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Institutions and Organizational Structure: The Case of State-Owned Corporate Pyramids

Institutions and Organizational Structure: The Case of State-Owned Corporate Pyramids. Joseph P.H. Fan T.J. Wong Tianyu Zhang The Chinese University of Hong Kong. Emergence of Chinese State Owned Corporate Pyramids.

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Institutions and Organizational Structure: The Case of State-Owned Corporate Pyramids

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  1. Institutions and Organizational Structure: The Case of State-Owned Corporate Pyramids Joseph P.H. Fan T.J. Wong Tianyu Zhang The Chinese University of Hong Kong Organization and Value

  2. Emergence of Chinese State Owned Corporate Pyramids • Since the 1990s China witnessed a wave of enterprise restructuring in which state assets were spun off from parent state-owned enterprises (SOEs) and injected into their newly set up subsidiaries. • The organizational transformation is typically through several rounds of joint ventures established by SOEs and their subsidiaries with other government and SOE partners. A subsidiary may further spin off assets into another newly created subsidiary, and so on. • The system of state-owned companies forming China’s business groups is called “Multi-layer Legal Person System (多级法人制)” (Wu, 2005). Organization and Value

  3. SOE Under Old System Central Govt SOE

  4. SOE Under New System Central Govt CSRC, Judicial Courts Banks Local Govt / SAMB Market competitions Product and jurisdictions Parent SOE / SAMC External auditors Listed SOE Outside Shareholders Board of directors Managers

  5. Types of Control of SOEs in China SAMB SAMB SAMB Parent SOE/SAMC Parent SOE Listed Firm Listed Firm Intermediate Companies Listed Firm

  6. Pyramidal Organizational Structure in China(Multi-layer Legal Person System) Organization and Value

  7. Pyramidal Organizational Structure X X V=50% Y V=C=50% Y V=C=10% Z V=20% Z V = 20%, weakest link in the chain, C = 10%. Pyramid structure allows leveraging up in control Organization and Value

  8. Why pyramiding? • Highly popular around the world • Why the owner builds pyramid is a puzzle • Few theoretical and empirical works • Morck, Wolfenzon, Young (2004); Khanna and Yafeh (2005) • Tax (Morck, 2005) • Facilitating business group formation • Relieving financial constraints while preserving control (Almeida and Wolfenzon , 2006) • Expropriation due to separating control from ownership Organization and Value

  9. Why Chinese build pyramids? • No prior research • Ownership transfer restriction of SOEs precludes equity financing and expropriation as primary motives • Separation between ownership and control of SOEs is small • Cash flow over voting rights of common stocks Organization and Value

  10. Why pyramiding?Our new hypothesis • Credibly decentralizing decision rights within organization • From a controlling owner (headquarter) to a local (divisional) manager • Intermediate layers associated with high information cost, making the owner difficult to intervene the manager’s daily decision process • Compared with a horizontal control structure, a pyramidal structure allows local managers more autonomy in decision making Organization and Value

  11. Theories of Firm Decentralization • Williamson (1985): decentralization provides manager high-power incentive • Jensen and Meckling (1992): the gain of decentralization arises from co-locating knowledge and decision rights • Credibility of decentralization depends on how costly is ex post intervention • The IO literature emphasize information cost as a credible commitment (Cremer, 1995; Aghion and Tirole, 1997; Baker, Gibbson, Murphy, 1999) • The extent of decentralization is constrained by the cost of losing control (agency problem) • Evidence is sparse: Baker (1992), Rajan and Wulf (2006) Organization and Value

  12. Division of Power in SOEs • The government, lack of managerial expertise and information, will typically empower managers • Gain from the autonomy might be expropriated by managers – agency problem • However, empowering managers means lower government intervention – political cost • Optimal division of power should be the point where marginal agency cost equals marginal political cost Organization and Value

  13. Ownership Transfer Restriction and Pyramiding of SOEs • The ownership restriction of SOEs prevents outright sales (such as M&As, MBOs) as a means to transfer decision rights that is common in markets of diffused ownership (Burkart, Gromb, Panuzi, 1997) • Pyramiding is a way of decentralizing business decision rights, or establishing real authority (Aghion and Tirole, 1997) as oppose to formal authority, short of actual transfer of ownership • Compared with a policy order, decentralization through pyramid is more credible to firm management • Credible because of high information and bureaucratic costs if the government intervenes ex post Organization and Value

  14. This research focuses on local government controlled firms upon their going public Organization and Value

  15. China –One Country, Many Systems Protection for property rights High Low Middle Missing Organization and Value

  16. Predictions of the Extent of Pyramidal Layers Controlling a Publicly Listed SOE • A government owner’s (whose transfer rights is restricted) pyramiding (decentralization) decision is affected by his conflict with the firm in objective and the degrees of managerial agency problem • Regional unemployment problem (-) • Fiscal health (+) • Government long-term incentive (R&D and education expenditure) (+) • The degree of conflicts of interest reduces when the market and the laws provide strong disciplines • Regional market development (+) • Regional legal environment (+) • Regional property rights protection (+) • Government deregulation (+) Organization and Value

  17. Empirical Design • Regression (probit) analysis to find the determinants of pyramids • Regression analysis to find whether firm performance/productivity is related to the pyramidal control structure Organization and Value

  18. Determinants of pyramids (probit regressions) Organization and Value

  19. Two-stage model Organization and Value

  20. Control Pyramids and Managerial Professionalism • More decentralized firms, more managerial professionalism • More decentralized firms, higher productivity • We do not claim causality Organization and Value

  21. Pyramidal Structures and Management ProfessionalismCEO and Chairman Organization and Value

  22. Pyramidal Structures and Management ProfessionalismBoard of Directors Organization and Value

  23. Pyramidal Structures and Employment Efficiency Organization and Value

  24. Structures and Total Factor Productivity Organization and Value

  25. Pyramidal Structures and Tobin’s Q Organization and Value

  26. Pyramidal Structures and Accounting Returns Organization and Value

  27. Government Government Parent SOE Firm A Firm B Survey of Bureaucrats in State Asset Management System the response from 15 government bureaucrats in state assets management system with regards to control of firms under different structure. 1 - if the government has more control of firm A’s particular decision than firm B’s. 0 - if the government has the same level of control over firm A and B’s decision. -1 - if the government has more control of firm B’s decision than firm A’s. Organization and Value

  28. Survey among bureaucrats in state assets management system Organization and Value

  29. Survey of Senior managers • 12 responses from SOEs and 19 from non-SOEs. • Does government set limit on a particular firm decision • 1-No limit; 2-Some limit; 3-Many limits; 4-Completely limit Organization and Value

  30. Survey among senior management Organization and Value

  31. Summary of Findings • The extent of a government-controlled pyramid is positively related to local government’s decentralization incentive • Positive relation between the pyramidal control structure and firm performance/efficiency • Positive relation between pyramidal control and managerial professionalism and productivity • Survey of bureaucrats and managers confirms our hypothesis Organization and Value

  32. Conclusions and Future Research Implications • The pyramidal ownership structures of China’s state enterprises are fundamentally related to state ownership transfer restriction • It is the right to transfer, not cash flow or voting right, that is of first order importance in shaping owners’/managers’ incentives • We need more research on the effects of these (and other) property rights constraints on firm behaviors • How general are the results? • Any state owned pyramids outside China? • Can the decentralization explanation of pyramiding behavior be generalized to private firms? Organization and Value

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