Ownership concentration and firm financial performance

Evidence from Saudi Arabia

By: Dr. Mohamed Moustafa Soliman Arab Academy for Sciences & Tech. Abstract The effect of ownership concentration on a firms performance is an important issue in the literature of finance theory. This study seeks to examine the effect of ownership concentration on firm financial performance in Saudi Arabia, using pooled cross-sectional observations from the listed Saudi firms for three years between 2006 and 2008. I find that firm financial performance measured by the accounting rate of return on assets and rate of return on equity generally improves as ownership concentration increases. I also find that there exists a hump-shaped relationship between ownership concentration and firm performance, in which firm performance peaks at intermediate levels of ownership concentration. The study provides some empirical support for the hypothesis that as ownership concentration increases; the positive monitoring effect of concentrated ownership first dominates but later is outweighed by the negative effects, such as the expropriation of minority shareholders. The empirical findings shed light on the role ownership concentration plays in corporate performance, and thus offer insights to policy makers interested in improving corporate governance systems in an emerging economy such as Saudi Arabia.

Keywords: corporate governance, ownership concentration, financial performance, and Saudi Arabia.

1. Introduction The effect of ownership concentration on a firms performance is an important issue in the literature of finance theory. Ownership concentration may improve performance by decreasing monitoring costs (Shleifer and Vishny, 1986). However, it may also work in the opposite direction. There is a possibility that large shareholders use their control rights to achieve private benefits. Ownership concentration are considered as important factors that affect a firms health (Zeitun and Tian, 2007).

The idea that ownership concentration is one of the main corporate governance mechanisms influencing the scope of a firms agency costs is generally accepted (Shleifer and Vishny, 1997). Also, it has been shown in various contexts that better corporate governance is associated with higher financial performance. Different countries have developed distinct patterns of corporate governance. In this respect, different solutions to corporate governance problems may be appropriate depending on the institutional setting of each country. Therefore, it might be necessary to look into a countrys unique corporate structures, rules, and environments when analyzing the link between corporate governance and performance in the country.

It is worth noting that most research on ownership concentration and firm performance has been dominated by studies conducted in developed countries. However, there is an increasing awareness that theories originating from developed
2

countries such as the USA and the UK may have limited applicability to emerging markets. Emerging markets have different characteristics such as different political, economic and institutional conditions, which limit the application of developed markets empirical models (Zeitun and Tian, 2007). Recent studies of corporate governance suggest that geographical position, industrial development and cultural characteristics along with other factors affect ownership concentration which in turn have impacts on a firms performance (Pedersen and Thompson, 1997). There is a significant lack of applied studies dealing with financial distress in Middle Eastern countries such as Saudi Arabia.

The main objective of this study is to examine the effect of ownership concentration on firm financial performance of listed companies in Saudi Arabia. After a decade of an extensive privatization program, a unique feature of the Saudi stock exchange is that many listed companies have varying ownership structure and concentration because many of them were formerly family-owned enterprises, before being restructured and listed on the stock exchange. The results consistently support the potential association between ownership concentration and firm financial performance, though the relationship differs across different group of owners. The organization of the paper is as follows: Section 2 reviews the existing literature on the effects of ownership concentration on firm performance. Section 3 presents for hypotheses development. Section 4 provides a discussion of the variables tested, model development and sample. Section 5 presents a discussion and summary of the results. Section 6 concludes the study.

2. Literature review The effects of ownership concentration on firm performance are theoretically complex and empirically ambiguous. Concentrated ownership is widely acknowledged to provide incentives to monitor management. Large shareholders might have the greater incentive to improve firm performance than do dispersed shareholders. Furthermore, concerted actions by large shareholders are easier than by dispersed shareholders. In other words, large shareholders have both an interest in getting their money back and the power to demand it. However, despite the obvious benefits from concentrated ownership, attention has also been focused on the adverse effects. For example, while dispersed ownership offers better risk diversification for investors, concentrated ownership imposes increasing risk premia because of risk aversion of large shareholders (Demsetz and Lehn, 1985), causing potential under-investment problems. A more important issue in this respect is that concentrated ownership could lead to another sort of agency problem, that is, conflicts between large shareholders and small shareholders. Large shareholders have incentives to use their controlling position to extract private benefits at the expense of minority shareholders (Lee, 2008).

Since concentrated ownership has its own specific benefits and costs, it is theoretically open which one dominates. Just as in the theoretical consideration, while some empirical research supports the positive relationship, other empirical research suggests that concentrated ownership does not necessarily lead to better firm performance. Several papers (Short, 1994; Shleifer and Vishny, 1997; Gugler, 2001) provide comprehensive surveys and show that the overall empirical evidence on the effects of ownership concentration on firm performance is mixed.

There have been different studies examining the effects of ownership concentration on performance. Hill and Snell (1988) show that ownership structure affects firm performance as measured by profitability through strategic structure. Later, Hill and Snell (1989) confirm this positive relation for US firms by taking productivity as a measure of performance. On the contrary, McConnell and Servaes (1990) do not find evidence supporting any direct effect of large shareholders on firm value. Nevertheless, the empirical evidence in Agrawal and Mandelker (1990) supports the hypothesis proposed by Shleifer and Vishny (1986) that the existence of large owners or a high concentration ownership leads to better management and also better performance, especially when ownership is concentrated in institutional investors rather than individual investors. Therefore, institutional ownership could increase a firms performance. Wu and Cui (2002) study the effect of ownership structure on a firms health. They found that there is a positive relation between ownership concentration and accounting profits, indicated by return on assets (ROA) and return on equity (ROE), but the relation is negative with respect to the market value measured by the share price-earning ratio (P/E) and market price to book value ratio (M/B). Also, the contribution of government (state) and institution ownership is significantly positive to company profit, while negative to the market value. Xu and Wang (1997) investigated whether ownership structure has significant effects on the performance of publicly listed companies in China. They find that ownership structures, both the mix and concentration of ownership have a significant effect on the performance of stock companies. There is a significant and positive relationship between ownership concentration and firms profitability.
5

Also the effect of ownership concentration is stronger for companies dominated by shareholders than for those dominated by the state.

There is also some empirical evidence of a negative impact of large equity holders on firm performance. Lehmann and Weigand (2000), focusing on German corporations, find indeed a negative effect of ownership concentration on firm performance. Leech and Leahy (1991) analyse the implications of the separation of ownership from control for a UK firm value. They describe ownership structure using several measures of concentration and control types. Therefore, ownership structure is expected to affect a firms performance through the effects of ownership concentration. They found that there is a negative and significant relationship between ownership concentration and firm value and profitability. Another study of the British case, by Mudambi and Niclosia (1998), confirms this negative relationship between ownership concentration and performance. Prowse (1992) examines the structure of corporate ownership in a sample of Japanese firms in the mid-1980s. His empirical work indicated that there is no relationship between ownership concentration and profitability. Also, Chen and Cheung (2000) found a negative relationship between concentrated ownership and firm value for a sample of 412 publicly listed firms in the Hong Kong stock exchange through 1995-1998.

A nonlinear relationship between ownership concentration and firm performance is another important issue in empirical analysis. Thomsen and Pedersen (2000) show empirically that firm performance first improves as ownership is more concentrated, but eventually declines in the largest European companies. It indicates that, at high levels of ownership concentration, the benefit of
6

concentrated ownership is outweighed by the negative effects. Among the negative effects, the expropriation of small shareholders by large shareholders is noteworthy. Porta et al. (1999) find that the main problem in large firms of 27 advanced countries may be the potential expropriation because controlling shareholders have control rights significantly in excess of cash flow rights via pyramid structure. Using data for public companies in East Asia, Claessens et al. (2002) show that firm market value increases with the cash-flow ownership of largest shareholders, but drops when the control rights of largest shareholders exceed their cash-flow ownership. Similar results are often found in Korea (Joh, 2003; Baek et al., 2004). Interestingly, evidence shows that, in emerging economies, control rights in excess of cash flow rights are related to lower firm values, but not enough to offset the benefits of concentrated ownership (Lins, 2003). However, according to Sanchez-Ballesta and Garca-Meca (2007), the relationship is moderated by institutional environment. The relationship is stronger in continental countries than in Anglo-Saxon countries, which would support the argument that ownership is more positively related to firm performance in countries with lower levels of investor protection.

In spite of all these efforts to investigate the effect of ownership concentration on firms performance until now there are few studies of the effect of ownership concentration on firms health especially in the Middle East.

3. Hypotheses development

This study seeks to determine whether ownership structure affects firm financial performance in Saudi Arabia listed companies. Ownership structure is analyzed in
7

terms of ownership concentration and identity. According to agency theory, ownership structure should affect the efficiency of monitoring mechanisms. Traditionally, the theory holds that concentrated ownership should mitigate the agency problem. Based on the traditional agency theory, the study predicts that ownership concentration positively affects firm financial performance. The first hypothesis to be tested is as follows:

H1: Ownership concentration is positively associated with firm financial performance.

However, as discussed above, the negative effects of concentrated ownership are shown to be considerable. The positive and negative effects could be combined to develop the hypothesis that at low levels of ownership concentration, firm performance improves as ownership concentration rises, but at high levels of ownership concentration, an inverse relation between ownership and performance is observed. Thus the second hypothesis is as follows:

H2: There is a hump-shaped relationship between ownership concentration and firm financial performance.

4. Research method 4.1. Sample The data used in this study included 64 publicly listed companies on the Saudi Stock Exchange (SSE), over the period 2006-2008, forming approximately 67 percent of the total population of firms listed on the SSE, and fairly represents a
8

wide cross-section of industries. The banking and insurance sectors are not included in this study as the characteristics of these firms are different from the firms in other industrial sectors in terms of financial statement profitability measures and liquidity assessment (Zeitun and Tian 2007). All of the data were collected from official Saudi Stock Exchange web site (tadawul). 4.2. Variables selection Using pooled data for the listed companies in the SSE, three ownership structure variables are used in the study. As a proxy for ownership concentration, the percentage of shares held by a controlling shareholder (labeled as CR) is used. The controlling shareholder refers to a group of shareholders who control the company, such as shareholders owning substantial equity stake in a company, their family members, and affiliated entities (Lee, 2008). Two variables are selected as a proxy for firm financial performance: return on assets ratio (ROA) and return on equity ratio (ROE). Several control variables are introduced in the study: firm size, leverage, liquidity, and business cycle. Natural logarithm of total assets (LNA) and natural logarithm of total sales (LNS) are included to control for firm size. As for leverage, equity to assets ratio (EAR) is employed to control for capital structure effect, and in order to control for longterm financial distress, liabilities to equity ratio (LER) is utilized. With regard to liquidity, current ratio (current assets to current liabilities ratio, CUR) is a wellknown liquidity ratio and is utilized as a proxy for a firms financial capacity to meet its short-term financial distress. A quick ratio (QKR) is also employed, which is stricter than the current ratio, because it subtracts inventory from current assets. Each firms inventory to total assets ratio (IVA) is introduced to control for the
9

effect of business cycle. The description of the variables and summary statistics for the sample are presented in Table I.

Table I: Description of Variables and Summary Statistics

Variable Performance Label ROA ROE Ownership Concentration Size LNA LNS Leverage EAR LER Liquidity CUR QKR Business Cycle IVA CR Description Net income/ total assets Net income / total equity Mean 6.3873 8.5689 Median 1.9800 3.1500 15.000 Min -8.87 -13.14 5.00 Max 43.45 54.29 70.00

The percentage of shares held by 25.156 large shareholders Natural Logarithm of total assets Natural Logarithm of total sales Equity to total assets ratio Liabilities to equity ratio Current assets to liabilities ratio Quick ratio Inventory to total assets ratio 9.8755 7.0381 .4928 1.3856 2.5998 1.9455 .0558

9.8200 9.0600 .5200 .8100 2.4100 1.8800 .0300

8.06 .00 .02 .08 .50 .20 .00

11.43 11.18 .92 5.24 6.99 4.56 .45

4.3. Regression models To provide empirical testing to the hypotheses addressed in the study, a linearmultiple regression analysis was used to test the association between the dependent variables of firm financial performance and the independent variable of ownership concentration. The following two models are estimated: ROA = 0 + 1 CR+ 2 LNA+ 3 LNS+ 4 EAR + 5 LER + 6 CUR + 7 QKR + 8 IVA + ROE = 0 + 1 CR+ 2 LNA+ 3 LNS+ 4 EAR + 5 LER + 6 CUR + 7 QKR + 8 IVA +
10

(1)

(2)

Where ROA, return on assets; ROE, return on equity; CR, percentage of shares held by a controlling shareholder; LNA, natural logarithm of total assets; LNS, natural logarithm of total sales; EAR, equity to assets ratio; LER, liabilities to equity ratio; CUR, current ratio; QKR, quick ratio; and IVA, inventory to assets ratio. Table II represents a correlation matrix for the selected variables, The Pearsons correlation matrix shows that the degree of correlation between the independent variables is either low or moderate, which suggests the absence of multicollinearity between independent variables. As suggested by Bryman and Cramer (1997), the Pearsons R between each pair of independent variables should not exceed 0.80; otherwise, independent variables with a coefficient in excess of 0.80 may be suspected of exhibiting multicollinearity. Correlations coefficients in the sample are within an acceptable range.

Table II. Correlation coefficients Matrix of the variables used in the study:
ROA ROA ROE CR 1 .322 .203 1 .306 .088 .423 .530 -.480 .648 .548 .141 1 .588 .220 -.017 -,058 .123 .137 .062 1 .072 -.399 ,229 .040 .016 -.108 1 .166 -.129 .408 .290 .328 1 -.502 .610 .647 -.034 1 -.419 -.588 .057 1 .647 -.017 1 -.131 1 ROE CR LNA LNS EAR LER CUR QUK IVA

LNA .020 LNS .332

EAR .569 LER -.388 CUR .663 QUK .530 VIA .047

11

5. Results The results of the regression analysis provides evidence that ownership concentration has positive effects on firm financial performance. Table III presents the regression analysis for the financial performance variables (ROA & ROE), using binary logistic procedure. The explanatory power of the two models is 0.227 and 0.324 respectively . The results show that the return on assets ratio (ROA) is positively associated with ownership concentration (sig. = 0.00). Firm financial performance represented by return on equity (ROE) also a significant variable with a positive sign (sig. = .001).

The significant impact of concentration ratios on ROE and ROA is in support of the Shleifer and Vishny (1986) hypothesis that large shareholders may reduce the problem of small investors, and hence increase the firms performance. These results are consistent with Abdel Shahid (2003); that ROA and ROE are the most important factor used by investors rather than the market measure of performance. This finding is also consistent with the results of Wu and Cui (2002); Zeitun et al. (2007) and Lee (2008), that there is a positive relationship between ownership concentration and accounting profits, indicated by ROA and ROE.

The effects of some control variables on firm financial performance are confirmed to be significant in the regression. Among control variables, liquidity is noticeable. The relation between the liquidity variables (CUR and QKR) and the dependent variables is shown to be statistically significant: 0.00 (t=7.763), 0.00 (t=6.747) for

12

ROA, and 0.00 (t=4.986) and 0.00 (t=4.101) for ROE. No significant association was found between the remaining control variables and firm financial performance.

Table III. The regression results of the variables used in the study:
ROA B Constant 7.07 CR LNA LNS EAR LER CUR QUK IVA .237 -921 -.037 19.01 -.396 14.76 -17.17 -24.07 SE 19.38 .055 1.84 .228 .375 -.108 -.013 Coeffi. t .365 4.306 -1.043 -.101 2.635 -.411 7.763 6.747 -2.240 Sig. .716 .000 .301 .872 .011 .683 .000 .000 .029 B 7.964 .326 -1.638 .438 7.451 -3.618 15.563 -17.14 -8.678 SE 13.821 .090 3.023 .374 11.845 1.582 3.121 4.179 17.648 .365 -.065 .108 .107 -.321 1.572 -1.289 -.432 ROE Coeffi. t .250 3.616 -.542 1.171 .629 -2.287 4.986 4.101 .491 Sig. .803 .001 .590 .247 .532 .026 .000 .000 .625

7.215 .385 .964 -.050

1.901 2.108 2.545 -1.827 10.75 -.171

Adjusted R Squire .735 F Significance 23.176 .000

Adjusted R Squire .643 F Significance 15.408 .000

Where ROA, return on assets; ROE, return on equity; CR, percentage of shares held by a controlling shareholder; LNA, natural logarithm of total assets; LNS, natural logarithm of total sales; EAR, equity to assets ratio; LER, liabilities to equity ratio; CUR, current ratio; QKR, quick ratio; and IVA, inventory to assets ratio.
13

In relation to the second hypothesis that a hump-shaped relation exists between ownership concentration and firm performance, Ramsey Regression Equation Specification Error Test (RESET) is conducted. The RESET tests whether nonlinear combinations of the independent variables help explain the dependent variable (Ramsey, 1969). The test results (p < 4.17e 08 for ROA; p < 2.8e 16 for ROE) confirm the nonlinear relationship between ownership concentration and firm performance. In order to test the hump-shaped pattern, piecewise OLS regression and quadratic OLS regression are used.

The results of the piecewise regression and the quadratic regression can be understood as supporting the idea of the hump-shaped relationship between ownership concentration and firm financial performance. The effect of ownership concentration on firm performance is positive at lower levels of ownership concentration, but negative at higher levels of ownership concentration. The piecewise regression results show that firm performance increases as ownership concentration increases up to the point at which ownership concentration reaches 60%, but decreases slowly after the peak point. The slopes in each regression are Sig. 0.11 (t=4.30), Sig. 0.09 (t=3.61) respectively, at low levels of ownership concentration. At high levels of ownership concentration, teh slopes are -0.04, 0.10,. The results reflects the hump-shaped relation between ownership concentration and firm performance. Especially, the results provide strong evidence of the rapid increase in ownership concentration at lower levels. The nonlinear hump-shaped relation of the present study is completely matched with Belkaoui and Pavlik (1992), Xu and Wang (1999) on China. The results provide some empirical support for the hypothesis that as ownership concentration increases; the positive monitoring effect of concentrated ownership first dominates
14

but later is outweighed by the negative effects, such as the expropriation of minority shareholders.

6. Conclusion The possible impact of ownership concentration on firm financial performance has been a central question in research on corporate governance, but evidences on the nature of this relationship has been decidedly mixed. While some theories and empirical investigations suggest that ownership concentration affects firm financial performance, some others suggest the irrelevance of the relationship between ownership concentration and firm financial performance.

This study investigates the relationship between ownership concentration and firm financial performance. Using panel data for 64 publicly listed companies on the Saudi Stock Exchange (SSE), over the period 2006-2008, the study finds that firm performance improves as ownership concentration increases. The empirical findings in this study shed light on the role ownership structure plays in firm financial performance, and thus offer insights to policy makers interested in improving corporate governance systems in an emerging economy such as Saudi Arabia. This finding is consistent with the prediction of agency theory revealing that lower level ownership concentration has negative performance effect, while higher level has positive effect. Explanatory power of other governance and control variables of the models also produce expected results.

The data also provide strong evidence that there exists a hump-shaped relationship between ownership concentration and firm financial performance, in which firm performance peaks at intermediate levels of ownership concentration. The finding
15

provides empirical support for the hypothesis that as ownership concentration increases, the positive monitoring effect of concentrated ownership first dominates but later is outweighed by the negative effects, such as the expropriation of minority shareholders. Given substantial ownership concentration in Saudi firms, the influence of controlling shareholders can lead to the expropriation of minority shareholders. Although Saudi Arabia has made significant progress in legal and regulatory reforms, the current legal framework is still deemed to be too weak to prevent the expropriation of minority shareholders.

16

References: Abdel Shahid, S. (2003), Does ownership structure affect firm val ue? Evidence from the Egyptian stock market, working paper, Cairo and Alexandria Stock Exchange (CASE), Cairo. Agrawal, A. and Mandelker, G. (1990), Large shareholders and the monitoring of managers: the case of antitakeover charter amendments, Journal of Financial Quantitative Analysis, Vol. 25 No. 2, pp. 143-161. Baek, J. S., Kang, J. K. and Park, K. S. (2004), Corporate governance and firm value: evidence from the Korean financial crisis, Journal of Financial Economics, Vol. 71, PP. 265313. Belkaoui, A. and Pavlik, E. (1992), The effects of ownership structure and diversification strategy on performance, Management and Decision Economics, Vol. 13, PP. 343-352. Bryman, A. and Cramer, D. (1997), Quantitative Data Analysis with SPSS for Windows: A Guide for Social Scientists, Routledge, London. Chen, Z. and Cheung, Y.L. (2000), Corporate governance, firm performance and agency conflicts in closely-held firms: evidence from Hong Kong, working paper, City University of Hong Kong, Hong Kong. Claessens, S., Djankov, S., Fan, J. P. H. and Lang, L. H. P. (2002), Disentangling the incentive and entrenchment effects of large shareholdings, Journal of Finance, Vol. 57, PP. 27412772. Demsetz, H. and Lehn, K. (1985), The structure of corporate ownership: causes and consequences, Journal of Political Economy, Vol.93, PP.11551177. Gugler, K. (2001), Corporate Governance and Economic Performance. New York: Oxford University Press. Joh, S. W. (2003), Corporate governance and firm profitability: evidence from Korea before the economic crisis, Journal of Financial Economics, Vol. 68, PP. 287322.
17

Hill, C. and Snell, S. (1988), External control, corporate strategy, and firm performance in research-intensive industries, Strategic Management Journal, Vol. 9, pp. 577-90. Hill, C. and Snell, S. (1989), Effects of ownership structure and control on corporate productivity, Academy of Management Journal, Vol. 32 No. 1, pp. 2546. Lee, S. (2008), Ownership structure and financial performan ce: evidence from panel data of South Korea, Corporate Governance & Control, Vol.6 No. 2, PP. 254-267. Leech, D. and Leahy, J. (1991), Ownership structure, control type classifications and the performance of large British companies, The Economic Journal, Vol. 101 No. 409, pp. 1418-1437. Lins, K. V. (2003), Equity ownership and firm value in emerging markets, Journal of Financial and Quantitative Analysis, Vol. 38, PP. 159184. McConnell, J. and Servaes, H. (1990), Additional evidence on equity ownership and corporate value, Journal of Financial Economics, Vol. 27 No. 2, pp. 595612. Mudambi, R. and Niclosia, C. (1998), Ownership structure and firm performance: evidence from the UK financial services industry, Applied Financial Economics, Vol. 8 No. 2, pp. 175-180. Pedersen, T. and Thompson, T. (1997), European patterns of corporate ownership: a twelve country study, Journal of International Business Studies, Vol. 28 No. 4, pp. 759-78. Porta, R. L., de Silanes, F. L. and Shleifer, A. (1999), Corporate ownership around the world, Journal of Finance, Vol. 54, PP. 471517. Prowse, S. (1992), The structure of corporate ownership in Japan, The Journal of Finance, Vol. 47 No. 3, pp. 1121-41.

18

Ramsey, J. B. (1969), Tests for specification errors in classical linear least squares regression analysis, Journal of the Royal Statistical Society, Series B (Methodological), Vol 31, PP.350371. Sanchez-Ballesta, J. P. and Garca-Meca, E. (2007), A meta-analytic vision of the effect of ownership structure on firm performance, Corporate Governance, Vol.15, PP. 879893. Shleifer, A. and Vishny, R. (1986), Large shareholders and corporate control, Journal of Political Economy, Vol. 94 No. 3, pp. 461-88. Shleifer, A., R. Vishny (1997) A survey of corporate governance. Journal of Finance 52, 737- 783. Short, H. (1994), Ownership, control, financial structure and the performance of firms, Journal of Economic Surveys, Vol. 8, PP. 203249. Thomsen, S. and Pedersen, T. (2000), Ownership structure and economic performance in the largest European companies, Strategic Management Journal, Vol.21, PP. 689705. Wu, S. and Cui, H. (2002), Consequences of the concentrated ownership structure in Mainland China evidence of Year 2000, working paper, City University of Hong Kong, Hong Kong. Xu, X. and Wang, Y. (1997), Ownership structure, corporate governance, and corporate performance: the case of Chinese stock companies, working paper, The World Bank, Washington, DC. Xu, X. and Wang, Y. (1999), Ownership structure and corporate governance in Chinese stock companies, China Economic Review, Vol. 10, PP. 75-89. Zeitun, R. and Tian, G. (2007), "Does ownership affect a firm's performance and default risk in Jordan?", Corporate Governance, Vol.7 No. 1, PP. 66-82.

19