4.3 Ownership Structure, Diversification Strategy and Firm Performance 64
4.3.3 Ownership Identity, Diversification Strategy and Firm Performance 69
In chapter two and chapter three, I have reviewed studies on ownership identity and firm performance conducted in the China context. The literature documents that ownership identity does have a critical impact on a firm’s performance and different category of shareholdings do have significant ly different effects when compared to each other (Berkman et al., 2002; Xu & Wang, 1997). For example, scholars have provided both theoretical and empirical arguments on state share’s inefficiency in enhancing firm’s performance (Dewenter & Malatesta, 2001). Therefore, when exploring the relationship between diversification strategy and firm performance, it may give me more insightful findings if I take the ownership identity into consideration.
Diversification is a double-edged sword for a firm. In the previous chapters I have reviewed both the benefits and costs for a firm in a diversification strategy.
Diversification can benefit the firm when there is effective monitoring of shareholders, especially in the emerging economies. Diversified firms can employ a number of mechanisms to create and exploit market power advantages (Caves &
Christensen, 1980). Diversification can also provide a firm with different sources of capital other than external ones because it can provide an efficient internal capital market (Lang & Stulz, 1994). Diversified firms can shift capital between business sectors to achieve the efficiencies that are unavailable to single-business firms (Gertner et al., 1994). However, the costs of diversification under inefficient monitoring are also conspicuous. Without effective supervision, management team can entrench and expropriate through over-diversification. The lack of supporting
resources can deteriorate the firm performance when a firm is overly diversified (Palich et al., 2000). Thus, it is important to explore the relationship between diversification and firm performance on the condition of the effectiveness of shareholder’s monitoring, and under the type of shareholder.
Among all the Chinese listed companies in 2002, almost one-third has state shareholding as the majority ownership (Table 3-1). State ownership has been criticized as being inefficient in monitoring firm’s management (Majumdar, 1998) and as contributing to corruption (Megginson et al., 1994). Thus the agency problem of a firm whose majority shareholding is controlled by the government is significantly worsened (Boycko et al., 1996). Government shareholders have neither enough incentive nor eligible expertise to effectively supervise management to pursue the profit maximization of the firm (Xu & Wang, 1997). Additionally, as one of the biggest emerging economies in the world, China’s capital market and financial infrastructure are far from well developed and personal connections play a critical role in a firm’s daily business operations, sometimes even more so than contracts.
Both the establishment and enforcement of law are limited and the information asymmetry problem is severe between block shareholders and minority shareholders (Tan, 2002). Thus, like those in other emerging economies, firm managers of China’s SOEs, which are mostly owned by the Chinese government, have a high propensity and chance to entrench and expropriate (Dharwadkar et al., 2000). As mentioned above, a diversification strategy offers the management both an opportunity and an
excellent approach to pursue individual interests (Li et al., 1998). I expect these management entrenchment activities to lead to a loss in shareholder benefits.
As to China’s listed companies, the second largest group are those companies whose majority ownership is legal person shareholding (Table 3-1). Legal person shareholders do not have to consider the political objectives which confine the state shareholding from maximizing firm’s profit (Claessens et al., 1999). Additiona lly, as the representatives of legal person shareholders are elected to the board rather than appointed, they may have more incentive and capability to effectively monitor the firm’s management. The legal person shareholders face more stringent budget constraints so that they may concern more about a firm’s profitability and its financial condition (Wolfensohn, 1998). Furthermore, legal person shareholders tend to hold board meeting more frequently and more regularly to enforce direct monitoring on the mana gement (Sun et al., 2002).
Empirically, scholars have found legal person shareholding more efficient in monitoring the management than state ownership (Xu & Wang, 1997). As I have argued above, in an emerging economy such as China, with its underdeveloped capital and labor markets, shareholders may consider diversifying the firm to deal with the market failure of the external market and to allocate the capital more efficiently (Tan, 2001a). Through diversification, a firm can acquire capital other than by the issuance of external debt, it can allocate the labor force inside the firm more efficiently and it does not need to rely on contracts when the enforcement of law is
weak (Khanna & Palepu, 1997). All these considerations can bring benefits to a firm’s performance.
In summary, both state shareholders and legal person shareholders use diversification as an important strategic tactic. The effectiveness of diversification on a firm’s performance is contingent on the monitoring role of shareholders. When the monitoring of shareholder is weak, such as it can be with state shareholders, diversification tends to result in the deterioration of a firm’s performance. However, when diversification is encouraged under the efficient monitoring of management, such as it can be with legal person ownership, it is likely to benefit rather than harm a firm’s performance. Thus I introduce the following hypotheses.
Hypothesis 6a State shareholding would make firm diversification have a greater negative impact on firm performance as diversification increases.
Hypothesis 6b Legal Person shareholding would make firm diversification have a greater positive impact on firm performance as diversification increases.