Inheritance Law and Investment in Family Firms

This post comes from Fausto Panunzi of Bocconi University.

In my paper Inheritance Law and Investment in Family Firms (co-written with Andrew Ellul and Marco Pagano) which I recently presented at the Law, Economics and Organizations Seminar at Harvard Law School, my co-authors and I investigate whether inheritance laws reduce investment and growth in family firms. Inheritance laws may constrain entrepreneurs to bequeath a minimal stake to non-controlling heirs. The larger the portion of the founder’s assets to be assigned to non-controlling heirs, the lower the fraction left to the heir designated to remain at the helm of the firm. Absent any friction in capital markets, a lower wealth of the controlling heir would not affect the family firm’ ability to borrow and invest. But in the presence of capital market imperfections, it may hinder the firm’s investment.

In the context of a stylized model of succession in a family firm, we show that larger legal claims by non-controlling heirs on the founder’s estate lead to lower investment by family firms, as they reduce the firm’s ability to pledge future income streams to external financiers. To perform empirical tests, we collect data on inheritance law for 62 countries, mainly via questionnaires sent to law firms that are part of the Lex Mundi project. We measure the “permissiveness of the inheritance law” of each country as the maximum share of a testator’s estate that can be bequeathed to a single child, depending on the presence or absence of a spouse and the total number of children. We then merge this indicator with measures of investor protection and with data for 10,245 firms from 32 countries for the period 1990-2006.

We find that indeed the strictness of inheritance law is associated with lower investment and growth in family firms, while it leaves investment unaffected in non-family firms. Moreover, the negative effect of strict inheritance law on family firms’ investment is exacerbated by poor investor protection, which is also in accordance with the model. We also find that the results are mostly driven by family firms that experience succession in our sample period. It is precisely around and after succession that the effects of inheritance laws are mostly felt, because it is at this time that the decision on who is appointed as the controlling heir and his/her stake is determined. Indeed we find that during and after succession family firms experience a decrease in investment that is more severe for firms located in countries with stricter inheritance law. Also in this case, poor investor protection is found to exacerbate the effect of strict inheritance law, as well as having a direct negative effect on investment. Our results are robust to the use of different specifications of the investment equation, to the inclusion of inheritance taxes (which have no statistically significant effect on family firms’ investments), to different definitions of family firms and different measures of financial dependence.

The full paper is available for download here.

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