Competition Laws, Governance, and Firm Value

Ross Levine is the Willis H. Booth Chair in Banking and Finance at University California Berkeley Haas School of Business; Chen Lin is the Stelux Professor in Finance at the University of Hong Kong; and Wensi Xie is Assistant Professor in Finance at the Chinese University of Hong Kong Business School. This post is based on their recent paper.

Policymakers increasingly call for strengthening antitrust laws. For example, the U.S. House Judiciary Committee’s Antitrust Subcommittee concluded a 16-month investigation in October 2020 by stressing the need to bolster antitrust laws, policies, and enforcement. In recent months, authorities in China, the European Union, Japan, and the United Kingdom have also signaled their intent to strengthen antitrust laws. The push for more stringent antitrust laws raises questions about the impact of such reforms on firms. In a recent paper, we provide what we believe is the first analysis of how changes in antitrust laws shape corporate valuations.

Economic theory offers conflicting predictions about the impact of antitrust laws that intensify competition on firm value. The agency view holds that because competition tends to force inefficient firms out of business, intensifying competition spurs firms to reduce inefficiencies. In particular, competition can induce firms to address inefficiencies associated with agency problems that allow managers to shirk, empire-build, tunnel, and engage in other actions that extract private benefits from the firms at the expense of shareholder value. Similarly, competition can generate information about managerial performance that shareholders use to mitigate agency problems. In contrast, other theories highlight how competition can reduce firm value. Intensifying competition tends to reduce market power, squeeze cash flows, and lower profits, putting downward pressure on valuations. Furthermore, by squeezing cash flows, competition lowers firm value by constraining firms from exploring long-run growth opportunities. These conflicting theoretical predictions about the impact of competition laws on firm value help motivate our empirical examination.

We examine the impact of antitrust laws that intensify competition on corporate valuations using a sample of about 200,000 firm-year observations, across 90 countries, from 1990 through 2010. To measure competition laws, we use the Competition Law Index compiled by Professors Anu Bradford and Adam Chilton. It measures for a panel of countries the degree to which antitrust laws and authorities limit firms from engaging in anticompetitive agreements, abusing dominant positions, and conducting mergers and acquisitions that restrict competition. Increases in the Competition Law Index signify more stringent antitrust laws that foster competition among firms. Indeed, we find that increases in the Competition Law Index are associated with subsequent decreases in the Herfindahl-Hirschman index of product market concentration. To measure corporate valuations, we use Tobin’s Q, which equals the book value of total assets plus the market value of equity minus the book value of equity, divided by the book value of total assets.

Consistent with the agency view, we find a positive and economically meaningful connection between the stringency of antitrust laws and firm values. The coefficient estimates imply that a one-standard-deviation increase in the Competition Law Index leads to a rise in Tobin’s Q equivalent to 8% of the sample mean of Tobin’s Q. The baseline regressions include firm and industry-time fixed effects to condition out all time-invariant firm and country characteristics (such as corporate culture or differences in corporate governance laws) and all time-varying industry factors (such as economic or technological shocks). The regressions also hold when including (or excluding) time-varying firm traits (e.g., size, age, leverage, and profitability) and each country’s level of economic development, financial development, property rights, government integrity, capital gains tax rates, and dividend tax rates.

We also evaluate the underlying mechanisms linking competition law stringency and valuations. Specifically, we test whether the association between competition laws and corporate valuations varies across countries, firms, and industries in ways consistent with the agency view.

The agency view stresses that competition laws that spur competition boost valuations by easing agency frictions. Therefore, a natural corollary of the agency view is that intensifying competition will improve governance and boost valuations more when there are larger pre-existing agency frictions. The intuition for this corollary is that competition will not materially reduce agency frictions if other corporate governance mechanisms have already alleviated those problems. To assess this corollary, we examine whether the association between competition laws and corporate valuations is stronger among (a) firms in countries with weaker investor protection laws that impede sound corporate governance, (b) firms with weaker firm-specific governance provisions, and (c) more opaque firms, as informational asymmetries tend to enhance the manifestation of agency frictions.

The evidence is strongly consistent with the agency view’s corollary that making antitrust laws more stringent boosts corporate valuations more when there are larger pre-existing agency problems. The competition-valuation nexus is (a) stronger in countries with weaker investor protection laws, (b) more pronounced among firms with weaker governance mechanisms, measured by internal governance quality, equal treatment of shareholder rights, and the use of provisions that entrench incumbent management (namely poison pills, blank checks, supermajority votes, golden parachutes, limited shareholder rights to call for special meetings, and classified boards), and (c) larger among firms that are informationally more opaque, as proxied by having less asset tangibility, fewer analysts covering the firm, and more earnings management.

We next evaluate another corollary of the agency view that focuses on pre-existing product market competition. The agency view stresses that making competition laws more stringent boosts valuations by intensifying competition and ameliorating agency problems. In this case, the impact of competition laws on valuations should be smaller among firms operating in industries that were already highly competitive before the change in competition laws. At the extreme, strengthening antitrust laws should have no impact on valuations in perfectly competitive industries, according to the agency view.

Consistent with the agency view, intensifying competition laws disproportionately boosts valuations among firms in more concentrated industries. These results provide additional support to the view that strengthening competition laws spurs competition, and the intensification of competition boosts valuations by mitigating agency problems.

As a final test, we examine the relationship between competition laws and firm-specific measures of operating efficiency. That is, we provide direct evidence on how making antitrust laws more stringent shapes firm behaviors. We use two operating efficiency measures. Selling, General & Administrative Expenses/Sales includes expenditures on items not directly involved in the manufacturing of goods or the provision of services, such as marketing and advertising expenses. The second measure, Staff Costs/Sales, equals wages paid to employees and other labor-related costs (such as employee benefits, pension expense, profit-sharing expense, insurance, etc.) divided by total sales. Albeit imperfect, researchers often use these measures to gauge firms’ operating performance and managerial slack. We use them to shed additional empirical light on why intensifying competition laws is associated with subsequent increases in corporate valuations.

We discover that intensifying competition laws is associated with improved operational efficiency among firms in economies with weaker investor protection laws. These findings are consistent with the agency view: strengthening antitrust laws lowers operating costs more in economies with weaker shareholder protection laws.

The complete paper is available for download here.

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