Rent Extraction by Large Shareholders: Evidence Using Dividend Policy in the Czech Republic

1. Rent Extraction by Large Shareholders:Evidence Using Dividend Policy in the Czech Republic Jan Bena, Jan Hanousek Round Table Seminar CERGE-EI, Prague May, 2006

2. Intro – Ownership, Corporate Governance and Firm Performance • Early surveys created a general presumption that the effect of privatization on firm performance is positive • Most recent studies used larger data sets and controlled for endogeneity/selection of ownership • Domestic private ownership has much less definite impact on performance • Foreign ownership (especially concentrated) has a positive effect on many performance indicators • For more details: Hanousek, Kočenda, Svejnar (2006), also a survey Estrin, Hanousek, Kočenda, Svejnar (invited to JEL, 2006).

3. Intro – Ownership, Corporate Governance and Firm Performance • New evidence: • Privatization to domestic owners has only limited effects on performance • Only privatization to (certain types) of foreign owners appears to have improved efficiency of firms • effect of the state not only negative

4. Motivation:State of the Literature • Empirical tests do not point out single main driving force behind corporate payout policy in cross-section • Empirical tests of corporate dividend behavior carried out almost exclusively using data from the most developed countries • Existing theoretical literature addresses predominantly the U.S. experience

5. Motivation:Questions • Does ownership structure affect dividend policy? • Concentration, Type, and Nationality • How are benefits from firms distributed among shareholders • Do majority shareholders steal profits from minority shareholders? • Are dispersed shareholders able to extract dividends from firms run by managers?

6. Contribution • Evidence that ownership structure determines corporate payout policy • Dividend policy in the Czech Republic reflects the conflict among shareholders how to distribute benefits from firms • The first empirical study of dividend behavior in the Central and Eastern Europe • Important robustness check to established theories since we are using data from country with unique recent economic history and institutional setting

7. Outline • Stylized Facts about Corporate Dividend Policy • Survey of Dividend Theories • Dividend and Capital Gains Income Taxation • Closest Papers Review • Specific Features of the Czech Economy • Ownership Structures • Model & Data • Estimation Technique • Endogeneity of Ownership • Results

8. Stylized Facts about Corporate Dividend Policy • Long-term target dividend payout ratio • Changes in dividends rather than absolute levels: initiations, omissions, increase/decrease announcements • Dividend smoothing • Changes in dividends reflect changes in long-term ability of firms to generate earnings • Managers increase dividends only when they are confident that increased earnings are permanent • Managers decrease dividends only in financial distress

9. Survey of Dividend Theories • Lintner (1956): partial adjustment process towards a target payout ratio • Free Cash Flow Theory Divert free funds managers have power over within corporations away from them • Theory: Easterbrook (1984); Jensen (1986); Zwiebel (1996) • Empirics: Gugler (2003); DeAngelo, DeAngelo, and Stulz (2004); Desai, Foley, and Hines (2002); Dewenter and Warther (1998); Laporta, Lopez-de-Silanes, Shleifer, and Vishny (2000)

10. Survey of Dividend Theories, cont. • Signaling Theory Communicate the level and growth of earnings or future prospects of the company to investors • Theory: Bhattacharya (1979); Miller and Rock (1985) • Empirics YES: Bernheim and Wantz (1995); Amihud and Murgia (1997) • Empirics NO: Benartzi, Michaely, and Thaler (1997)

11. Survey of Dividend Theories, cont. • (Tax) Clientele Theory • Some investors benefit from special treatment in the tax law • Summary: Allen, Bernardo and Welch (2000)

12. Dividend and Capital Gains Income Taxation • Companies distribute dividends from after-tax-profits • Same income dividend tax treatment applied to individuals and corporations • Flat tax rate 25 %; in 1999 lowered to 15 % • Foreign owners: tax treaty between Czech Republic and the country of the receiver • Double taxation of dividends prevented • Marginal tax rate on cash dividends is the same for all types of shareholders • Tax considerations or tax clientele effects cannotdrive cross-sectional differences in dividend policies

13. Closest paper: Gugler (2003) • Estimates the effect of ownership on dividend policy using data from Austria • Ownership and control structure of a firm is a significant determinant of its dividend policy • State-controlled firms • Engage in dividend smoothing, have the highest target payout ratios, are the most reluctant to cut dividends • Family-controlled firms • Do not smooth dividends, are the least reluctant to cut dividends

14. Closest paper: Gugler and Yurtoglu (2003) • Analyze dividend announcements and pay-out ratios in Germany -- Look at the conflict between large controlling shareholder and minority shareholders arising from private benefits of control • Dividends are device for small shareholders to limit rent extraction by controlling owners • "Majority-controlled and unchecked" firms have the smallest target pay-out ratio • "Majority-controlled and checked" firms have the largest target pay-out ratio

15. Major differences from previous papers • Czech economic environment and institutional setting is very different from the one in Austria (Germany) • We benefit from a large sample • We use a different estimation technique to account for specifics of an emerging market environment (including privatization)

16. Specific Features of the Czech Economy • Privatization • Ownership structure of Czech companies was primarily set (exogenously) by government bureaucrats • Economy was privatizedand deregulated fairly quickly • Market forces drove majority of economic activity very early during transition • Ownership structure stabilized after 1996

17. Specific Features of the Czech Economy, cont. • Legal Uncertainty • Evolution of institutional and legal framework was considerably slower • Lawmakers were well behind the economic activity • Corporate law incomplete and kept changing literally every year • Slow / weak law enforcement

19. Ownership Structures: Concentration • Large shareholding is the most important control device in the Czech Republic • Only highly concentrated owners are able to control managers effectively • Because of underdeveloped legal system and financial market, dispersed ownership structures cannot enjoy benefits from • Greater market liquidity and • Better risk diversification

20. Ownership Structures:Variables Definition • Domicile -- Czech, Foreign • Type -- State, Private individual, Industrial firm, Financial institution • Concentration- Czech corporate law assigns control rights to different ownership levels: • Majority > 50.0% • Blocking minority > 33.3% and ≤ 50.0% • Legal minority > 10.0% and ≤ 33.3% • Minority ≤ 10.0% • We define concentration of ownership variables: majority, monitored majority, minority, dispersed

21. Starting Model • Benartzi, Michaely, and Thaler (1997): "... conclusion we draw from [our] analysis is that Lintner's model of dividends remains the best description of the dividend setting process available." • Lintner's Model • Ownership Structure Determines Dividend Payments

22. Model: Control Variables • Firm Size (Total assets) • Leverage (Total liabilities / Total assets) • Bank Power (Bank loans / Total liabilities) • CashHoldings (Cash / Total Assets) • Growth Opportunities (Industry level sales growth rate) • Year dummies

23. Data • Medium and large non-financial companies traded on the Prague Stock Exchange • Fix the population by choosing 1,664 companies privatized in 1991-1995 • Financial and ownership data from database ASPEKT • To estimate dividend equations we use data from 1996-2003 (post-privatization market economy period) • Data from 1991-1994 (privatization period) are used as instrumental variables that allow us to control for the endogeneity of ownership • Privatization period data come from the Ministry of Privatization

24. Descriptive Statistics: Dividend Payments

25. Problems with direct application of the Lintner's model • Fewer firms paying dividends (<10% of sample) hence OLS estimation leads to biased results • Missing financial data (weak market supervision), more pronounced for those not paying dividends (about 50%) • Our study follows privatization when the ownership is potentially endogenous with respect to corporate performance (e.g., state versus private, domestic versus foreign).

26. 2 Stage Estimation Procedure • STAGE 1:Decision to pay dividends Estimated as binary 0/1 regression, ownership and control variables Options:probit, logit, linear probability, tobit.. • STAGE 2:Conditional decision about the size of dividend paid. Classical regression model on a subset of firms decided to pay dividends • Options: OLS, IV, GMM, or use Heckman selection procedure (combination Stage 1)

27. How to Fix for Missing Financial Data? • STAGE 0: Heckman selection procedure (“Heckit”), inverse Mills ratio included in the first stage. variables related to not reporting and optimally not used later • Size -- Total number of Shares (TNS) and NS offered under the voucher privatization (NSVP) • Previously having problems with reporting: set of 0/1 indicators of missing financial data (profit,sales, debt, and the number of employees) in priv. projects (91-93) • VP characteristics -- average price, total holdings (in %) of the investment privatization funds and individual investors.

28. How to Fix for Endogeneity of Ownership? • Hanousek, Kočenda, and Švejnar (2004): ownership is endogenous with respect to corporate performance • Expect bidirectional link between ownership structure and the decision to pay dividends • Therefore we should account for possible endogeneity of ownership: • A) Use a reduced form equation (PROBIT) to predict the type of the single largest owner • B) Use linear probability model in STAGE 1 anduse standard IV techniques here

29. LPM is Optimal Choice for the First Stage • See Angrist and Krueger (2001) for a deep discussion.. • The linear probability model allows to instrument ownership and provides consistent estimates under standard assumptions, while probit regression with plugged predicted values of ownership "do not generate consistent estimates unless the nonlinear model happens to be exactly right, a result which makes the dangers of misspecification high" (ibid). • Also, the linear probability model can be corrected for sample selection. (We redo the first stage using probit as a robustness check.)

30. Estimation Technique:STAGE 0 • STAGE 0: Heckman regression for missing financial data • Regression using I[missing]as a binary response

31. Estimation Technique:STAGE 1 • STAGE 1: Decision to pay dividends (0-1 variable) • Regression using I[Di,t > 0]as a binary response We also included a set of control (financial) variables and efficiency measures..

32. Additional Variables in STAGE 1: • Control variables: total assets, total liabilities to total assets, bank loans to total liabilities, cash holdings to total assets, and the growth rate of average sales in the industry the firm is part of excluding the firm itself. • Efficiency measures: profit (or total sales) to total assets and total sales to total labor costs.

33. Estimation Technique: STAGE 2 • STAGE 2: Conditional decision about the size of dividend paid • OLS regressionon a sub-set of firms paying dividends (Di,t > 0)

34. Results Summary: Main Specification

35. Results Summary: Main Specification, cont.

36. Results (Domicile & Concentration) • A dominant majority owner pay dividends less often and their target payout ratio is small. • Checked majority owners pay dividends more often and the target payout ratio is large. • Dominant owners extract rents from firms and that strong minority shareholders can prevent this behavior. • Interference with institutional framework

37. Robustness Checks • LOGIT/PROBIT in Decision to Pay Dividends Eq. • Earnings Measures: Operating profit, Profit after/before income tax, Including/excluding extraordinary items • Control Variables: Industry dummies for growth opportunities • Earned Equity • Retained earnings / Total equity • Dividends before they are paid out • Coefficients in front of ownership dummiesremain significant and almost unchanged

38. Descriptive Statistics: Ownership Concentration

39. Descriptive Statistics: Nationality of SLO