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

Czech Republic

Jan Bena, Jan HanousekRound Table Seminar

CERGE-EI, PragueMay, 2006

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).

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

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

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?

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

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

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

Survey of Dividend Theories

Lintner (1956): partial adjustment process towards a target payout ratio

Free Cash Flow TheoryDivert 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)

Survey of Dividend Theories, cont.

Signaling TheoryCommunicate 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)

Survey of Dividend Theories, cont.

(Tax) Clientele Theory Some investors benefit from special treatment

in the tax law Summary: Allen, Bernardo and Welch (2000)

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 cannot drive

cross-sectional differences in dividend policies

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

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

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)

Specific Features of the Czech Economy

Privatization Ownership structure of Czech companies was

primarily set (exogenously) by government bureaucrats

Economy was privatized and deregulated fairly quickly

Market forces drove majority of economic activity very early during transition

Ownership structure stabilized after 1996

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

Number of Phrases "with exception of" and Total Number of words in the Czech Income Tax Law (1993 - 2004)

30

50

70

90

110

130

150

170

190

210

230

250

Date when Came into Force (Total number of updates is 52)

Num

ber o

f exc

eptio

ns

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

Num

ber

of w

ords

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

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

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

Di,t i i i,t 1 iDi,t 1 i,t

Di,t j

j j j i,t 1 jDi,t 1 OWNj i,t i,t

Model: Control Variables

Firm Size (Total assets)

Leverage (Total liabilities / Total assets)

Bank Power (Bank loans / Total liabilities)

Cash Holdings (Cash / Total Assets)

Growth Opportunities (Industry level sales growth rate)

Year dummies

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

Descriptive Statistics: Dividend Payments

  Year NOB

Number of companies paying dividends in a given year

1996 711997 861998 751999 612000 632001 582002 54

  Total 468

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).

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)

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 laterSize -- 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.

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 and

use standard IV techniques here

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.)

Estimation Technique: STAGE 0

STAGE 0: Heckman regression for missing financial data

Regression using I[missing] as a binary response

),,),93/91(,,,(][ IIIPFAPMissFNSVPTNSconstfMissFI

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..

)),.1(,.),(,(][ 9896, MILLStDIVTjOWNconstfDI ti

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.

Estimation Technique: STAGE 2

STAGE 2: Conditional decision about the size of dividend paid

OLS regression on a sub-set of firms paying dividends (Di,t > 0)

Di,t j

j j j i,t 1 jDi,t 1 OWNj i,t

1TA i,t 2TLTA i,t

3BLTL i,t

4CHTA i,t

5grSA i, t1t

MILLSi,t i,t

#

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Results Summary: Main Specification

 

Marginal Contribution to Probability

To Pay Dividends

Target Payout Ratio

Weight Placed on Current Earnings

  % % %Czech 11 49 13

Foreign 35 60 46Industrial 14 47 56

(Cz) Financial(F) Financial

24100

9999

5454

Results Summary: Main Specification, cont.

 

Marginal Contribution to Probability

To Pay Dividends

Target Payout Ratio

Weight Placed on Current Earnings

CZ Majority 10 47 13CZ Monitored

Majority 16 45 82

F Majority 26 72 61F Monitored

Majority 58 85 86

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

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 dummies remain

significant and almost unchanged

Descriptive Statistics: Ownership Concentration

    Mean Std. Dev. NOBTotal Assets Majority 1,0E+06 7,9E+06 1 775

Monitored 1,4E+06 8,2E+06 2 235Dispersed 1,9E+06 9,0E+06 1 866

Dividend / Profit Majority 0,040 0,68 1 775Monitored 0,026 0,29 2 235

  Dispersed 0,032 0,16 1 866Profit / Total Assets Majority 0,02 0,16 1 719

Monitored 0,04 0,24 2 204Dispersed -0,01 0,12 1 853

Liabilities / Total Assets Majority 0,40 0,28 1 719Monitored 0,63 0,36 2 204

  Dispersed 0,35 0,24 1 853Sales / Staff Costs Majority 8,00 37,29 1 719

Monitored 15,91 38,51 2 204  Dispersed 6,31 7,72 1 853

Descriptive Statistics: Nationality of SLO

    Mean Std. Dev. NOBTotal Assets Czech 1,0E+06 7,4E+06 5 786

  Foreign 1,8E+06 7,6E+06 844Dividend / Profit Czech 0,012 1,25 5 786

  Foreign 0,068 0,27 844Profit / Total Assets Czech -0,01 0,29 5 688

  Foreign 0,05 0,15 827Liabilities / Total Assets Czech 0,48 0,35 5 688

  Foreign 0,43 0,34 827Sales / Staff Costs Czech 11,42 46,78 5 688

  Foreign 9,62 19,13 827