Ownership Structure, Managerial Behavior

and Corporate Value

J.R. Davies¤

David Hillier¤

Patrick McColgan¤

JEL Classi¯cation: G32

Keywords: Ownership Structure; Capital Expenditure; Corporate Value; Tobin's Q.

The authors would like to thank John Capsta®, Scott Linn, Andrew Marshall, JamesWansley and seminar participants at the Financial Management Association International(2001), European Financial Management Association (2002), Trinity College Dublin andUniversity of Strathclyde for their valuable comments on an earlier version of the paper.The normal caveat applies.

¤Department of Accounting & Finance, University of Strathclyde, Glasgow. G4 0LN.Phone: 00 44 141 548 3889. Fax: 00 44 141 552 3547. Corresponding Author e-mail:d.j.hillier@strath.ac.uk.

October 24, 2002

1

Ownership Structure, Managerial Behavior andCorporate Value

Abstract

The nonlinear relationship between corporate value (Tobin's Q) and man-

agerial ownership is well documented. This has commonly been attributed

to the onset of managerial entrenchment, which results in a decrease of cor-

porate value for increasing levels of managerial holdings. We propose a more

complex structure for the corporate value { managerial ownership function,

which accounts for the e®ect of con°icting managerial incentives and external

and internal disciplinary monitoring mechanisms. Using this speci¯cation as

the basis for our analysis, we provide evidence that the managerial ownership

- corporate value relationship is co-deterministic. This ¯nding is at odds with

recent work by Cho (1998) and Himmelberg et al. (1999) who report that

corporate value determines managerial ownership but not vice-versa.

2

Contents

1 Introduction 4

2 Overview of Relevant Literature 6

3 UK Institutional Features 9

4 Theoretical Motivation 11

4.1 Low levels of managerial ownership . . . . . . . . . . . . . . . 12

4.2 Intermediate levels of managerial ownership . . . . . . . . . . 13

4.3 High levels of insider ownership (less than 50%) . . . . . . . . 14

4.4 High levels of managerial ownership (greater than 50%) . . . . 15

4.5 Very high levels of managerial ownership . . . . . . . . . . . . 15

4.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

5 Empirical Results 16

5.1 Description of the data . . . . . . . . . . . . . . . . . . . . . . 16

5.2 Estimation of ownership breakpoints . . . . . . . . . . . . . . 21

5.3 Endogenity of managerial equity ownership, investment and

corporate value . . . . . . . . . . . . . . . . . . . . . . . . . . 23

6 Conclusions 28

7 References 31

8 Tables 36

3

1 Introduction

In a market without agency problems, corporate management will choose

investments that maximize the wealth of shareholders. In practice, com-

peting objectives that are incompatible with the classic shareholder wealth-

maximizing paradigm may also be pursued. Following Jensen and Meckling

(1976), a large literature has developed examining the e®ect of management

and their behavior on the performance and value of ¯rms they control. A vi-

brant strand of this literature concerns the relationship between managerial

ownership levels, the direct investment decisions made by management and

the inherent value of the ¯rm, as proxied by Tobin's Q ratio.

Morck, Shleifer and Vishny (1988), McConnell and Servaes (1990), and

Hermalin and Weisbach (1991) provide evidence of a signi¯cant non-linear

relationship between corporate value and managerial ownership. Speci¯cally,

corporate value increases with management equity holdings to a certain level

after which entrenchment behavior becomes dominant, leading to decreases

in ¯rm value. Whereas, Morck et al. (1988) and Hermalin and Weisbach

(1991) document a further change in the corporate value-managerial holdings

relationship at high levels of equity ownership, McConnell and Servaes (1990)

report no such change.

Recent work by Cho (1998) and Himmelberg, Hubbard and Palia (1999)

have shed doubt on these earlier ¯ndings by controlling for the e®ects of en-

dogeneity and unobservable (to the econometrician) ¯rm characteristics in

their analysis. Applying a two-stage least squares methodology, Cho (1998)

showed that managerial ownership had no e®ect on corporate value and in-

vestment but that corporate value had a signi¯cant impact on managerial

4

ownership. Himmelberg et al. (1999) showed that controlling for endogeneity

eliminated the observed relationship between corporate value and managerial

ownership but also that a large proportion of the cross-sectional variation in

managerial holdings was explained by unobserved ¯rm heterogeneity.

In this paper, we propose an alternative structure to the managerial

ownership-corporate value relationship which captures a more complex char-

acterization of the evolving behavior of managers. We argue that at high

levels of managerial ownership when external market discipline becomes in-

e®ective, there will be a resurgence of entrenchment behavior. With equity

holdings around 50%, managers will have gained implicit control of their

company, but still do not have objectives completely aligned to external

shareholders. Only at very high levels of managerial holdings, are incentives

akin to other shareholders.

In contrast to Cho (1998) and Himmelberg et al. (1999), when this model

is applied to a large sample of ¯rms incorporated in the UK, managerial

ownership is shown to have a signi¯cant impact on corporate value. This re-

lationship is endogenous, and consistent with Cho (1998) and Himmelberg et

al. (1999), corporate value has a corresponding e®ect on levels of managerial

ownership. Surprisingly, we ¯nd that although ownership levels are a®ected

by ¯rm level capital expenditures (investment), there is no evidence of the

reverse occurring.

We provide a more detailed review of the relevant literature in the next

section. In section three we justify an examination of this issue using UK

data and discuss some important features of the UK market. In section

four we outline a simple model of managerial ownership in which corporate

5

value increases non-linearly with management equity holdings. We present

empirical results in section ¯ve and conclude in section six.

2 Overview of Relevant Literature

Since Jensen and Meckling (1976) ¯rst proposed that share ownership would

provide managers with an incentive to reduce private perquisite consump-

tion, empirical research has produced con°icting results as to the veracity of

their proposals. An initial attempt to model a linear relationship between

corporate performance, as measured by accounting pro¯t rate, and owner-

ship concentration was made unsuccessfully by Demsetz and Lehn (1985).

However, Morck et al. (1988) documented a signi¯cant non-linear relation

between ownership and value in their study of 371 Fortune 500 companies.

Their ¯ndings point to a positive impact on corporate value for ownership lev-

els between 0% and 5% managerial ownership and a negative e®ect between

5% and 25%. This change in sign is attributed to managerial entrenchment,

when they gain enough power (with insu±cient external controls) so as to

be able to pursue their own objectives at the expense of shareholder value.

Although managerial interests will converge to that of shareholders as their

equity stake grows, behavior is still dominated by entrenchment. At levels of

ownership above 25%, Morck et al. (1988) found that the alignment of ob-

jectives became prominent and increases in ownership were associated with

higher levels of corporate value.

McConnell and Servaes (1990) provide some evidence to support Morck

et al. (1988). In a larger and more diverse sample, they report a signi¯cant

6

quadratic relation between managerial ownership and corporate value. As

ownership increases, so too does value. However, above equity holdings of

approximately 50% and 40% in their 1976 and 1986 samples respectively, ¯rm

value declines. Their interpretation is attributed to initially increased man-

agerial incentives but with entrenchment prevailing at higher levels of owner-

ship. Similarly, Hermalin and Weisbach (1991) also report a non-monotonic

relationship between ownership and corporate value but with di®erent turn-

ing points.1

More recent work has built upon the ¯ndings of Demsetz and Lehn (1985)

who argue that levels of managerial ownership will be determined endoge-

nously in equilibrium. They ¯nd ownership to be a function of the volatility

of a ¯rm's stock. Managers holding large share stakes in their own ¯rm ¯nd

it more di±cult to diversify their portfolio risk, and thus their incentive to

hold large shareholdings declines as the risk of their ¯rm's stock increases.

Cho (1998) extended the argument of Demsetz and Lehn (1985) by exam-

ining the interdependence of managerial ownership, investment, and corpo-

rate value. Initially, Cho (1998) reported the same non-monotonic relation

between ownership and value as found by Morck et al. (1988). Further-

more, he also found this same relation between levels of ownership and cor-

porate investment, suggesting that \ownership structure a®ects investment

and, therefore corporate value." (p. 114) However, drawing on Demsetz

1Hermalin and Weisbach use both OLS and instrumental variable regressions, the latterbeing an attempt to control for potential simultaneity between ownership and corporatevalue. However, they argue that such an approach is imperfect. In addition, Himmelberget al. (1999) are critical of an instrumental variables approach, as the instruments formanagerial ownership and corporate value will be similar and determined within the ¯rm'scontracting environment.

7

and Lehn (1985), simultaneous regression analysis was utilized to control for

endogenity and it was found that ownership structure was endogenously de-

termined by corporate value (as measured by Tobin's Q). It was also reported

that investment and not managerial ownership signi¯cantly in°uenced corpo-

rate value. Cho (1998) concluded that managers in ¯rms with higher Tobin's

Q, or with better investment opportunities tend to hold a higher fraction of

their ¯rm's shares. However, he found no evidence that managerial ownership

had a causal e®ect on investment or corporate value.

Himmelberg et al. (1999) interpret similar ¯ndings of endogeneity in a

di®erent manner. They propose that endogeneity provides evidence of di®er-

ing optimal contracting relationships within various types of ¯rms. In this

situation, incentives provided by managerial ownership will di®er in impor-

tance depending on both observable and unobservable characteristics of a

¯rm's contracting environment. Their ¯ndings point to the importance of

¯rm heterogeneity in determining levels of managerial holdings. Moreover,

when taking these unobserved factors into account, they found no evidence

of a causal relationship between managerial ownership and corporate value.

However, Zhou (2001) is heavily critical of the ¯xed e®ects panel data ap-

proach employed by Himmelberg et al. (1999). He comments that such a

methodology will remove any cross-sectional variation in the data, and there-

fore, reveal no meaningful link between managerial ownership and corporate

value. Both Hermalin and Weisbach (1991) and Zhou (2001) argue that

cross-sectional variation is likely to be a signi¯cant factor in any relationship

between managerial ownership and value.

With UK companies, Short and Keasey (1999) and Faccio and Las-

8

fer (1999) both utilize a cubic speci¯cation to model the corporate value-

managerial holdings relationship and both reported a signi¯cant non-linear

functional form similar to Morck et al. (1988). Speci¯cally, Short and Keasey

(1999) document turning points of 12.99% and 41.99% and Faccio and Las-

fer (1999) document breakpoints of 19.68% and 54.12% in their sub-sample

of above average growth ¯rms. However, neither study fully examines the

misspecifying impact of endogeneity on their results.2

3 UK Institutional Features

The UK o®ers an interesting environment for the conduct of a study of this

kind in several respects. First, with roughly 2,500 national and multinational

companies listed on the London Stock Exchange (LSE), the UK is a major

international ¯nancial market. Furthermore, corporate governance structures

in the UK are largely similar to those in the US in terms of corporate boards,

diverse ownership structures and active external markets which in theory

should contribute to improved managerial monitoring.

Investment practices in the UK resemble those of the United States, where

¯nancial institutions such as pension funds control 80% of UK securities. As

a consequence, the UK mirrors closely US corporate and ¯nancial practices,

enabling meaningful comparisons with prior US-based studies.

Both the UK and US have ¯nancial and regulatory traditions that are

2Whilst Faccio and Lasfer (1999) ignore this possible e®ect, Short and Keasey (1999)take ownership as a lagged value as at the end of 1988 and then measure value as theaverage for 1989 to 1992. As an alternative approach they also use ¯xed year dummyvariables within a panel regression framework. However, Himmelberg et al. (1999) contendthat even such an approach doesn't adequately account for endogenity as the contractualnexus of a ¯rm will change only very slowly over time.

9

di®erent from those of other developed economies such as Japan and Western

Europe. Evidence of this is provided by Dahya, McConnell and Travlos

(2002), who document the same statistically signi¯cant relationship between

outsider dominated corporate boards and performance related management

turnover as that reported by Weisbach (1988) for US companies. This is in

contrast to Kang and Shivdasani (1995) who could ¯nd no such relationship

existing in Japanese companies.

Any proposed similarity between the UK and US is tempered by the em-

pirical ¯ndings of a poor disciplinary takeover market in the UK by Franks

and Mayer (1996) who, in contrast to the ¯ndings of Martin and McConnell

(1991) for US corporate forms, ¯nd no signi¯cant relation between poor com-

pany performance, hostile takeovers and top management turnover. These

¯ndings point to a similarity between the UK and Germany where Franks

and Mayer (2000) discuss a lack of takeover market in which to provide man-

agement with incentives for maximising ¯rm value. In addition, Short and

Keasey (1999) note that UK companies are substantially less active in their

use of takeover defences, largely due to opposition from ¯nancial institu-

tions. Were this to be the case, managerial ownership would take on greater

signi¯cance in the UK.

Institutional stakeholders in the UK are also likely to be more active in

their monitoring capacity than their US counterparts. As Short and Keasey

(1999) point out, the extreme geographical clustering of large institutions

within the City of London can lead to an e®ective but informal monitoring

mechanism for the management of London Stock Exchange listed companies.

In addition, Short and Keasey(1999) argue that much of the monitoring

10

activity of UK institutions is carried out privately `behind closed doors' and

unlike many of their US counterparts, UK ¯nancial institutions face no legal

duty to vote at company AGMs.

Finally, Franks, Mayer and Renneboog (2001) note the minority protec-

tion laws in the UK are far more stringent than those applied to US corpora-

tions. These laws may be vitally important in shielding minority shareholders

from expropriation by company management or other major shareholders.

4 Theoretical Motivation

In this section, we propose an alternative structure to the managerial holdings-

corporate value relationship and argue that the cubic, or simpler representa-

tions, used in earlier studies (see Morck et al. (1988), McConnell and Servaes

(1990), Hermalin and Weisbach (1991), Cho (1998) and Himmelberg et al.

(1999) for US companies and Short and Keasey (1999) and Faccio and Las-

fer (1999) for UK companies) are unnecessarily restrictive and misspeci¯ed.

The model that is presented in this paper captures further nonlinearities

in this relationship at high levels of managerial holdings and has a quintic

speci¯cation.

Management are faced with both negative and positive incentives to en-

sure that they follow objectives that maximize shareholder wealth. The ef-

fectiveness of incentives is potentially a function of the level of managerial

ownership in the ¯rm. Since compensation packages such as stock options

are a transfer of wealth from shareholders to management, the value of these

incentives will lessen as management ownership increases. External market

11

discipline is also a function of managerial ownership. Martin and McConnell

(1991) argue that the takeover market is an e®ective means of disciplining

management for poor performance. However, large shareholdings by top

management act as a deterrent for takeovers because of the greater ability

to oppose a hostile bid or drive up premiums to the point where bidders no

longer view the target company as a positive net present value investment,

[Stulz (1988)]. Finally, internal controls in the form of monitoring from large

shareholders and corporate boards should reduce the scope for managers to

diverge greatly from the interests of shareholders. Again, however, such dis-

cipline is likely to be inversely related to managerial control.

We view the propensity of management to maximize shareholder wealth

to be a function of three unobserved factors: external market discipline (even

if it is weak), internal controls and convergence of interests. Moreover, the

strength of each factor can be viewed as a function of the level of managerial

ownership in the ¯rm.

4.1 Low levels of managerial ownership

For low levels of managerial ownership, external discipline and internal con-

trols or incentives will dominate behavior [see for example Fama (1980), Hart

(1983) and Jensen and Ruback (1983)] leading towards value maximization.

Empirically, Morck et al. (1988), McConnell and Servaes (1990), Hermalin

and Weisbach (1991) and the original analysis of Cho (1998) report results

consistent with this behavior. However, there is also a possibility that lower

levels of ownership within this range have endogenously arisen from perfor-

mance related compensation packages, such as stock options and stock grants

12

rather than increased ownership leading to higher Q ratios.

4.2 Intermediate levels of managerial ownership

At intermediate levels of managerial ownership, convergence of interests be-

comes stronger. However, with greater ownership comes greater power in

the form of voting rights. Managers may be able to maximise their own

wealth through increasing their perquisites and guaranteeing their employ-

ment at the expense of corporate value. In addition, whilst ownership in the

previous range may have arisen through the vesting of compensation plans,

it is unlikely that such plans will provide management with even a mod-

erate ownership stake in the ¯rm. Although external market controls are

still in place, these and the e®ect of convergence of interests are not strong

enough to align the behavior of management to shareholders. Managerial

labour markets operate on the principal that managers can be removed for

poor performance and appropriately disciplined. Studies by Denis, Denis

and Sarin (1997) in the US and Dahya et al. (2002) in the UK both ¯nd

an inverse relation between top-management turnover and managerial own-

ership. This lack of discipline provides evidence of a de¯ciency in incentives

for managers to maximise shareholder value at this level of ownership. Em-

pirically, the management entrenchment hypothesis, as suggested by Fama

and Jensen (1983), has been veri¯ed by Morck et al. (1988), McConnell and

Servaes (1990), and Hermalin and Weisbach (1991) amongst others.

13

4.3 High levels of insider ownership (less than 50%)

As levels of managerial equity ownership increase, objectives converge further

to those of shareholders. At ownership levels below 50%, management do not

have total control of the ¯rm and external discipline still exists. While per-

haps no longer being subject to any major discipline from external markets,

it is likely that even at these levels of ownership, managers are still subject

to discipline from external block shareholders. This is particularly true in

the UK, where because of strong informal ties between institutions [Short

and Keasey (1999)], a lax regulatory environment concerning the ownership

of listed companies [Roe (1990)] and low monitoring costs [Faccio and Lasfer

(1999)], institutional activism is stronger than in the US.3 This suggests that

even at high ownership levels, blockholders may still be able to in°uence man-

agerial decision-making. This alignment of interests together with external

controls that can be applied by blockholders may in e®ect lead to managers

reverting to a value maximising strategy, a pattern consistent with Morck et

al. (1988). This is also consistent with Franks et al.'s (2001) contention of

strong minority protection laws in the UK, combined with monitoring from

UK institutions, which may allow external shareholders to impose some form

of control on management.

3For a more in-depth discussion of the institutional di®erences and similarities betweenthe United Kingdom and United States, see Short and Keasey (1999) and Faccio andLasfer (1999).

14

4.4 High levels of managerial ownership (greater than

50%)

At levels above 50% managerial ownership, management have complete con-

trol of their company. Although atomistic shareholders are likely to have

been unable to in°uence managers at far lower levels of ownership than this,

there is always a possibility that a cartel of blockholders (allied with minority

shareholder's rights under UK company law) may be able to mount a chal-

lenge to corporate managers if they fail to make decisions in shareholders'

best interests. At greater than 50% managerial ownership, this possibility

is no longer likely to be a serious issue to management. Furthermore, at

levels of 50% managerial ownership the probability of a hostile takeover ef-

fectively becomes zero. The failure of external discipline at such ownership

levels combined with a lack of blockholder incentives above 50% may result

in a decrease in corporate value for a small window of managerial holdings

above this level. The fall in corporate value at this level can be considered

similar to that found by McConnell and Servaes (1990).

4.5 Very high levels of managerial ownership

Finally, as managerial shareholdings rise to very high levels, management

e®ectively become sole owners of the company leading to value maximising

behavior. Consistent with Morck et al. (1988), Short and Keasey (1999),

Faccio and Lasfer (1999) and the initial ¯ndings of Cho (1998), above a

certain level of ownership corporate managers are faced with such severe

¯nancial penalties for failing to maximise the value of their companies that

15

they are forced to make decisions which will maximise ¯rm value, regardless

of how this a®ects their preferences for corporate power.

4.6 Summary

Our characterisation of a highly nonlinear relationship between managerial

equity holdings and corporate value is in contrast to earlier studies [Morck et

al. (1988), McConnell and Servaes (1990)4, Hermalin and Weisbach (1991),

Cho (1998) and Himmelberg et al. (1999)], which posit fewer breakpoints

in their analysis. There is little theoretical basis on which the individual

breakpoints can be determined, and the ¯ndings of Kole (1995) suggest that

these will be determined by the size of the ¯rms in the sample. However,

it is expected that the second local maximum will be in the region of 50%

managerial ownership re°ecting the stage at which management gain total

control of the company. In the next section, the main tests of our hypotheses

will be carried out.

5 Empirical Results

5.1 Description of the data

We use data on managerial and external block ownership for 1995 from the

Macmillan London Stock Exchange Yearbook for 1996 and 1997. The Year-

book provides summary accounting data including a consolidated balance

sheet, information on company directors, legal information on the company's

4McConnell and Servaes (1988) modelled the corporate value-managerial ownershiprelationship as a quadratic function, which by construction has only one turning point.

16

lawyers, auditors and stockbrokers, principle activities, company history, cap-

ital and dividend payments and industrial sector for the vast majority of all

quoted companies and securities.5 The register could be considered similar

to the Value Line Investment Survey used in comparable US studies by, for

example, McConnell and Servaes (1990) and Denis et al. (1997).6 We re-

strict our attention to non-¯nancial companies only and require that each

¯rm have complete managerial and external ownership data for 1995, which

leaves 802 industrial companies in our sample. Data on capital expenditures,

total assets employed, after tax pro¯ts, depreciation, leverage, equity market

values and research and development costs are collected from Datastream.

We estimate Tobin's Q ratio (our proxy for corporate value) using the

formula below:

Q =MVEQ+ PREF +DEBT

BV ASSETS(1)

Where

MVEQ = the year-end market value of the ¯rm's common stock;

PREF = the year-end book value of the ¯rm's preference shares (pre-

ferred stock);

DEBT = the year-end book value of the ¯rm's total debt; and

BV ASSETS = the total assets employed by the ¯rm, which is measured

as total assets minus current liabilities.

Our measure is consistent with the modi¯ed version of the formula as

5Recently listed, merged or acquired ¯rms are not included.6It should be noted that our data includes only the equity stakes of the company's

directors, whereas McConnell and Servaes (1990) ownership data also includes the hold-ings of company o±cers. UK companies are not required to disclose the stakes of suchindividuals.

17

used by Chung and Pruitt (1994) who ¯nd that 96.6% of the variability in the

popular Lindenberg and Ross (1981) algorithm of Tobin's Q is explained by

their approximation. Our method also avoids the data availability problems

which arise from using the more rigorous algorithms proposed by Lindenberg

and Ross (1981) and Lewellen and Badrinath (1997) as both require many

years data in estimating replacement costs of assets.

In addition, ¯nancial reporting di®erences between the UK and the US

make Tobin's Q a problematic measure to apply to UK data. Firms in the

UK have had far more freedom in revaluing their companies' ¯xed assets than

those in the US and implicit in the more complex Lewellen and Badrinath

(1997) and Lindenberg and Ross (1981) algorithms is an assumption that

no revaluations have occurred. Updating previously revalued assets would

lead to an overestimation of the value of a ¯rm's assets and as such would

understate the value of Tobin's Q. Furthermore, only including ¯rms that

report separate pure historical cost accounts would introduce a bias in favour

of larger ¯rms who would have an incentive to do so for the purpose of

international exchange listing requirements.

We use book value of preferred stock and long-term debt, rather than the

market values proposed by Lindenberg and Ross (1981) and Lewellen and

Badrinath (1997). In the UK there is a far less active market for the trading

of corporate debt than that which exists in the US, and as such it is more

di±cult to obtain market values, even through using the relatively simple

bond rating tables as suggested by these previous studies. Since preference

shares make up such a minute proportion of traded capital in the UK it is

unlikely to be necessary to update this for market values. In a ¯nal strati¯-

18

cation of our sample, we mitigate the problem of potential outliers and trim

twenty-¯ve ¯rms with the largest and smallest Tobin's Q measure, leaving a

¯nal sample of 752 ¯rms.7

Table 1 presents descriptive statistics for our sample data. The mean

managerial ownership stake of all board members is 13.02%, which is similar

to comparable US studies, but slightly lower than Faccio and Lasfer (1999)

who report mean ownership of 16.7%.

Tobin's Q is slightly higher than that reported for related US work with

a mean value of 1.96. The standard deviation of Tobin's Q is 1.21 and is also

greater than other studies. However, it is substantially less than the mean

of 2.47 reported by Doukas, McKnight and Pantzalis (2002) and is relatively

similar to the mean value of 1.86 Short and Keasey (1999) report for their

market valuation ratio.8 The most likely explanation for this di®erence is

the greater heterogeneity of ¯rms in our sample. UK ¯rms in general also

tend to be smaller than their US counterparts which would also explain the

higher average Tobin's Q in our analysis.

The mean blockholder ownership is 37.34% and is on a par with that

reported for US ¯rms by McConnell and Servaes (1990) (32.4%) and 34.57%

reported by Faccio and Lasfer (1999) for UK ¯rms. The average capital ex-

penditure by ¯rms in the sample is approximately $21 million and the cap-

ital expenditure to total assets employed ratio is approximately 0.1, which

7This is a larger sample than that used by Morck et al. (1988) - 371 ¯rms, Cho (1998)- 326 ¯rms and Himmelberg et. al (1999) - maximum 427 ¯rms in any one year.

8Measured as the market value of equity divided by the book value of equity, minusany intangibles. It should also be noted that Doukas et al. (2002) measure Q between1998 and 2000 which was the height of the technological boom on the UK stock market.Faccio and Lasfer (1999) fail to report summary statistics for this variable.

19

is again similar to that reported by Cho (1998) for US companies. Debt

to Asset ratios average 0.14 and is lower than the UK average leverage ra-

tio for non-¯nancial ¯rms. The full range of ¯rm sizes are included in the

sample with the smallest company having an equity market capitalization

of $680,000 and the largest company's equity valued at approximately $26

billion. The mean company in the sample has a market capitalization of

$335 million, which is considerably smaller than the average ¯rm traded on

NYSE, but is the equivalent of a FTSE 100 company in the UK.

Table 2 provides the distribution of sample statistics grouped by manager-

ial ownership. A very large proportion of the sample (62%) have managerial

ownership levels less than or equal to 10%. However, a large fraction of

companies (11%) also in the sample had boards which owned at least forty

percent of all outstanding equity. As would be expected, outside blockholder

ownership decreases with managerial ownership. At ownership levels of 30%,

blockholder ownership is slightly less at 24%. It is probable that external

discipline, as provided by blockholders, would still be strong at these lev-

els of managerial holdings, particularly where informal coalitions amongst

blockholders are more prominent [Short and Keasey (1999)]. At higher levels

of managerial holdings, blockholder ownership decreases sharply leading to

a collapse in the power of blockholders. For example, between 50% and 60%

managerial holdings, blockholder ownership falls by approximately half to

12.4% of the company's outstanding equity. Managerial ownership is a de-

creasing function of company size indicating that a high level of managerial

ownership is more prevalent in smaller size companies. Although ¯rm sizes

in the UK are considerably smaller than US ¯rms, the ratios in table 2 are

20

similar to summary statistics provided in Morck et al. (1988), McConnell

and Servaes (1990), Cho (1998) and Himmelberg et al. (1999).

Table 2 also illustrates the non-linear relationship between Tobin's Q and

managerial holdings. Visual inspection points to two maximum points in

the region of 10% to 20% and 50% to 60% respectively. The convergence of

interests e®ect at very high levels of managerial ownership is not apparent at

this stage because of the large managerial ownership grouping for holdings

above 70%. However, the statistics for all other groupings are consistent with

our theoretical motivation.

5.2 Estimation of ownership breakpoints

In order to model the Tobin's Q - managerial ownership (IO) function as

having two maximum and two minimum turning points, we specify a quintic

function.

Q = ®0 + ®1IO + ®2IO2 + ®3IO

3 + ®4IO4 + ®5IO

5 + " (2)

For the nonlinear relationship discussed in section 4 to be valid, the co-

e±cients in [2] must have the following signs: ®0 > 0;®1 > 0;®2 < 0;®3 >

0;®4 < 0;®5 > 0: The estimated values of the coe±cients in [2] are given in

table 3. The intercept coe±cient, which is an estimate of Tobin's Q in ¯rms

with no managerial holdings, is 1.85. Each slope coe±cient is of the correct

sign and statistically signi¯cant at the 5% level. Although the adjusted R2

is low, it is similar to that found in comparable US studies. The use of this

model as a basis to estimate managerial ownership breakpoints leads to four

21

critical values: 7.01%, 26.0%, 51.4%, 75.7% and is illustrated in ¯gure 1.

To establish the robustness of our regression model, the spline approach as

applied by Morck et al. (1988), Cho (1998) and Himmelberg et al. (1999) to

estimate managerial breakpoints was carried out using our generated break-

points. Table 4 presents the coe±cients resulting from the piecewise linear

regression. Similar to table 3, each coe±cient has the expected sign and all

but one variable is statistically signi¯cant at the 5% level. The only variable

that is not signi¯cant, IOover76%, has the correct sign. The probable cause

for the lack of signi¯cance is the small number of ¯rms in this managerial

ownership grouping.

An examination of these results suggests that Tobin's Q increases in ¯rms

for managerial ownership levels up to 7% and then declines to ownership

levels of 26%. This is almost exactly the same as the breakpoints in Morck

et al. (1988) and Himmelberg et al. (1999) (5% and 25% respectively) and

is comparable to Cho (1998) who use breakpoints of 7% and 38%. However,

it di®ers from the UK studies of Short and Keasey (1999) and Faccio and

Lasfer (1999) who each report two turning points of 12.99% and 41.99% and

19.68% and 54.12% respectively. Earlier studies limited the turning points

to two but in our extension it is clear that there are another two turning

points at much higher levels of managerial ownership. It also appears that

market discipline has an in°uence on managerial objectives up to the point

where the board takes complete control (51%). Tobin's Q then decreases

until ownership levels reach 76% after which Q increases.

Denis and Sarin (1999) argue that cross-sectional studies may be sub-

ject to bias, whereby they fail to account for events with potentially large

22

valuation consequences.9 As a further test of robustness, we carried out the

quintic analysis for Managerial ownership and Tobin's Q for the same sample

of available ¯rms in 1997.10 Again, each coe±cient was signi¯cant with the

correct signs and the turning points from the estimated model were relatively

stable at 7.9%, 26.5%, 55.2% and 86.2%.

5.3 Endogenity of managerial equity ownership, in-

vestment and corporate value

To analyse for the e®ects of endogeneity in the managerial ownership, invest-

ment and corporate value relationship we follow Cho (1998) and carry out

a simultaneous equations analysis using two stage least squares. Cho (1998)

and Himmelberg et al. (1999) showed that once endogeneity was controlled

for, the perceived impact of managerial ownership on corporate value dis-

appeared. Moreover, corporate value was found to positively a®ect levels of

managerial ownership.

It is possible that if the model speci¯cation employed by these studies is

wrong, what appears to be a lack of statistical signi¯cance in the endoge-

nous variables in the simultaneous equations analysis may actually be due

to errors in variables arising from the intermediate regressions. We re-run

the two-stage least squares analysis of Cho (1998) using our more complex

speci¯cation.11 The control variables in our regression are the same as in

9Examples of such events may include receiving a takeover bid, top managementturnover, etc.

10Some ¯rms fell out of the sample because of mergers, delisting and being taken over.11Cho (1998) also attempts to control for speci¯cation error by re-estimating his si-

multaneous regression analysis using managerial ownership as a linear variable and again¯nds no relationship between managerial ownership and corporate value. However, if in-

23

Cho (1998). Namely, managerial ownership, investment and corporate value

are de¯ned to be endogenously determined by each other as well as some

additional relevant exogenous variables. That is:

InsiderOwnership = f(market value of ¯rm's common equity, corporate

value, investment, volatility of earnings, liquidity, industry)

CorporateV alue = g(insider ownership, investment, ¯nancial leverage,

asset size, industry, block ownership, largest stakeholder)

Investment= h(insider ownership, corporate value, volatility of earnings,

liquidity, industry)

In addition to the variables used by Cho (1998), we include blockholder

ownership and largest stakeholder in the corporate value regressions to re°ect

the potential impact of blockholder discipline in the UK and the role of a

founding or dominant individual on corporate value. All accounting and

market variables are taken at the ¯nancial year-end from Datastream.

In table 5 we report results from the simultaneous equations analysis.

Taking the managerial ownership regression ¯rst, all variables with the ex-

ception of investment have coe±cients with the expected sign. managerial

ownership is negatively related to the market value of equity, which re°ects

the fact that managerial wealth constraints and risk-aversion will prevent

them from holding substantial stakes in large ¯rms. Firm level liquidity is

shown to be positively related to managerial ownership, which is a stronger

result than Cho (1998) who reported no signi¯cance for this variable. Impor-

tantly, Tobin's Q is found to be signi¯cant and positively related to the level

of managerial ownership. This is consistent with Cho (1998) but is opposed

deed there is a non-linear relationship between ownership and corporate value, such anapproach would fail to capture this

24

to Demsetz and Villalonga (2001) who ¯nd the opposite e®ect. This result

suggests that managers tend to hold larger stakes in ¯rms that are successful

or have higher corporate value. This may also be indicative of successful

managers bene¯ting from equity related compensation policies.

The investment variable, which has a negative impact on managerial own-

ership is surprising as theory predicts that ¯rm level investment will be pos-

itively related to managerial ownership. Himmelberg et al. (1999) contend

that ¯rms with high investment spending will have high managerial owner-

ship to alleviate the monitoring problem caused by discretionary managerial

spending. However, Jensen (1986) argued that ¯rms may over-invest as a

result of an earnings retention con°ict, rather than under-invest as Jensen

and Meckling's (1976) moral hazard theory would predict. When a ¯rm is

in this situation, managers may be able to maximise their size-related com-

pensation, but are aware that this may ultimately reduce the value of their

shareholdings. Although tentative, this could in part explain the negative

relation between investment and ownership. Cho (1998) also ¯nds a negative

(but insigni¯cant) coe±cient on the investment variable using both capital

and research and development expenditures. In addition, further analysis

by Cho (1998) provided evidence of investment insigni¯cantly decreasing in

general with managerial ownership.

The estimated coe±cients from the corporate value regression are given

in the second column of table 5. Corporate value is shown to be positively

related to investment and leverage. Whilst the investment coe±cient is as

expected, the sign of the leverage variable requires more discussion. Morck

et al. (1988) found that leverage had a negative but insigni¯cant impact on

25

corporate value and attributed this to the possibility of managers in highly

levered ¯rms holding a higher than average level ownership. However con-

sistent with our results, McConnell and Servaes (1990) reported a positive

signi¯cant coe±cient for leverage. Leverage can have various e®ects on ¯rm

value. The notion that high debt levels lead to greater corporate value has

been argued by Modigliani and Miller (1963) with respect to valuable tax

shields, Ross (1977) and Myers (1977) with respect to a signalling hypothe-

sis and Jensen's (1986) free cash °ow hypothesis. Ultimately, leverage is one

way of imposing external discipline on management and if it is e®ective, will

lead to increased corporate value.

We view the most important result from the corporate value regression

as being the signi¯cance of the managerial ownership variables. Our results

indicate that although managerial ownership levels are determined by corpo-

rate value, corporate value itself is determined in part by managerial owner-

ship. This ¯nding is at odds with Cho (1998) and Himmelberg et al. (1999)

but consistent with the classical view of Jensen and Meckling (1976) and

empirical work by Morck et al. (1988) and McConnell and Servaes (1990).

Interestingly, blockholder ownership is shown to negatively impact To-

bin's Q. This result is consistent with Faccio and Lasfer (1999, 2000). They

¯nd that block ownership negatively impacts on corporate value and that

UK occupational pension funds are associated with poor performance in the

companies they invest in. McConnell and Servaes (1990) suggest that this

could be due to a con°ict of interests, which results from blockholders be-

ing forced into aligning themselves with managers so as not to jeopardize

their other dealings with the ¯rm. Alternatively, the negative coe±cient

26

may be explained by the strategic alignment hypothesis, which argues that

blockholders and managers ¯nd it mutually bene¯cial to cooperate with each

other, undertaking activity not necessarily value-maximising in nature. Fi-

nally, such ¯ndings may be consistent with the arguments of Burkart, Gromb

and Panunzi (1997) in that too much block ownership will overly constrain

management and reduce their ability to take value maximising investment

decisions.

The investment regression coe±cients presented in column three of table

5 show a signi¯cant positive e®ect of corporate value on investment and a

negative e®ect of pro¯t volatility on investment. The ¯nding that corporate

value has a positive e®ect on investment is consistent with the arguments of

Cho (1998) that highly valued ¯rms will have large investment opportunities.

Also, ¯rms with variable earnings will be reluctant to invest if future income

is uncertain. Managerial ownership is found to have no impact on ¯rm level

investment. However, this may re°ect optimality in that investment policy

may be one way in which managers a®ect value, but not the only means.

Ultimately we view our ¯ndings of a causal relation between ownership and

¯rm value as being of greater signi¯cance than the lack of a relation between

ownership and investment. These results are consistent with Cho (1998) but

slightly stronger, in that volatility of earnings is signi¯cant in our regressions

but insigni¯cant in Cho (1998).

27

6 Conclusions

Debate as to the relationship between corporate value and managerial own-

ership in the US is still unresolved. Studies such as Morck et al. (1988), Mc-

Connell and Servaes (1990), and Hermalin and Weisbach (1991) document

a non-linear relation between these two variables. More recent work by Cho

(1998), Himmelberg et al. (1999), and Demsetz and Villalonga (2001) show

that when controlling for endogeneity, managerial ownership is determined

by corporate value but not vice-versa.

We argue that even accepting corporate value and managerial ownership

to be endogenously related to each other, misspeci¯cation of the managerial

holding-corporate value relationship may lead to spurious conclusions con-

cerning the direction of causality. Applying a quintic structure, we present

results which suggest that the correct form of this relationship is a double

humped curve. This is in contrast to other studies that have assumed a cubic

or quadratic speci¯cation and by construction only one hump.

The second hump or local maximum is attributed to a collapse in external

market discipline at or around the point where managers take overall control

of their ¯rm. At this point - which is around 50% ownership, the management

is not su±ciently akin to owners but has su±cient power to disregard any

form of external monitoring or discipline. This has a detrimental e®ect on

corporate value for a short window of managerial holdings. At high levels

of managerial ownership, managers e®ectively become owners of their ¯rm

leading to a convergence of interests with other outside shareholders.

Utilizing the quintic speci¯cation for managerial ownership, we show that

even when controlling for endogeneity, not only is corporate value a deter-

28

minant of managerial ownership but managerial ownership is also a determi-

nant of corporate value. This ¯nding is consistent with the classical work of

Jensen and Meckling (1976) as well as the early empirical work of Morck et al.

(1988) and McConnell and Servaes (1990) who do not control for endogeneity

in their analysis of corporate value and managerial ownership.

We believe our analysis to have several important contributions to the lit-

erature on corporate value. First, our quintic speci¯cation extends previous

work in this area and successfully captures the complex nonlinear relationship

between corporate value and managerial ownership. Second, by analysing

a completely di®erent market which is similar in structure to the United

States, we strengthen the power and insights gained from earlier compara-

ble US studies. Third, we provide evidence that corporate value, ¯rm level

investment and managerial holdings are interdependent on each other. This

has implications for the debate on the e®ectiveness of compensation policies

involving stock options for top managers. Moreover, our ¯ndings suggest

that some levels of managerial ownership may not be bene¯cial to outside

shareholders even when these levels are high. At the very least, this paper

has served to add to the debate concerning the importance of managerial

ownership on corporate value by providing evidence that even controlling for

endogenous e®ects, managerial ownership and stock compensation schemes

do have a signi¯cant in°uence on corporate value.

Our research has provided an initial step towards a more accurate char-

acterisation of the corporate value-managerial ownership relationship. While

we do not posit that our speci¯cation can be applied to every given data set,

we argue that previous research may be misspeci¯ed where it has failed to

29

fully explore alternative speci¯cations of the managerial ownership { corpo-

rate value relationship.

Future work in this area may focus on other structural forms, which more

e®ectively re°ect the interdependence of managerial ownership and corporate

prospects. The nonlinear endogenous impact of blockholders on corporate

value and managerial ownership would also provide interesting insights on

the external discipline that is faced by ¯rm managers and the role this has

on corporate value.

30

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35

8 Tables

Table 1 - Descriptive Statistics

Insider ownership data measures the total level of holdings held by company managementthat are greater than 0.5% of a company's equity. Blockholder data measures the totallevel of holdings by outside blockholders that are greater than 3% of a company's eq-uity. Largest stakeholder is the largest single outside blockholder that holds at least 3%of company's outstanding equity. Capital expenditure (thousands), total assets employed(thousands), after tax pro¯ts, depreciation, leverage, equity market values (millions) andresearch and development costs (thousands)are collected from Datastream. Tobin's Q ismeasured as the ratio of the market value of equity and book values of debt and preferredequity to the book value of assets in the ¯rm minus current liabilities. Shareholdings datais taken from London Stock Exchange Handbook for 1996 and 1997. All data are forindustrial companies quoted on London Stock Exchange in 1995.

Variable Mean Std. Dev. Minimum MaximumInsider Holdings 13.02% 18.06% 0.00% 79.90%Blockholder Holdings 37.34% 23.57% 0.00% 100.00%Largest Stakeholder 18.82% 21.64% 0.00% 100.00%Capital Expenditures 21,221 75,317 7 1,024,200Total Assets Employed 255,642 1,583,274 268 37,774,000After Tax Pro¯ts less de-preciation

0.1425 0.4763 -10.977 3.4207

Debt/Assets Employed 0.1411 0.2252 0.0000 4.8358Market Value of Equity 335 1399 0.68 26,224Research and Develop-ment

2,918 44,108 0 1,198,988

Tobin's Q 1.9647 1.2092 0.4502 7.0997

36

Table 2 - Breakdown of Sample by Insider Ownership

Insider ownership data measures the total level of holdings held by company managementthat are greater than 0.5% of a company's equity. Blockholder data measures the totallevel of holdings by outside blockholders that are greater than 3% of a company's eq-uity. Largest stakeholder is the largest single outside blockholder that holds at least 3%of company's outstanding equity. Capital expenditure (thousands), total assets employed(thousands), after tax pro¯ts, depreciation, leverage, equity market values (millions) andresearch and development costs (thousands) are collected from Datastream. Tobin's Q ismeasured as the ratio of the market value of equity and book values of debt and preferredequity to the book value of assets in the ¯rm minus current liabilities. Shareholdings datais taken from London Stock Exchange Handbook for 1996 and 1997. All data are forindustrial companies quoted on London Stock Exchange in 1995.

Insider OwnershipLevel

NumberofFirms

Block-holderOwn-ership%

Tobin'sQ

TotalAssetsEm-ployed

CapitalEx-pendi-tures/AssetsEm-ployed

Liquidity

0 · I/O · 10% 464 43.3 1.952 393,861 0.106 0.13010 · I/O · 20% 87 34.5 2.033 44,093 0.161 0.12920 · I/O · 30% 75 34.4 1.736 26,186 0.124 0.15730 · I/O · 40% 41 24.0 2.109 34,322 0.117 0.19440 · I/O · 50% 34 22.7 2.113 35,864 0.114 0.19450 · I/O · 60% 26 13.0 2.257 28,190 0.100 0.17760 · I/O · 70% 21 12.7 1.933 14,234 0.099 0.16970 · I/O · 100% 4 5.8 1.808 10,127 0.114 0.239

37

Table 3 - Regression Results for Tobin's Q on Insider Ownership

The following equation was estimated using data for 752 ¯rms listed on London StockExchange during 1995.

Q = ®0 + ®1IO + ®2IO2 + ®3IO

3 + ®4IO4 + ®5IO

5 + "

where Q is Tobin's Q and IO is insider ownership. Insider ownership data is taken fromLondon Stock Exchange Yearbook and Tobin's Q is calculated from Datastream.

Variable Intercept IO IO2 IO3 IO4 IO5

Coe±cient 1.85 0.12 -0.013 4.63 x 10¡4 -6.73 x 10¡6 3.36 x 10¡8

t-statistic 28.14 3.23 -3.08 2.82 -2.53 2.24Adj:R2 0:017 F 2:651

38

Table 4 - Regression Results for Tobin's Q on Insider Ownership

The following equation was estimated using data for 752 ¯rms listed on London StockExchange during 1995.

Q = ®0 + ®1IOupto7% + ®2IO7%to26% + ®3IO26%to51% + ®4IO51%to76% + ®5IOover76% + "

where Q is Tobin's Q andIOupto7% =insider ownership if insider ownership < 7%, =7% if insider ownership >

7%.IO7%to26% = 0 if insider ownership < 7%, = insider ownership minus 7% if 7% <

insider ownership < 26%, =26% if insider ownership > 26%.IO26%to51% = 0 if insider ownership < 26%, = insider ownership minus 26% if 26% <

insider ownership < 51%, =51% if insider ownership > 51%.IO51%to76% = 0 if insider ownership < 51%, = insider ownership minus 51% if 51% <

insider ownership < 76%, =76% if insider ownership > 26%.IOover76% = 0 if insider ownership < 76%, = insider ownership minus 76% if insider

ownership > 76%.Insider ownership data is taken from London Stock Exchange Yearbook and Tobin's

Q is calculated from Datastream.

Variable Intercept IOupto7% IO7%to26% IO26%to51% IO51%to76% IOover76%Coe±cient 1.854 0.056 -0.020 0.0187 -0.053 0.624t-statistic 28.38 2.93 -2.62 2.57 -1.99 1.12Adj:R2 0.012 F 2.769

39

Table 5 - Simultaneous Equations Analysis of Insider Ownership,Corporate Value and Investment

Results from a simultaneous equations analysis of insider ownership, corporate value andinvestment for 752 ¯rms, using the two stage least squares method to estimate the followingequations:

InsiderOwnership = f(market value of ¯rm's common equity, corporate value, in-vestment, volatility of earnings, liquidity, industry)

CorporateV alue = g(insider ownership, investment, ¯nancial leverage, asset size, in-dustry, block ownership, largest stakeholder)

Investment = h(insider ownership, corporate value, volatility of earnings, liquidity,industry)

In the above equation, Insider ownership measures the total level of holdings held bycompany management that are greater than 0.5% of a company's equity. Blockholderdata measures the total level of holdings by outside blockholders that are greater than3% of a company's equity. Largest stakeholder is the largest single outside blockholderthat holds at least 3% of company's outstanding equity. Investment is de¯ned as capitalexpenditure/total assets employed, leverage is the ratio of total debt to total assets andliquidity is measured as cash °ow divided by total assets. Capital expenditure, total assetsemployed, after tax pro¯ts, depreciation, leverage, equity market values and pro¯t volatili-ties are collected from Datastream. Tobin's Q is measured as the ratio of the market valueof equity and book values of debt and preferred equity to the book value of assets in the¯rm minus current liabilities. Shareholdings data is taken from London Stock ExchangeHandbook for 1996 and 1997. All data are for industrial companies quoted on LondonStock Exchange in 1995. t-statistics are in parenthesis.

40

Table 5(cont.) - Simultaneous Equations Analysis of Insider Own-ership, Corporate Value and Investment

Variable Insider Ownership Corporate Value InvestmentMVEQ -1.8 x 10¡5

(-3.74)Tobin's Q 0.127

(4.63)0.073(2.35)

Volatility -1.0 x 10¡6

(-0.74)3.89x10¡6

(-2.86)Liquidity 0.035

(2.24)0.013(1.01)

Investment -1.314(-2.67)

5.136(2.23)

Leverage 1.088(4.36)

Asset Size 3.33x10¡8

(1.17)Largest Stake -0.020

(-0.06)Blockholder -0.837

(-2.60)IO 1.588

(3.07)-0.035(-0.46)

IO2 -0.395(-2.22)

0.018(0.72)

IO3 0.037(1.64)

-0.003(-0.92)

IO4 -0.001(-1.14)

1.72x10¡4

(1.03)IO5 1.9x10¡5

(0.76)-3.12x10¡7

(-1.07)Industrydummy

Yes Yes Yes

Adj. R2 0.045 0.033 0.009F 8.014 3.497 2.497

41

Figure 1 Estimated relationship between Tobin’s Q and Insider Ownership Tobin’s Q was modelled as a quintic function of insider ownership using ordinary least squares regression. The estimated regression line is:

5846342 1036.31073.61063.4013.012.085.1 IOxIOxIOxIOIOQ −−− +−+−+=

Estimated Relationship between Tobin's Q and Insider Ownership

1.20

1.40

1.60

1.80

2.00

2.20

2.40

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

Insider Ownership

Tobi

n's

Q