Corporate Governance Reforms and Firm-Level Allocation of International Capital Flows

by Yao Lu, University of Michigan.

Posted by R. Christopher Small, Co-editor on The Harvard Law School Forum, November 8th, 2010

In the paper, Corporate Governance Reforms and Firm-Level Allocation of International Capital Flows, recently made publicly available on SSRN, I investigate how investor protection (IP) of acquirer and target countries affects international capital flow allocation at the firm level. A simple model provides an explanation for a well documented but little understood phenomenon on international capital flows—namely, foreign acquirers’ tendency to target better-performing firms in emerging markets.

When the acquirer country has stronger IP than the target country, the foreign acquirer’s controlling shareholder values control premiums less than the controlling shareholder of the local target firm. Within a given legal environment, controlling shareholders of better-performing firms consume fewer private benefits because of the greater opportunity costs of foregoing profitable investment projects and, hence, they may demand lower control premiums. Lower control premiums, in turn, make these firms more attractive to foreign acquirers, who are subject to stronger-IP regulations and consume fewer private benefits.

This tendency to select better-performing targets becomes weaker (stronger) as the IP gap between the acquirer and target countries decreases (increases), because smaller (larger) IP gaps cause less (greater) disagreement on the value of control premiums at the country level.

These predictions are tested with data on cross-border acquisition bids. Among 35 acquirer and target sample countries, I identify corporate governance reforms (CGRs) undertaken by 26 countries, which are used to estimate the impacts of changes in the IP gap between acquirer and target countries on the cherry picking tendency. I find a significant decrease in the cherry picking tendency after weak-IP target countries reduce the IP gap by undertaking CGRs. In contrast, CGRs undertaken by acquirer countries increase the IP gap, exacerbating the cherry picking tendency among foreign bidders after their own countries enact CGRs.

These findings imply that weak IP in target countries impedes cross-border M&A markets from functioning fully. In particular, weak IP in target countries prevents poorly performing local firms from gaining access to foreign investors. These firms tend to have greater room for improvement, which can be facilitated by foreign capital and managerial know-how. Thus, the negative impact of weak IP is particularly damaging to the spread of the potential benefits of globalization. More generally, the results in this paper highlight the importance of investor protection in guiding international capital flows not only across countries, but also across firms within a country.

Finally, recent studies demonstrate that cross-border acquisitions are an important channel to transfer corporate governance systems from strong to weak legal regimes. However, this paper identifies an important distortion in that channel. The transmission of governance systems through cross-border acquisitions may occur only for firms that already have relatively sound governance systems, leaving firms with weak governance untouched. When weak-IP capital importing countries improve their legal environments, they help alleviate the distortion by inducing foreign acquirers to reach out to underperforming firms, which in turn enhances the allocation efficiency of foreign capital. However, when strong-IP capital exporting countries enact reforms to enhance legal IP, the reforms have the unintended consequence of exacerbating the distortion by inducing acquirers from those countries to further shy away from poorly performing firms.

The full paper is available for download here.

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