Journal of Business and Policy Research Volume 5. Number 2. December 2010 Pp.

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The Effects of Ownership Structure on Operating Performance of Acquiring Firms in Emerging Markets
Tze-Yu Yen and Paul Andr
This paper determines the effect of ownership structure, governance mechanisms, and legal systems on long term operating performance of acquiring firms in emerging countries. The major finding is that the acquiring firms with controlling shareholders (especially holding ownership between 25%-30%) improve post acquisition operating performance over three years after transaction. Board composition indexes for acquiring firms in emerging countries are more influential to post acquisition performance than those of CEO position and block-holders. Value creating deals associate with higher quality accounting standards and superior investor protection of emerging market countries.

Field of Research: Mergers and Acquisitions, Ownership Structure, Corporate Governance, Legal Institutions, Emerging Markets

1. Introduction
One of the most important drivers of corporate performance in the past twenty years is the level of merger and acquisition (M&A) activities companies are involved in. The 1990s merger wave peaked in 2000 encompassed megadeals, globalization, and consolidation in telecommunications, media, and technology (TMT) industries. Companies invested billions of dollars making acquisitions but most empirical studies show that shareholders of acquiring firms experienced significant loss on average, or at best broke even (Agrawal, Jaffe & Mandelker, 1992; Goergen & Renneboog, 2004). The lessons of this wave not only moved academics to investigate factors leading to value reduction, but also gave rise to the revolution in corporate governance among companies worldwide. Data supplied by Thomson Financial (TOB) indicate that the pace of the recent merger wave has been gradually recovering and strengthening since 2002. A significant aspect of this trend has been the rapid growth of Asian M&A transactions with a non-large amount deals value. With strong financial resources and broad domestic markets, these emerging market businesses
Tze-Yu Yen, Department of Finance, National Chung Cheng University, email: fintyy@ccu.edu.tw Paul Andr, Business School, ESSEC, email: andre@essec.fr

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have not only consolidated domestic enterprises to gain size advantage, but also attempted to make a giant leap forward in Europe and the United States market by conducting global M&As. To be expected, emerging competitors in the near future will present a potential threat to companies in developed countries and change the face of the world economy.
A recent leading work by La Porta, Lopez-de-Silanes & Shleifer (1999) points out that one or two shareholders who own a large percentage of the firms shares control most public corporations worldwide. Especially in emerging market countries, a particular family often controls corporations and listed companies. Controlling owners may have more

incentive to maximize firm value because firm performance closely links to their welfare (Jensen & Meckling, 1976; Shleifer & Vishny, 1986).But when owners cannot separate their own financial preference from those of minority shareholders, they have more power to act on their own interest at the expense of firm performance through specific corporate decisions (La Porta et al., 1999; Claessens, Djankov & Lang, 2000). The affect of ownership concentration on corporate performance is still a question for discussion. In general, the solution for these agency concerns is to enhance monitoring mechanisms in corporate systems (firm-level) and request the Government to enact a comprehensive law to protect investors (country-level). This paper joins the ongoing debate by investigating the effects of concentrated ownership, governance mechanisms, and legal protection on corporate performance of acquiring firms in emerging market countries. Referring to arguments that short term market performance may not fully capture anticipated benefits from an acquisition (Hitt, Harrison, Ireland & Best, 1998), this paper follows the work of Healy, Palepu & Ruback (1992) and takes long term operating cash flows as performance measures to examine M&A value creation. Based on a sample of sixty-nine deals over 1998-2004 in thirteen emerging countries including English, German, and French legal origins, we find that
acquiring firms with controlling shareholders (especially holding ownership between 25%30%) improve post acquisition operating performance over three years after transaction. Board composition indexes for acquiring firms in emerging countries are more influential to post acquisition performance than CEO positions and block-holders do. Value creating

deals associate with higher quality accounting standards and superior investor protection of emerging markets.

2. Literature Review
Prior studies focusing on the relationship between ownership and firm performance show that firm value increases with ownership of the largest shareholders (McConaughy, Walker, Henderson & Mishra, 1998; Claessens, Djankov, Fan & Lang, 2002; La Porta, Lopez-de-Silanes, Shleifer & Vishny, 2002; Anderson & Reeb, 2003). In contrast, other studies suggest that without effective monitoring, controlling shareholders are likely to exploit minority shareholders and make sub-optimal decisions when control rights exceed cash flow rights (Faccio, Lang & Young, 2001; Cronqvist & Nilsson, 2003). Many studies also suggest that the relationship may not be linear (Anderson & Reeb, 2003; Morck, Shleifer & Vishny, 1988; McConnell & Servaes, 1990). 218

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Another branch of ownership research centers on separation problems which indicate that controlling shareholders often have greater control rights than cash flow rights because of pyramidal structures, cross-holdings, dual class shares, and various other control devices (La Porta et al., 1999; Claessens et al., 2000). This separation provides an opportunity for controlling shareholders to expropriate minority shareholders and therefore has a significantly negative effect on firm performance (Claessens et al., 2000; La Porta et al., 2002; Faccio & Lang, 2002; Cronqvist & Nilsson, 2003). Based on the costs of concentrated ownership, governance research has generally examined the following mitigating factors. The first one is board structure. Academics, regulators, and shareholder activists generally suggest the size of the board (not too large and not too small) and separating the CEO/COB position leads to better governance (Rosenstein & Wyatt, 1990; Weisbach, 1988; Vefeas & Theodorou, 1998; Brickley, Coles & Jarrell, 1997). The second factor is CEO position. Whether an individual who is the dominant shareholder should occupy the seat of CEO is still debatable. Anderson & Reeb (2003) suggested that with effective outside monitors, family CEOs might provide essential firm-specific expertise and reduce agency problems. Many researchers, however, offer a different view: dominant CEOs may more easily entrench themselves and thus deviate from firm value maximization (Sharma & Ho, 2002; Barth, Gulbrandsen & Schonea, 2005). The third factor relates to other large shareholders. Large block holders such as institutional investors, have the means to monitor and influence the controlling shareholder (Andr, Kooli & L'Her, 2004). Maury & Pajuste (2005) showed that not only the presence, but also the equal distribution of voting shares among block holders, has positive effect on firm value. Recent papers have emphasized the importance of legal institutions in protecting investors and limiting self-dealing by controlling shareholders. La Porta, Lopez-de-Silanes, Shleifer & Vishny (LLSV, 1998) formed an antidirector rights index to measure the level of shareholder rights and concluded that the average anti-director right index in English origin countries is significantly better than that in the other countries with different legal origins. Comparing to the wide discussion about corporate governance mechanisms on general firm performance, there is relatively scarce theoretical or empirical research to provide evidence on the relationship between governance mechanisms and specific acquisition performance. One stream of governance researchers proved the incentive effect by showing that increasing insiders ownership has positive effect on acquirers returns (Lewellen, Loderer & Rosenfeld, 1985; Carline, Linn & Yadav, 2002; Yen & Andr, 2007). However, the other stream of governance researchers has argued that majority shareholders, have stronger power to expropriate minority shareholders via M&A events, especially when they can separate their control rights from their cash flow rights (Conyon & Murphy, 2002; Holmen & Knopf, 2004; Bae, Kang & Kim, 2002; Ben-Amar & Andr, 2006; Faccio & Stolin, 2006). Researches regarding the effects of ownership, governance mechanisms, and legal/ extralegal systems on M&A performance in emerging markets are even 219

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rare. Previous literature investigating the impact of emerging markets targets the acquisition performance of cross border deals. This stream of studies generally finds that corporate governance quality of target nations affects acquisition performance (Moeller & Schlingemann, 2005; Bris & Cabolis, 2002; Fauver, Houston & Naranjo, 2003; Chari, Ouimet & Tesar, 2004; Michael, Emmanuel & Alfred, 2008). Studies have ignored the characteristics of acquiring firms from emerging countries for a long time. Bae et al. (2002) studying for Korean companies presented a comparable research with this paper, but they tested the traditional market based abnormal returns and focused only on a single country. Implications for emerging markets and operating performance measures in need of additional research are discussed.

3. Data and Research Methodology

3.1 Sample Selection The data set of this project was obtained from the Thomson Financial Securities Datas SDC PlatinumTM Worldwide Mergers & Acquisitions Database. This sample meets the following criteria: 1) Observations are from 1998-2004; 2) Acquiring firms are from countries included in the MSCI emerging market (EM) index; 3) Deals are completed and are mergers, exchange offers, or acquisitions of a majority interest; 4) Companies with several M&A during the period are included; 5) Acquiring firms and targets are public companies; 6) Government, financial, and investment companies are excluded because of their specific accounting and regulatory requirements; 7) Companies have financial and accounting data for the seven-year window, and ownership data is available from proxies or annual reports of each company from company websites. Our final sample includes sixty-nine deals (46 acquiring firms) in thirteen emerging market countries. Table 1, panel A reports the annual numbers, aggregate values, and mean values of deals. The sample comprises sixty-nine acquisitions with a total market value of over US$16 billion. Acquiring firms paid, on average (median), US$235.6 (119.1) million for the targets. Panel B presents acquisitions by primary SIC code. The largest proportion of deals is in the manufacturing sector. Panel C lists firms and deal values by country. Most deals are initiated in South Africa (21.7%) followed by Brazil (20.3%), and Taiwan (14.5%). The other deals are spread across the following countries: India, Malaysia, Argentina, Russian Fed, Chile, Hungary, Indonesia, Mexico, Philippines, and Thailand.

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3.2 Variables 3.2.1 Dependent Variable Based on Healy et al. (1992), this paper used pre-tax operating cash flow (OCF) to measure acquisition performance and defined operating cash flow as operating income after depreciation plus depreciation and goodwill amortization, i.e. EBITDA. This definition ensures that performance measure is unaffected by different merger accounting methods, tax policy, or the type of financing used to fund the acquisition. Operating cash flow return ( OCFR) is calculated as operating cash flow divided by market value of asset. Operating cash flow returns are computed for each company up to three years before and after the acquisition event. Pre-acquisition performance is calculated as a weighted-average of the operating cash flow rate for the bidder and the target. The weights are based on the market values of assets of both companies the year before acquisition. The median of OCFR three years before and after acquisition ( MEGpre and MEGpost) is used. This measurement is consistent with that of Healy et al. (1992 and 1997) and Ghosh (2001). In addition, following Ghoshs (2001) critique of Healy et al. (1992), we set the criteria to select a list of matched firms based on size, industry, and pre-performance. The industry, size, and pre-performance adjusted operating cash flow return (ACFR) is the operating cash flow return of the merging firm minus that of the matched pair of firm. Similar to Healy et al. (1992), the median of ACFR three years before and after acquisition (ACFRpre and ACFRpost) is calculated. The post performance ( ACFRpost) is examined as our major performance metric (Loughran & Ritter, 1997; Linn & Switzer, 2001; Rahman & Limmack, 2004; Powell & Stark, 2005). 3.2.2 Independent Variables Independent variables in this project were primarily grouped into four categories: ownership variables; governance variables; legal variables and typical deal variables. Country variables were set to control the country effects. Table 2 illustrates the detailed definition of each variable. The coding approach for ownership variables is similar to prior research (Faccio & Lang, 2002; Yen & Andr, 2007). This study included seven dummy ownership variables reflecting different voting share thresholds held by the largest shareholder. The first dummy variable ( OWN10) was for companies having a large shareholder holding more than 10% of the voting shares. Studies have broadly used the 10% level as a cut point to test the difference between dispersed and concentrated ownership structures because it provides a significant stake and most countries mandate disclosure at this level or lower (La Porta et al., 1998; Faccio et al., 2001). The second dummy variable (OWN20) was set for companies whose large shareholder holding was more than 20% of voting shares because some literature has argued that 20% might be a better cut-off point to define ownership concentration (Demsetz & Lehn, 1985; La Porta et al., 1999; Claessens et al., 2000; Faccio et al., 2001). Furthermore, consider that when a large shareholder holds more than 50% of the voting shares, it not only dominates, but legally controls the firm (Becht & 222

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Roell, 1999; Faccio & Lang, 2002). Therefore, we set the third dummy variable (OWN50) at the 50% threshold to examine this specific ownership structure. The other dummy variables for ownership concentration between 10-20% (OWN1020), 20-25% (OWN2025), 25-30% (OWN2530), and 30-50% (OWN3050) were created to identify the effects of different ownership categories.

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This research also used a continuous variable ( OWN) to measure the actual percentage of voting shares held by the largest shareholder (from 10% or more). The variable was squared and cubed to capture the potential nonlinear relationship between controlling ownership and acquiring performance as in other previous research (Morck et al., 1988; McConnell & Servaes, 1990; Anderson & Reeb, 2003 ; Yen & Andr, 2007).

4. Empirical Results
4.1 Operating Cash Flow Returns Table 3 presents the operating cash flow returns for the merged and matched firms and the adjusted operating cash flow rates. The results in panel A show that the median operating cash flow return for merged firms ( MEGi) in the three years before acquisition range from 12.06% to 18.11% and from 11.76% to 12.13% for matched firms (MATi) . The same measure of industry, size, and pre-performance adjusted return ( ACFRi) for year -3, -2, and -1 is -1.08%, 0.12%, and 3.51%. The measures concurrently increase from year -3 to -1 and are significantly positive at the end of the year before transaction. In addition, the median adjusted return over the three-year pre-acquisition period (ACFRpre) is 0.95% and statistically different from zero. The measure of mean operating performance draws similar conclusions. On the other side, the median measures of operating cash flow return for merged firms (MEGi) in each of the three post acquisition years are from 15.62% to 17.84% and from 13.43% to 13.90% for matched firms ( MATi). The same measure of adjusted return ( ACFRi) for year +1, +2, +3 and over the post three years (ACFRpost) is 0.48%, 2.82%, 1.13%, and 1.13% in sequence. All the figures are positive and distinguishable from zero except the year +1. The results of the mean measures are consistent. These findings demonstrate that merged firms in the study sample are competitive with the benchmark firms before M&As and especially outperform in the last year before transactions. This result coincides with prior studies (Healy et al., 1992; Ghosh, 2001) but contradicts Yen & Andr (2007), which sample firms from English origin countries. Compared to their rivals, while the acquiring firms in our sample lose their superiority right after M&As (insignificant at year +1), they still achieve better results overall on long-term operating performance after transactions ( ACFRpost is significantly different from zero at the 5% level). This result is consistent with that reported by Healy et al. (1992) for US deals, Powell and Stark (2005) for UK deals, and Yen & Andr (2007) for English origin deals. However, in panel B, we present the regression results of the three-year post operating adjusted cash flow returns ( ACFRpost) on the three-year pre acquisition adjusted returns (ACFRpre). The intercept (0.012) is positive but not significantly different from zero, indicating that the operating performance in our sample does not significantly improve in the post-acquisition period after controlling for pre-performance effects. This result proposes a different view from prior operating performance literature (Healy et al., 1992 and 1997; 225

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Yen & Andr, 2007), but in some degree proves the good performance of acquiring firms from emerging markets before transactions. M&A activities could not create abnormal industry, size, and pre-performance adjusted returns for these acquiring firms. The slope coefficient (0.661) is positive and different from zero. Therefore, the slope coefficient captures persistence over time, consistent with the results of Healy et al. (1992 and 1997), Ghosh (2001), and Yen & Andr (2007).

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4.2 Descriptive Statistics and Univariate Analysis Table 4, panel A displays summary statistics of all variables for the full sample, and examines the relationship between performance and each variable on a univariate basis. For ownership variables, acquiring firms with a concentration ownership structure above the 10% threshold (OWN10) are dominant (86%) in our sample. At a 20% cut off (OWN20), we found a 72% concentration that is very close to the figure (70%) in the La Porta et al. (1999) research. Using 50% cut off (OWN50), 25% of cases in our sample are concentrated. In addition, the median (mean) voting share of the largest shareholder (OWN) is 34.59% (39.79%). The univariate results show that voting share percentage of the largest shareholder positively correlates with performance, but not significantly. The only group with significant outperformance in the post acquisition period is the acquiring firms with the largest shareholder stakes from 25% to 30% ( OWN2530). For governance variables, separation of voting and cash flow rights ( SEP) is 13% of the sample. This ratio is not as high as expected for acquiring firms from emerging markets, but closer to that (15%) in Yen & Andr (2007) examining English origin countries. The mean (Median) board size ( B_Size) is 9.62 (10.00), on average. Seventy-five percent of acquiring firms have a board with an audit committee (B_Audit) but they significantly underperform their peers on post performance at the 1% level of significance. The mean (median) ratio of independent directors on the board ( INDDIR) in our sample is 0.6 (0.58). The post acquisition performance significantly improves with increasing this independent director ratio in our acquiring firms. The CEO is also Chairman of the board (CEOdual) in 28% of cases; there is a linkage between CEOs and the largest shareholder ( CEOLSH) in 10% of cases. Both governance variables focusing on manager characters are not significant. Fifty-nine percent of cases across all sample countries have multiple blockholders (LSHs). The existence of block-holders positively correlates with performance, but not significantly. Legal variables weakly relate to post adjusted cash flow returns ( ACFRpost) by the univariate test. According to the anti-director rights index (Antidir_H) of LLSV (1998), 49% of deals classify as countries with a high score (more than 4). Companies with high anti-director rights indexes have a lower mean and median measure (0.80%, 0.34%) but the difference is not significant. Beyond the investors protection law (anti-director right), this study investigates law enforcement. Referring to Nenova (2003), we mainly use the measure for rule of law (Enforce_ruleoflaw) from LLSV (1998). The mean (median) score of the rule of law is 5.82 (5.51) for all countries in our sample and companies with stronger law enforcement have better performance measures. We also tested the quality of accounting standards ( ACCOUNT), another proxy applied in LLSV (1998). We found that the mean (median) score of the accounting standard is 62.35 (61.00) for the sample countries and the accounting quality is negative, but the effect is economically trivial to post adjusted returns. While existing governance research focuses mostly on the function of legal institutions, the current work draws attention to the features of extra-legal institutions by analyzing a variable (XLegal) introduced in Dyck & Zingales 227

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(Dyck-Zingales, 2004). The mean (median) rank score is 23.91 (23.00) of sample countries and the univariate test results show an insignificant and negative correlation (-0062) with performance. For deal characteristics, 35% of deals are with targets from English-origin countries ( T_English) and 28% of cases are cross border deals (Cross_Border) . Most deals (87%) in our sample are friendly ( Atti_F). Thirtytwo percent of deals are pure stock deals (Pay_Share); 57% of deals are classified as both target and acquirer in the same industry with the same 2-digit SIC code (Industry_rel ); and acquirers initiate 61% of deals with a toehold (Toehold). The mean (median) 4-week premium (Prem_4wks) is 21.79% (10.91%) overall. The average size ( Size-rel) of targets is about 57% smaller than that of acquirers and the average level of acquirers leverage (LEV) is relatively high (48%) for emerging market deals compared to 21.5% in Maury (2005) for Western European firms and 16% in Yen & Andr (2007) for English origin deals. Among the deal variables, only two variables have a significant relationship with post acquisition performance. Cross border transactions ( Cross_Border) are statistically low in our study for emerging markets because acquirers might face obstacles that offset possible advantages when entering new markets (Campa & Hernando, 2004; Andr et al., 2004). Related M&A (Industry_rel) is also documented with significantly poor performance in the long run. These findings are consistent with some studies which suggest that conglomerate mergers may raise entry barriers, reduce systematic risk, improve income stability, and lower capital costs (Limmack & McGregor, 1995; Andr et al., 2004). 4.3 Regression Results Table 5 reports the regression results for the operating performance measure on ownership structure after controlling for pre-performance, governance mechanisms, legal variables, and transaction characteristics. All models are significant and that adjusted R2 are between 54.1 and 57.3 percent. Looking at ownership, acquiring firms with a large shareholder holding of more than 10% ownership (OWN10) outperform widely held firms (model 1). Likewise, the presence of a large shareholder holding more than 20% ownership (OWN20) significantly improves post performance by 6.7% (model 2). When we further separate firms with large shareholders over 20% ownership into two groups (between 20% and 50% ( OWN2050) and more 50% (OWN50)), the OWN2050 group outperforms (model 3). Turning to the actual level of concentration, the linear model (models 4) suggests that post performance increases by 3.9% for a one percent change in concentration (but not significantly). These findings verify the results in univariate tests and posit that after controlling for governance mechanisms and deal characteristics, value-creating deals associate with higher levels of concentration, especially between 20% and 50%, consistent with decreasing agency costs as the controlling shareholders wealth invested in the acquiring firm increases.

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This evidence is not only for US family firms in Anderson & Reeb (2003) or bidders from English origin countries in Yen & Andr (2007), but also for acquiring companies from emerging markets in this study. Looking at a broad set of governance variables, board composition has significant impact on firm performance for acquiring firms in emerging markets. First, board size (B_Size) positively relates to post performance. This result indicates larger boards are more likely to include various experts to compensate for managers weakness (Agrawal & Chadha, 2005), but contradicts the potential inefficiency of larger boards suggested in prior literature (Jensen, 1993; Yermack, 1996; Conyon and Peck, 1998). Second, this study questions the effectiveness of an audit committee (B_Audit) according to the results. Earlier researchers have had similar concerns whether intense scrutiny surpasses the potential contribution of audit committees (Turpin & DeZoort, 1998; Turley & Zaman, 2004) and lack of expertise and experience in making important investment decisions (Hatherly, 1999; Cohen, Krishnamoorthy & Wright, 2002). Third, the proportion of independent (non-executive) directors on the board ( INDDIR) has a positive association with post acquisition performance similar to a number of studies (Fama & Jensen, 1983; Rosenstein & Wyatt, 1990). Other variables such as separation, CEO position (CEO duality and related CEO), or other blockholders are not significant in explaining long-term M&A performance. Concerning legal variables, this work validated that companies in countries with a higher score of anti-director right do better performance (Johnson, Boone, Breach & Friedman, 2000; Nenova, 2003) and too strong legal enforcement is negatively related to post acquisition performance. However, the results of these two legal indexes are not statistically significant. Moreover, this study found that the quality of accounting standards (ACCOUNT) is significantly positive associated with good M&A decisions for all model specifications. This study did not find any important link between long-term acquisition performance and the Dyck-Zingales (2004) extra-legal index. Regarding deal characteristics, the entirely equity-financed M&As (Pay_Share) significantly under-performed in the long run . Confirming the signal effect of payment methods (Loughran & Vijh, 1997; Andr et al., 2004; Faccio & Masulis, 2005). The toehold interests (Toehold) have slightly negative effects on postadjusted performance at the 10 percent significance level. This result challenges the argument that pre-merger equity interests help bidders shareholders to retain acquisition benefits (Franks & Harris,1989; Sudarsanam, Holl & Salami,1996). The presence of multiple bidders ( Compete) has a significant positive impact on acquiring performance. Similar to the view of Capron & Pistre (2002), this positive competition effect provides a valuable point that if acquirers control unique
resources, similar to most acquiring firms in emerging markets, they still can expect to earn abnormal returns. In addition, the larger bid premium (Prem_4w) triggers a more negative acquiring performance (Goergen & Renneboog, 2004; Healy, Palepu & Ruback,1997) and

acquirers with a higher leverage ratio ( LEV) will motivate managers to undertake value-enhancing M&A projects (Stulz, 1990; Maloney, McCormick & Mitchell, 1993). Other variables such as targets legal origin, cross border, 230

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transaction attitude, industry relatedness, and size effect do not have significant impact in explaining the operating performance of acquiring firms in emerging markets.

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This paper determines the effects of ownership structure, governance mechanisms, and legal systems on long term operating performance of acquiring firms in emerging countries . The findings suggest a role for controlling shareholders
(especially holding ownership between 25%-30%) in improving post acquisition operating performance over three years after transaction. Findings show no significant differences between acquiring firms with and without separation of ownership and voting rights . Among firm-level corporate governance mechanisms, boar composition indexes are stronger related to post acquisition performance than those of CEO position and block-holders. For country-level legal systems, value-creating deals associate with higher quality

accounting standards and superior investor protection of emerging markets. Like most accounting-based performance literature, to examine the long term operating performance, this study was confined by the pre-2004 deal samples those accounting numbers are available for three years after M&A deals. The further study should consider post-2004 data to see the validity of the findings.

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