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Attracting Foreign Capital

Why Foreigners Invest Less in Poorly Governed Firms

Research by
Christian Leuz

Christian Leuz is Joseph Sondheimer Professor of International Economics, Finance, and Accounting and Richard N. Rosett Faculty Fellow at the University of Chicago Booth School of Business.

Firms with weak corporate governance are much harder and more costly for foreign investors to figure out.

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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 figure out.

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 disclosure requirements.

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, August 2009.