By Andrew Wilson and Marc Schleifer
Last month in Karachi, CIPE’s Deputy Director for Strategic Planning and Programs Andrew Wilson and Pakistan Country Director Moin Fudda took part in a conference organized by the Pakistan Institute for Corporate Governance, together with CIPE and the Association of Chartered Accountants, on the corporate governance implications of concentrated ownership in listed firms. Wilson was invited to give the keynote address and provide an international perspective at this event, which received coverage by the local press in Pakistan. To help spur discussion, we wanted to share Wilson’s remarks on the CIPE blog, since concentrated ownership is an issue that firms, shareholders and regulators grapple with worldwide.
Some of the basic theories of corporate governance start with an idealized picture of a firm with widely dispersed ownership, but in practice, the theoretical model of diffuse ownership faces problems. When a company is owned by numerous small shareholders, it can be difficult for them to get information about the firm’s operations, meaning that a great deal of the real control rests with management; the principal-agent problem arises and company performance can suffer, to the detriment of the owners (the shareholders). This would seem to argue in favor of a more concentrated ownership system, and in fact, around the world we see that diffuse ownership is indeed the exception, not the rule.
In most countries, the dominant organizational form is concentrated ownership, with control of most firms either in the hands of a family, a larger holding company, major institutional investors, or in some cases the state. This is true even in developed economies with robust capital markets and a high level of private ownership, where individual listed corporations are often part of a complex network of international or domestic holdings, which themselves in turn may or may not be listed. There are various reasons why this might be the case.
First, in less developed economies, capital markets are thinner, there is less equity in the hands of the population, and we often see a more active state role in the economy, as well as a greater tradition of family ownership, which all lend themselves to concentrated ownership. In more developed economies, we have seen the natural growth of large institutional investors, including banks, hedge funds and other large financial players, and the pooling of pension funds that turns individual small owners into large investors. Thus again we see a tendency toward concentrated ownership.
Concentrated ownership does come with certain benefits. Large investors with a significant stake may have a particular interest in the firm’s long-term growth and performance, and are better able to resolve the principal-agent problem with management by using their resources to closely monitor the firm’s operations.
At the same time, concentrated structures come with their own set of problems, as we see from recent corporate and financial history. For example, dominant shareholders can exercise control at the expense of minority investors, diverting resources. This is especially a risk if a subset of shareholders is too close to management, or there is weak oversight due to cross-population among individuals in the management and on boards of multiple corporations.
Furthermore, investor confidence – as well as sound regulatory oversight – depends on transparent and accountable disclosure regimes, and complex and concentrated ownership can undermine such transparency, creating risks both to investors and the wider public. This can also cause foreign investors to either disinvest or not to invest in the first place. In the worst cases such complex and concentrated structures have been used to facilitate fraud or corruption, particularly if there is an international dimension. In some countries the state itself holds a blocking share, which poses challenges as related-party transactions become more difficult to monitor, and the question of who is a reliable monitor to ensure fairness comes into play. Moreover, in state-owned enterprises the government might artificially boost the number of employees for political reasons, which costs the firm profits.
Just as there is a certain tendency toward concentrated ownership, which might bring certain benefits for firm performance, there is a countervailing trend toward, and need for, more diffuse ownership. Specifically, as the real and financial sectors of economies grow and individuals acquire savings that they seek to mobilize, there will be a natural movement toward more robust capital markets, which bring a diffusion of ownership. At the same time, firms seek new sources of capital for investment, research and development, acquisitions and so on, which will have the effect of diluting ownership structures.
In this dance between diffuse and concentrated ownership, with various interests among regulators, investors of different sizes, and management, the aim should be to maximize the benefits of both concentrated and diffuse ownership, while somehow avoiding the various pitfalls of both. Overall, due to globalization of capital markets and liberalization of trade, there is some tendency toward harmonization of corporate governance systems achieve that aim, but of course this balance will likely not prove easy to strike. Questions will arise about what form of ownership best ensures profitability, and particularly in the wake of the financial crisis, how to balance a low public appetite for the use of public funds for corporate rescues against the private sector’s desire to avoid overly burdensome regulation that can stifle firm growth.
This is why we need to encourage the creation of effective governance structures, which can maximize both stability and profits, and thus lessen the need for extensive regulations, setting the stage for a private sector and investment community oriented toward long-run growth.
In Pakistan, as various stakeholders look at how these issues will be addressed, questions will arise including: Can the country encourage the needed influx of fresh capital through new listings and a deeper capital market, thus lessening the concentration of ownership, without running into firm performance issues? Can Pakistan best protect minority shareholder rights without the stifling effect of shareholder litigation that sometimes arises in other countries? Can Pakistan effectively reduce the ownership stake and level of management control of the state while still respecting its sovereign economic development concerns? And can Pakistan successfully resolve the tensions within the governance of family owned firms as they mature into third generation firms where the tradeoffs between return on investment and growth come into heightened conflict as non-involved family no longer have a stake in growth?
At the international level, the OECD itself is midway through the process of examining its own well-established guidelines on corporate governance. In particular, the OECD is examining the heightened role that institutional investors must play in demanding better governance standards, certainly an issue that pertains to concentrated ownership. Because the OECD is conducting this review with public participation, and Pakistan is not an OECD member, CIPE is eager to explore ways to help channel input from Pakistan into the process, as CIPE is a member of the Business and Industry Advisory Committee to the OECD.
Andrew Wilson is Deputy Director for Strategic Planning and Programs at CIPE. Marc Schleifer is Senior Program Officer for South Asia at CIPE.