Do Foreigners Invest Less in Poorly Governed Firms?

This post comes to us from Christian Leuz of the University of Chicago, NBER and ECGI, Karl V. Lins of the University of Utah, and Francis E. Warnock of the University of Virginia and NBER.

In our forthcoming Review of Financial Studies paper entitled Do Foreigners Invest Less in Poorly Governed Firms? we investigate the factors that make investors shy away from providing capital to foreign firms. Poor corporate governance is one factor that draws considerable attention from outside investors and regulators. Institutional investors frequently claim that they avoid foreign firms that are poorly governed. In addition, regulators are concerned that weak governance and low transparency hinder foreign investment and impede financial development. At the same time, outside investors who fear governance problems and expropriation by insiders can reduce the price they are willing to pay for a firm’s shares. As a result of price protection, even poorly governed firms should offer an adequate return, raising the questions of whether and why governance concerns manifest themselves in fewer holdings by foreign outside investors.

Our sample consists of 4,409 firms from 29 countries for which we have comprehensive data on foreign holdings by U.S. investors in 1997. As there can be a host of reasons why foreign investors avoid or seek stocks from a particular country, such as the degree of market integration, benefits from diversification, transaction costs, restrictions on capital flows, proximity, and language, we control for country fixed effects in our tests. Thus, we analyze which stocks U.S. investors choose within a given country. We find strong evidence that U.S. investors hold significantly fewer shares in firms with high levels of managerial and family control when these firms are domiciled in countries with weaker disclosure requirements, securities regulations, and outside shareholder rights, or in code-law countries. In contrast, firms with substantial managerial and family control do not experience less foreign investment when they reside in countries with extensive disclosure requirements and strong investor protection. This effect is particularly pronounced when earnings are opaque, indicating that information asymmetry and monitoring costs faced by foreign investors likely drive the results.

Our results across countries with different institutions are consistent with the interpretation that, for foreign investors, information problems for firms with potentially problematic governance structures play an important role. Stringent disclosure requirements make it less costly to become informed about potential governance problems. They level the playing field among investors making it less likely that locals have an information advantage. Strongly enforced minority shareholder protection reduces the consumption of private control benefits and thus decreases the importance of information regarding these private benefits. In contrast, low disclosure requirements and weak investor protection exacerbate information problems and their consequences.

The full paper is available for download here.

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