Corporate Governance and Internal Capital Markets

In our paper, Corporate Governance and Internal Capital Markets, which was recently published on SSRN, my co-author, Zacharias Sautner, and I take advantage of a unique opportunity for a natural experiment provided by a recent tax change in Germany to explore the link between corporate governance and internal capital markets. In 2002, the prevailing 52% corporate tax on capital gains from investments in other corporations was repealed, thus eliminating a significant barrier to changes in ownership structures. The tax repeal affected most large shareholders in German corporations since, in addition to companies, banks, and other financial institutions that are commonly organized in corporate form, most wealthy individual and family shareholders in Germany hold their shares through intermediate corporations (La Porta, López de Silanes, and Shleifer (1999); Franks and Meyer (2001); Faccio and Lang (2002)). Indeed, the tax change gave rise to a significant reshuffling of corporate ownership structures. This exogenous shock allows us to overcome or at least mitigate concerns about the endogeneity of ownership in estimating its effect on internal capital markets.

The significant change in ownership structures that resulted from the German tax reform offers an additional advantage from an econometric point of view: It creates a longitudinal variation that is unusual in ownership studies and which, combined with the already-large cross-sectional variation in German ownership structures, allows us to identify the effects of ownership changes and structure with much greater statistical power than what could be obtained from U.S. data. Moreover, because German corporations disclosed segment information during our sample period, we are able to compute measures of diversification and internal capital market efficiency similar to those used by other researchers on U.S. data.

We find that firms with more concentrated ownership are less diversified and have more efficient internal capital markets. These findings are consistent with the theoretical arguments in Bolton and Scharfstein (1998) and Scharfstein and Stein (2000), which suggest that capital misallocations are partly a result of poor corporate governance. Our paper thus contributes to the internal capital markets literature by providing direct evidence of the effect of governance structures on how these markets work. In addition, our paper also contributes to the corporate governance literature by providing new evidence about the benefits and costs of ownership concentration. Ownership concentration as a governance mechanism can be a double-edged sword, since it can mitigate the agency problem between minority shareholders and managers (due to large shareholders’ greater incentives to monitor the managers) but it can bring about another agency problem, between large and small shareholders. (Burkart, Panunzi, and Shleifer (2003) provide a formal model of this tradeoff).

Because corporate diversification also has benefits and costs, our finding that firms with more concentrated ownership are less diversified can be interpreted in one of two ways. If diversification is overall value-destroying and internal capital markets are inefficient, corporate diversification can be seen as the outcome of an agency problem where either managers or controlling shareholders lead their companies to diversify to make up for their lack of personal diversification or extract other private benefits at the expense of minority shareholders, who only bear the costs. Under this view of diversification, our results would thus suggest that the agency benefits of ownership concentration outweigh its agency costs, since large shareholders are not only able to successfully prevent self-interested managers from diversifying the company’s business; their large equity stakes act as a commitment device for them not to engage in value-destroying diversification themselves. On the other hand, if diversification is value-enhancing, our results would suggest that the net benefits of ownership concentration are negative. Given Lins and Servaes (1999) finding of no diversification discount in Germany, our results imply that the benefits and costs of ownership concentration just offset each other. However, our own finding that more concentrated ownership leads to more efficient allocation of internal resources suggests that the net benefits of ownership concentration may in fact be positive.

Our findings have significant policy implications. To the extent that the German tax reform was meant to reduce ownership concentration and to improve minority investor protection in the country, our results suggest that the reform may have in fact been counterproductive. The broader policy implication is that lawmakers and regulators should be cautious when trying to harmonize corporate governance systems across countries with different institutional contexts and different governance mechanisms in play.

The full paper is available for download at here.