-7]. As shareholders are often practically unable to govern their firm together, they hire a professional management team and delegate some decision making authority to them. However, the interests of shareholder (principals) and managers (agents) do not naturally coincide. When ownership is not concentrated in the hands of a few shareholders, shareholders do not have enough power to monitor management (Demsetz (1983)) or suffer from the free-rider problem (Hart (1995)). Assuming that both parties of the principal-agent relationship are trying to maximize their utility function, it is likely that managers will not always act in the best interests of shareholders as managers can use their control to consume private benefits while making use of corporate assets. The conflicts of interest between shareholders and managers in firms are referred to as agency problems and are harmful to the firm s shareholders as these problems can lead to a lower stand-alone value of the firm. According to Jensen and Meckling (1976), owners can limit the consumption of private benefits by managers through establishing appropriate managerial incentives. Therefore, one possible solution to the agency problem concerns compensating managers with equity stakes in the firm. 8

10 A. Theories on the relation between managerial ownership and firm performance Previous literature has developed two distinct theoretical views on the relation between managerial ownership stakes and firm performance. Both theories are discussed in the next subsections. A.1. The convergence-of-interests and managerial entrenchment theory As common stock holders are entitled to the residual claim on the corporation s assets and cash flows, higher managerial ownership increases the extent to which both private benefits and costs are born by those managers. Therefore, managers with higher ownership levels have increased incentives to act in line with the interests of shareholders as they pay a larger share of the diverted resources themselves through their higher equity stakes. Thus, increasing managerial ownership aligns the interests of managers with the interest of shareholders and managers with larger ownership stakes are more likely to pursue a shareholder wealth maximization goal. Concluding, the convergence-of-interests hypothesis predicts a positive relationship between managerial ownership and firm performance. However, in addition to their claim on the residual cash flows, holders of company stock are entitled to vote on important corporate matters like the election of the board of directors. Therefore, managers with significant ownership have significant voting power. Mørck, et al. (1988) and Stulz (1988) argue that when managerial voting power becomes large, managers may become entrenched within the firm as the disciplinary power of the market for corporate control weakens. Findings by Weston (1979), who reported that no firm with managerial control of over 30% had ever been acquired in a hostile takeover, vote in favor of this argument. Whenever managers become entrenched within a firm, they can indulge in nonvalue maximizing activities and run their own agenda. For example, entrenched managers are able to continue their employment within a firm under favorable terms, even following bad performance. Studies by Denis, Denis, and Sarin (1997) using a sample of U.S. firms, and Dahya, McConnell, and Travlos (2002) using a sample of UK firms, reinforce this view as they report an inverse relation between managerial turnover and managerial ownership. Since the behavior of entrenched managers can be firm value destroying, the entrenchment-hypothesis 4 predicts that firm performance is inversely related to higher managerial ownership levels. However, Mørck et al. (1988) argue that it is unlikely that voting power is the sole driver of entrenchment as managerial stakes are often not large enough to singlehandedly elect directors or to win proxy contests. Furthermore, while some managers can be entrenched holding a relatively small percentage of company stock, other managers who own a higher 4 Related literature proposes additional theories that are in line with the entrenchment hypothesis. Fama and Jensen (1983) argue that higher managerial ownership leads to an increase in the costs of capital due to lower liquidity, while Benson and Davidson (2009) and Kim and Lu (2011) suggest that high levels of managerial ownership induce a risk aversion effect as undiversified wealth constrained managers lower the risk of the firm below the optimal level. 9

11 percentage of the outstanding equity might not be entrenched. Therefore, Mørck et al. (1988) argue that a broad range of forces like managerial tenure, status, personality, board composition, and monitoring by outside blockholders can influence managerial entrenchment. A graphical representation of the predicted link between managerial ownership levels and firm performance by the convergence-of-interests and entrenchment hypotheses is shown in Figure 1. Figure 1: The convergence-of-interests and managerial entrenchment hypotheses Convergence-of-interests effect Firm performance Managerial entrenchment effect Managerial ownership A.2. The optimal contracting theory Demsetz (1983) opposes the convergence-of-interests and managerial entrenchment hypotheses. He suggests that managerial ownership should be thought of as an endogenous variable as every firm optimally contracts with management given the firm s contracting environment. Even when managerial ownership is low, other mechanisms like market discipline (Fama (1980)), the market for corporate control (Jensen and Ruback (1983)), and the product market (Hart (1983)), can force managers to pursue a shareholder wealth maximization goal. However, these mechanisms are also likely to influence firm performance directly. Therefore, Demsetz (1983) predicts that managerial ownership and firm performance are unrelated when researchers properly account for the contracting environment of the firm. 10

12 B. Empirical findings A large ambiguous empirical literature developed addressing the issue whether or not compensating managers with equity stakes in the firm helps to alleviate agency problems and thus leads to an increase in firm performance. One of the earlier papers researching the relation empirically, is the cross-sectional study by Demsetz and Lehn (1985) using a sample of 511 U.S. firms obtained from the Corporate Data Exchange (1980), Banking & Finance (1980), and Fortune 500 (1981) directories. Furthermore, they obtain accounting data from Compustat and security price data from CRSP. Although Demsetz and Lehn (1985) do not research the relation between managerial ownership and firm performance but the relation between the ownership structure of a firm and firm performance, the same theories as described in section 2.A apply. First, Demsetz and Lehn (1985) research the determinants of the ownership structure of firms and find that the riskiness of a firm, measured by the volatility of the stock price, is positively related to ownership concentration, while larger firms on average show more dispersed ownership structures. They explain these findings by arguing that the scope for moral hazard is greater in riskier firms. Therefore, riskier firms on average choose a more concentrated ownership structure as their wealth gain achievable from establishing effective monitoring is higher. Furthermore, Demsetz and Lehn (1985) argue that in larger companies a smaller share of company stock is needed to achieve a given degree of control. This risk-neutral effect is magnified by risk aversion and discourages managers of large firms to maintain a costly concentrated ownership structure. While more dispersed ownership is accompanied by a greater scope for agency problems, the benefits of adopting such structure outweigh the costs for large firms. To test the optimal contracting theory of Demstez (1983), Demsetz and Lehn (1985) linearly regress firm performance, measured by the 1976 through 1980 period mean of accounting profit rate, on various measures of ownership concentration and a set of control variables. In their regressions they treat ownership concentration as an endogenous variable. All specifications show a highly insignificant coefficient on the measure of ownership concentration, suggesting that ownership concentration and firm performance are unrelated. Therefore, the results obtained by Demsetz and Lehn (1985) provide evidence in favor of the optimal contracting theory. However, Mørck et al. (1988) argue that the linear specification Demsetz and Lehn (1985) use is inappropriate to test the relation between ownership and performance as a linear specification is unable to capture both the opposing convergence-of-interests and entrenchment hypotheses. Therefore, Mørck et al. (1988) reexamine the link between managerial ownership and firm performance using data on 371 Fortune 500 firms in 1980 and run a variety of piecewise linear regressions to be able to capture both hypotheses. They proxy firm performance by Tobin s Q, and use the shareholdings of the board of directors as a measure of managerial ownership. Furthermore, Mørck et al. (1988) include a set of control 11

13 variables including the R&D and advertising-to-capital ratio, leverage, firm size and industry dummies. Their regressions show that for low levels of managerial ownership Tobin s Q is positively related to the level of managerial ownership. However, when managerial ownership further increases the relation becomes negative, but turns positive again when managers own more than 25% of the firm s equity. Mørck et al. (1988) explain these findings by concluding that the entrenchment effect becomes apparent when managers own more than 5% of the company s stock but its magnitude is monotonic for the 20%+ ownership levels. Furthermore, they conclude that the convergence-of-interests effect runs throughout the whole range of board ownership. However, the findings of Mørck et al. (1988) are not robust to the use profit rate as an alternative measure of firm performance. McConnel and Servaes (1990) account for the presence of blockholders and large institutional investors while researching the link between insider ownership and firm performance. Their work builds upon Shleifer and Vishny (1986) who argue that regardless of the level of managerial ownership, large blockholders represent a potential takeover threat that works as an effective device for monitoring management. Furthermore, Pound (1988) predicts that institutional investors can monitor management at lower costs because they have greater expertise. Therefore, Pound (1988) suggests that institutional investors are effective monitors of managerial behavior, and Shleifer and Vishny (1986) and Pound (1988) predict that ownership by blockholders and institutional investors increases firm performance. To test these hypotheses, McConnel and Servaes (1990) use two cross-sectional data sets obtained from the Value Line Investment Survey and Compustat: one for 1976 including 1173 firms and one for 1986 including 1093 firms. When regressing Tobin s Q on the fraction of shares owned by corporate insiders, the fraction of shares owned by corporate insiders squared, various measures of blockholder ownership, and institutional ownership, they find a strong curvilinear relationship between insider ownership and firm performance for both samples. These findings are consistent with the empirical results of Mørck et al. (1988) and the theoretical model of Stulz (1988). Furthermore, McConnel and Servaes (1990) find a strong positive relation between Tobin s Q and the fraction of shares owned by institutional investors, consistent with the efficient-monitoring hypothesis of Pound (1988). However, all blockholder measures show up highly statistically insignificant in the regressions, which is at odds with the hypothesis of Shleifer and Vishny (1986). Finally, McConnel and Servaes (1990) test the robustness of their findings and obtain similar results when including the same set of control variables used in Mørck et al. (1988) and when using profit rate as an alternative measure of firm performance. Cho (1998) explores the possibility that the observed relation between ownership and performance found in previous cross-sectional studies like Mørck et al. (1988) and McConnel and Servaes (1990) is spurious as those studies treat a firm s ownership structure as exogenous. As a first step, Cho (1998) replicates the piecewise linear regression of Mørck et al. (1988) using a cross-sectional sample of Fortune 12

14 500 manufacturing firms in 1991, and finds a similar non-monotonic relation between insider ownership and firm performance. However, Kole (1994) argues that managers may prefer equity compensation in anticipation of good firm performance, while Murphy (1985) suggests that higher firm performance leads to an increase in managerial compensation. These arguments suggest a reversed ownership-performance relation. This view is reinforced by Hermalin and Weisbach (1991) who argue that managers have access to superior information which they use to buy (sell) shares in the market when anticipating good (poor) performance. Therefore, Cho (1998) suggests that ownership and performance might be interdependent and using OLS techniques to research this relation yields inconsistent results. To deal with this simultaneity issue, Cho (1998) runs simultaneous equation regressions, and shows that firm performance affects insider ownership, but not vice versa. Therefore, Cho (1998) argues that previous cross-sectional studies that threat ownership as an exogenous variable are misspecified and increasing managerial ownership might not be an effective tool to align the interests of managers and shareholders. Himmelberg et al. (1999) argue that cross-sectional studies like Demsetz and Lehn (1985), Mørck et al. (1988) and Cho (1998) are biased as the contracting environment across firms differs not only in observable but also in unobservable ways. They stress the importance of unobserved heterogeneity as an important driver of managerial ownership levels. To deal with this issue, Himmelberg et al. (1999) run firm fixed effects regressions using an unbalanced panel of 600 firms and assume that the firm specific unobserved variables are constant over time. Data is collected from SEC filed proxy statements and Compustat and concerns the 11-year period FY1982 through FY1992. As a first step, Himmelberg et al. (1999) examine the determinants of managerial ownership and find a positive relation with the advertising-to-capital, operating income-to-sales, capital expenditures-to-capital, and R&D-to-capital ratio, but a negative relation with the capital-to-sales ratio, firm size, and managerial risk aversion. They explain these findings by arguing that the scope for discretionary spending is higher within firms that have higher free cash flow, employ a smaller amount of fixed assets, or have higher R&D, advertising, or capital expenditures. Additionally, when the scope for discretionary spending is high, management should hold a significant stake in the firm to realign incentives with shareholders. As a second step Himmelberg et al. (1999) research the link between managerial ownership levels and firm performance, measured by Tobin s Q, by using the quadratic specification of Mcconnell and Servaes (1990) and the piecewise linear regression of Mørck et al. (1988). When controlling for a variety of observable firm characteristics and including firm fixed effects, both specifications show no statistically significant effect of managerial ownership on firm performance. Therefore, Himmelberg et al. (1999) argue that unobserved heterogeneity in the contracting environment across firms makes it difficult to conclude a causal link between managerial ownership and firm performance. Finally, Himmelberg et al. (1999) run instrumental variable regressions as an alternative approach to deal with the endogenous nature of managerial 13

15 ownership. In contrast to their previous findings, they find a significant and large inverse U-shaped relation between managerial ownership and firm performance in the pooled-ols regression and when controlling for industry fixed effects. However, when including firm fixed effects this hump shaped relation disappears. Zhou (2001) comments the study by Himmelberg et al. (1999) and provides evidence that managerial ownership changes very slowly from year to year within a firm. Therefore, the within firm variation in managerial ownership levels is very small and approaches that rely on this variation, like the fixed effects method applied by Himmelberg et al. (1999), may fail to detect a relationship between ownership and firm performance even if one exists. Furthermore, Zhou (2001) stresses the importance of stock options when researching the link between managerial incentives and firm performance. He provides evidence that since the beginning of the 1980 s rewarding managers with stock options has gained in popularity and that options provide ownership like incentives. As ignoring option holdings of managers may lead to wrong conclusions, Zhou (2001) argues that researchers should incorporate the incentive effect of stock options when researching the ownership-performance relation. Davies, Hillier, and McColgan (2005) suggest that the relation between managerial ownership and firm performance might be more complex than previously assumed. They suggest that misspecification of the ownership-performance relation may lead to wrong conclusions concerning causality. Therefore, Davies et al. (2005) question the results found in previous studies using a linear (e.g. Demsetz and Lehn (1985); Demsetz and Villalonga (2001)), quadratic (e.g. Mørck et al. (1988); Himmelberg et al. (1999)) or cubic (Short and Keasey (1999)) specification. To capture further non-linearities in the ownershipperformance relation, Davies et al. (2005) employ a quintic specification, and use a UK sample collected from the 1995 MacMillan London Stock Exchange Yearbook. They find that firm performance is positively related to low, high (<50%) and very high levels of managerial ownership but negatively related to intermediate and high (>50%) levels. Davies et al. (2005) explain these findings by arguing that managers gain full-control when they own around 50% of the outstanding equity. This leads to a collapse in external market discipline and affects firm performance negatively. However, when managers have very high ownership levels, they become practically the sole owners of the company. Therefore, the interests of managers with very high ownership levels are almost perfectly aligned to those of other shareholders and the core goal becomes of managers value maximization. As a second step Davies et al. (2005) control for endogeneity by carrying out a simultaneous equations analysis using two-stage least squares. They find that firm performance influences managerial ownership, but, in contrast to Cho (1998), managerial ownership is also a determinant of firm performance. Benson and Davidson (2009) build upon the Zhou (2001) critique and use a new measure of managerial incentive strength as proposed by Hall and Liebman (1998): pay-performance semi-elasticity. 14

16 Pay-performance semi-elasticity is defined as the amount the wealth of an executive increases due to a 1% increase in firm value and exhibits a higher magnitude and within firm variation when compared to managerial ownership. Therefore, Benson and Davidson (2009) argue that this alternative measure provides a solution to the Zhou (2001) critique and fixed effects models can be adopted to research the link between managerial incentives and firm performance. By estimating the value of managerial stock options as in Core and Guay (2002), Benson and Davidson (2009) incorporate the effect of options in this managerial incentive strength measure. First, Benson and Davidson (2009) model managerial ownership as an exogenous variable and run executive fixed effects 5 regressions including some of the Himmelberg et al. (1999) control variables. Their results show an inverse U-shaped pay-performance relation when using pay-performance semi-elasticity as managerial incentive measure. Therefore, the findings by Benson and Davidson (2009) support the convergence-of-interests and managerial entrenchment theory. As a second step Benson and Davidson (2009) employ two-stage least squares regressions to deal with the possibility that one or more of the variables explaining firm performance also depends upon firm performance. While the coefficients for pay-performance semi-elasticity and pay-performance semielasticity squared are individually insignificant, they are jointly significant. Therefore, Benson and Davidson (2009) argue that even after controlling for unobserved firm characteristics at the executive level and simultaneity bias, an inverse U-shaped relation between managerial ownership and firm performance remains. However, in contrast to Zhou (2001) and Benson and Davidson (2009), Kim and Lu (2011) argue that Himmelberg et al. (1999) fail to identify a relation between managerial ownership and firm performance because they measure managerial ownership with the total fraction of shares owned by insiders. According to Kim and Lu (2011), this measure might not be appropriate as it is influenced by changes in the composition of the board of directors and number of corporate insiders, while these changes do not necessarily have to lead to a shift in managerial incentives. When replicating the Himmelberg et al. (1999) specification with panel data from FY1992 through FY2006, Kim and Lu (2011) find no significant relation between managerial ownership and firm performance when managerial ownership is measured by the fraction of shares owned by insiders. However, when rerunning the same specification with CEO ownership or top 5 ownership as ownership measures, results support the convergence-of-interests and entrenchment hypotheses. Therefore, Kim and Lu (2011) argue that not a too low within firm variation in managerial ownership but an inappropriate ownership measure drives the insignificant managerial 5 Benson and Davidson (2009) report that firms and CEO s average 7.2 and 4.2 years respectively in their dataset. This implies that many firms experience CEO turnover over the sample period. According to Denis and Sarin (1999) ownership changes are strongly related to top executive turnover. To correct for the fact that within firm changes in managerial ownership can be the result of managerial turnover rather than changes in the pay-performance relation, Benson and Davidson (2009) include a dummy variable in their regressions for every unique CEO-firm combination in their sample. 15

17 ownership firm performance relation reported by Himmelberg et al. (1999). In addition, Kim and Lu (2011) study the effect of external governance mechanisms on the managerial ownership firm performance relation and find that only when external governance mechanisms are weak, their results support the convergence-of-interests and entrenchment hypotheses. Therefore, they conclude that external governance mechanisms like the industry concentration ratio and institutional ownership concentration can function as substitutes to managerial ownership in mitigating agency problems at low levels of managerial ownership. Furthermore, they argue that at high levels of managerial ownership, strong external governance can help to alleviate the entrenchment effect of managerial ownership. Finally, Zhang (2011) studied the effect of anti-takeover provisions, measured by the entrenchment index, on the link between managerial ownership and firm performance using an unbalanced panel dataset covering the FY1992 through FY2007 period. He suggests that anti-takeover provisions weaken the convergence-of-interests effect and magnify the managerial entrenchment effect of managerial ownership. After performing industry and firm fixed effects regressions, instrumental variables regressions, and after studying the stock market s reaction to open market transactions by managers, Zhang (2011) shows that managerial ownership is positively associated with firm performance at low levels of the entrenchment index. However, when firm adopt many anti-takeover provisions, the relation between managerial ownership and firm performance becomes negative. Therefore, Zhang (2011) argues that anti-takeover provisions decrease the value effect of managerial ownership on firm performance and managers of firm s with a higher entrenchment index are expected to have lower managerial ownership levels. 3. Methodology The methodology used in this study consists out of two parts. The first subsection deals with the methods used to examine the determinants of managerial ownership, while the second subsection elaborates on the methods used to examine the link between managerial ownership and firm performance. A summary of the managerial ownership and firm performance measures explained in this methodology can be found in Table 1, Panel A. A. The determinants of managerial ownership To examine the link between managerial ownership and firm performance, I start by constructing measures of managerial ownership and running pooled-ols regressions including a variety of observable firm characteristics. As a second step, I include firm or executive fixed effects into the regressions to deal with unobserved heterogeneity. 16

18 A.1. Measuring managerial ownership Prior research used a wide variety of measures of managerial ownership. While Mørck et al. (1988) and Hermalin and Weisbach (1991) applied the aggregate holdings of the members of the board of directors as their primary measure, Himmelberg et al. (1999) used the holding of top management reported in SEC filed proxy statements. However, Demsetz and Villalonga (2001) argue that the composition of the board is important as some board members represent a large outside shareholder and do not have the same interests as executive management. Furthermore, Kim and Lu (2011) argue that changes in the number of either directors or top managers causes variation in the measures employed by Mørck et al. (1988), Hermalin and Weisbach (1991), and Himmelberg et al. (1999). However, these changes do not have to lead to a shift in incentives. Therefore, measures of managerial incentive strength relying on the aggregate stock holdings of the board of directors or aggregate holdings of top management, might not be reliable. To deal with this other papers (e.g. Zhou (2001); Benson and Davidson (2009); Kim and Lu (2011)) use the fraction of shares owned by the firm s CEO. Using CEO ownership has two advantages. First, this measure is not influenced by changing characteristics of the board of directors or top management. Second, if there is a relation between managerial ownership levels and a firm s contracting environment, this relation should be most visible when using CEO ownership as measure since the CEO is the most influential manager within a firm. Therefore, I follow Zhou (2001), Benson and Davidson (2009), and Kim and Lu (2011), and also apply CEO ownership as my primary measure of managerial ownership. In addition, I check for the robustness of my results, by measuring managerial ownership as the fraction of shares owned by the top 5 executives reported in the Execucomp database (e.g. Zhang (2011); Kim and Lu (2011)). However, using a fractional variable like managerial ownership as a dependent variable can be problematic (Loudermilk (2007)). While managerial ownership has a clear minimum (0%) and a maximum (100%) bound, a statistical model can create fitted values outside this interval. To account for this, I follow Demsetz and Lehn (1985), Himmelberg et al. (1999), and Demsetz and Villalonga (2001), and apply the following logistic transformation to my measure of managerial ownership: (1) This transforms my bounded variable in an unbounded variable and makes OLS regressions consistent. However, one drawback of this solution is the fact that the transformation generates missing values whenever managerial ownership is exactly 0% or 100%. Although it is highly unlikely that CEO s singlehandedly own all outstanding shares since I examine large public firms, it is not unthinkable CEO s 17

19 own no shares in the company they manage. Therefore, omitting these observations might lead to sample selection bias. To deal with this issue, I run a robustness check and replace missing values of the transformed ownership variable with the minimum value. Finally, Zhou (2001) stresses the importance of stock options when researching the link between managerial incentives and firm performance. Although the value of stock options can be estimated using the method proposed by Guay (1999) and Core and Guay (2002), doing so is beyond the scope of this thesis. According to Zhou (2001) neglecting the incentive effect of options might lead to wrong conclusions unless the correlation between managerial ownership levels including and excluding options is exceptionally high. While Himmelberg et al. (1999) report that for data covering the FY1992 through FY1996 period this correlation exceeds 0.95, Benson and Davidson (2009) report upon request a correlation of 0.85 and a correlation exceeding 0.99 for two different managerial ownership measures using data from FY1995 through FY2009. Additionally, previous papers (e.g. Benson and Davidson (2009); Zhang (2011)) employ robustness test and report that their conclusions do not change when using an alternative measure of managerial ownership that does not take the incentive effect of stock options into account. Therefore, it is unlikely that excluding the effect of stock options in my measure of managerial ownership does affect my results. A.2. Pooled-OLS and fixed effect regressions I first estimate the relation between my transformed measure of managerial ownership and observable firm characteristics by running the following pooled-ols regression:, (2) where: i, t, and k refers to firm, time, and the specific observable characteristic respectively, equals the transformed measure of managerial ownership,, represent observable firm characteristics specified in section 4.1, and is the error term. To control for the effect of time on the level of managerial ownership, a dummy,, is included for every time period. However, pooled-ols regressions rely on both cross-sectional (between) and time-series (within) variation in managerial ownership. Himmelberg et al. (1999) argue that this might be problematic as the contracting environment across firms varies not only in observable, but also in unobservable ways. In a pooled-ols regression, the effect of this unobserved heterogeneity is captured by the error term. Therefore, equation (2) will violate the Gaus-Markov assumptions and yield inconsistent estimates when the observed firm characteristics are correlated with the unobserved characteristics. To deal with this 18

20 potential bias, I re-estimate the relation between managerial ownership and the firms contracting environment by including firm fixed effects into equation (2) as proposed by Himmelberg et al. (1999):, (3) where: equals n dummy variables to identify every firm. By including a dummy variable for every unique firm, a firm specific intercept captures the cross-sectional variation in managerial ownership. Therefore, firm fixed effects regressions rely essentially on the within firm variation in managerial ownership. Under the assumption that the unobserved heterogeneity is constant over time, OLS can be applied consistently as the effect of unobserved firm characteristics is no longer included in the error term. However, one drawback of applying this fixed effects approach is the fact that this model is incapable of producing coefficients on observable variables that show no time-series variation as these variables will be perfectly collinear with the firm dummies. Alternatively to including firm fixed effects, I rerun equation (3) and include a dummy for every unique firm-ceo combination as proposed by Benson and Davidson (2009). This way I correct for the possibility that within firm changes in managerial ownership can be the result of managerial turnover rather than the result of changes in the pay-performance relation. Finally, I follow Demsetz and Villalonga (2001) and include a measure for firm performance,, in equation (3) to account for the fact that higher managerial ownership can be the result of compensation plans (e.g. Kole (1994)) or insider trading (e.g. Hermalin and Weisbach (1991)):, (4) B. The link between managerial ownership and firm performance To research the link between managerial ownership and firm performance, I start by constructing measures of managerial ownership and firm performance, and run pooled-ols regressions. I include the same set of observable firm characteristic included in the managerial ownership regressions as control variables in the firm performance regressions to control for a spurious relation between managerial ownership and firm performance. As a second step, I include firm or executive fixed effects into the regressions to deal with unobserved heterogeneity. Finally, I divide my sample into subsamples based on below or above the median values for a variety of internal and external governance mechanisms to examine the interacting effect of managerial ownership and these governance mechanisms. 19

21 B.1. Measuring firm performance Although Demsetz and Lehn (1985) used the accounting profit rate to proxy firm performance, all following studies (e.g. Mørck et al. (1988); Himmelberg et al. (1999); Benson and Davidson (2009)) researching the link between managerial ownership and firm performance applied Tobin s Q as their primary measure. Demsetz and Villalonga (2001) argue that there are two distinct differences between the two: accounting profit rates are backward looking and influenced by accountants constrained by regulatory standards, while Tobin s Q is forward looking and influenced by the psychology of investors. Although Demsetz and Villalonga (2001) do not argue for or against one of the measures, I follow the vast majority of previous studies and use Tobin s Q to proxy firm performance, which I calculate as: (5) where: is Tobin s Q, equals the company s fiscal year end market value of common stock, calculated as common shares outstanding (Compustat item #25) times the share price (Compustat item #199), is the company s fiscal year end book value of equity (Compustat item #60), and equals the company s fiscal year end book value of total assets (Compustat item #6). Additionally, I use the accounting profit rate as an alternative proxy for firm performance to test for the robustness of my results, which I calculate as: / (6) where: is the return on assets and equals a company s fiscal year end net income (Compustat item #172). B.2. Measuring managerial ownership As a first step, I rely on the same measure of managerial ownership used in the managerial ownership regressions and described in section 3.A.1.: the fraction of shares owned by the firm s CEO. However, Zhou (2001) provides evidence that managerial ownership measures relying on the fraction of shares owned show almost no within firm variation. Therefore, he argues that approaches that rely on this variation, like the fixed effects method, may fail to detect a relationship between ownership and firm performance even if one exists. Benson and Davidson (2009) build upon the Zhou (2001) critique and use a new measure of 20