s capital markets around the world increasingly open
their doors to foreign investors, capital from abroad
is becoming an important source of financing for
local companies. Liberalizing capital markets, however, does
not always mean that foreigners are willing to supply capital
or that local companies are eager to receive it.
Poor corporate governance is one reason foreigners may
be reluctant to invest in certain companies abroad, according
to a recent study titled "Do Foreigners Invest Less in
Poorly Governed Firms?" by University of Chicago Booth
School of Business professor Christian Leuz, Karl Lins of the
University of Utah, and Francis Warnock of the University
of Virginia. In particular, foreigners are wary of investing in
a firm controlled by shareholders who are also its managers.
Foreign investors fear that these "insiders" may not act in
their best interest, and that it would be too costly to monitor
the managers and assess whether such an ownership structure
poses a threat.
Typically, the price of a firm's stock is expected to reflect
the consequences of weak corporate governance. Investors
protect themselves by lowering the price they are willing to
pay to ensure that they are getting a fair return. However, if
domestic investors have more information than foreigners
about the local business environment, then the price of the
firm's stock will reflect what the locals know but not the cost
that foreigners would have to incur in figuring out whether to
invest in a company. In other words, the share price will not
be low enough to adequately compensate foreign investors.
Locals have the upper hand in unraveling the activities
of corporate insiders, which puts foreign investors at a
significant disadvantage. In emerging markets where many
businesses are controlled by families, for instance, locals
have a better chance of understanding the complex and often
opaque nature of political and business connections, banking
relations, and other social and institutional factors that
can affect the quality of corporate governance. Locals have a
better sense of whether families run their companies in a way
that benefits everybody or engage in transactions that harm
outside investors. "For foreigners who are thousands of miles
away, it is much harder to make such assessments," says Leuz.
As a result, foreign investors may shy away from companies
with weak governance. The authors argue, however, that
understanding insider relationships and good governance
are likely to be more important in countries where investors
are poorly protected, and certainly more costly in countries
where firms provide little information publicly.
This probably explains why previous papers that have
looked at the impact of corporate governance on investing in
U.S. firms show very little effect, because shareholders in the
United States are well protected through effective disclosure
regulations and measures that safeguard outsiders' investments.
This is not the case in many other countries where
the information advantage that locals have could create a significant
wedge between the ability of a local and a foreigner
to assess firms.
Insider Control and Foreign Investment
The study analyzes the impact of corporate governance on
foreign holdings of U.S. investors for a large sample of firms
across many countries. Governance is measured as the extent
to which managers and their families control their companies.
A high level of control means it would be easier for
insiders to take advantage of small investors because their
decisions cannot be challenged by any other large group of
shareholders. Although the presence of powerful insiders is
not always bad, its implications are difficult for foreigners to
The study finds strong evidence that U.S. investors hold
significantly fewer shares in firms with high levels of managerial
and family control, but only when these firms are
located in countries with weaker disclosure requirements,
securities regulations, and outside shareholder rights. In
contrast, firms with substantial insider control that are located
in countries with strong investor protection and require
more transparency do not experience less foreign investment.
Looking at the effects of governance at both the level of
the firm and of the country makes sense, because the information
disadvantage faced by foreigners when considering
whether to invest in a company abroad could either be alleviated
or exacerbated by the quality of institutions of the country
where it is located.
In fact, the study shows that its findings do not simply
depend on a country's economic development but appear
to be directly related to its legal institutions and rules on
disclosure and investor protection. Previous papers have
noted that in Italy, which is considered a developed market,
favoring connected insiders at the expense of minority
shareholders may be tolerated at times within the country's
institutional and political frameworks. An emerging market
like Hong Kong, in contrast, has comprehensive and well-enforced
The Importance of Transparency
To find out if poor information is indeed at the center of the
study's results, the authors look at the impact of "earnings
management" on foreigners' decisions to invest abroad.
Under this practice, managers use their discretion in financial
reporting and the underlying
measurements are often based on
private information. This allows
insiders to make reported numbers
more useful in describing
performance, but they also can
abuse their discretion and private
information to manipulate earnings in order to give the
impression of a healthier bottom line.
Foreigners may stay away from firms that manage earnings
if they feel the practice substantially reduces transparency.
In fact, the study finds that investors hold fewer
foreign stocks if there is evidence of earnings management,
especially if the firm is located in a country with weak disclosure
requirements and investor protection.
The incentive to manipulate earnings is naturally higher
in firms where the ownership structure makes this easier
to do so, such as when managers and their families control
a company. To fully understand the mechanism behind the
relationship between corporate governance and foreign
investment, the authors analyze the combined impact on
foreign holdings if firms frequently practice earnings management
and if the company has a weak governance structure.
The authors find that in countries with little investor
protection, foreigners avoid investing abroad when earnings
management is prevalent and when there is a high level
of insider control. This combined effect is more significant
than the impact on foreign holdings of insider control alone,
which is expected since not all family-run companies deliberately
hide information from investors. These results confirm the authors' prediction that inadequate transparency
associated with poor corporate governance is what prevents
foreigners from investing abroad.
When Firms Say No to Foreign Capital
Given the study's indication that poor governance is a substantial
deterrent to foreign investment, firms could potentially
obtain more funding from abroad if they alter their
ownership structure or improve their disclosure practices
to make it easier for foreigners to evaluate their companies.
Regulators and governments aiming to substantially attract
more foreign investment also can change the set of rules and
laws that encourage insider control and opaqueness in the
first place, such as weak investor rights.
Leuz notes, however, that it is unclear whether all firms
would be willing to make changes especially if they have
other sources of capital that do not require more transparency.
"Whether firms want foreign capital depends also on
the country's political system and the way firms get domestic
financing," says Leuz.
In a another study by Leuz and Felix Oberholzer-Gee of
Harvard University that looks at the role of political connections
in firms' financing strategies in Indonesia, the authors
find that political connections and global financing are
actually substitutes. Firms with access to bank loans through
close ties with former President Suharto's regime were not
very interested in foreign capital. Instead, these well-connected
firms favored low-cost loans from state-owned banks
and disliked the accountability and scrutiny that comes with
publicly traded securities.
Thus, opening capital markets in this environment may
not necessarily lead to more foreign investment because
there is no incentive for firms to make themselves more
attractive to foreigners by improving corporate governance.
Institutional reforms that support good governance may
not be sufficient either in encouraging foreigners to bring
in more capital as long as firms do not have to raise money
from arm's length sources that force them to become more
transparent. "Institutional reform and political reform go
hand in hand," says Leuz.
"Do Foreigners Invest Less in Poorly Governed Firms?" Christian Leuz,
Karl V. Lins, and Francis E. Warnock. Review of Financial Studies,