1. Pyramidal Ownership Structure, Overinvestment, and Firm Performance in China Chao Chen Fudan University Donglin Xia Tsinghua University Song Zhu Beijing Normal University

2. Motivations Business groups organized by corporate pyramids enable the ultimate shareholders to control a portfolio of firms with less cash requirement. Business groups organized by corporate pyramids enable the ultimate shareholders to control a portfolio of firms with less cash requirement. It alleviates restrictions on external financing and reduces financing cost. It alleviates restrictions on external financing and reduces financing cost.

3. Motivations In China, governments and entrepreneurs control a large number of listed firms through the pyramidal ownership structure. In China, governments and entrepreneurs control a large number of listed firms through the pyramidal ownership structure. SOEs and NSOEs have different incentives for creating this pyramid structure within their organizations (Fan et al., 2005; Zhu, 2006). SOEs and NSOEs have different incentives for creating this pyramid structure within their organizations (Fan et al., 2005; Zhu, 2006).

4. Motivations SOEs utilize the pyramidal ownership structure to mitigate government intervention on listed firms and allow them more flexibility in operation. SOEs utilize the pyramidal ownership structure to mitigate government intervention on listed firms and allow them more flexibility in operation. For NOSEs, ultimate shareholders use the pyramid to control their portfolio firms with less cash flows and therefore create an internal capital market within the pyramid (Bianco and Casavola, 1999; Attig et al., 2003; Fan et al., 2005). For NOSEs, ultimate shareholders use the pyramid to control their portfolio firms with less cash flows and therefore create an internal capital market within the pyramid (Bianco and Casavola, 1999; Attig et al., 2003; Fan et al., 2005).

5. Motivations This study examines (1) the relationship between corporate pyramids and over investment, and (2) the influence of corporate pyramid and overinvestment on firm performance. This study examines (1) the relationship between corporate pyramids and over investment, and (2) the influence of corporate pyramid and overinvestment on firm performance.

6. Literature Reivew The external capital market contents “ lemon ” premium due to asymmetric information (Myers and Majluf, 1984). The external capital market contents “ lemon ” premium due to asymmetric information (Myers and Majluf, 1984). The external financing is much costly than that of internal capital financing due to market fictions (Brennan and Subrahmanyam, 1996; Easley and O ’ Hara, 2004). The external financing is much costly than that of internal capital financing due to market fictions (Brennan and Subrahmanyam, 1996; Easley and O ’ Hara, 2004).

7. 2. Literature Review Bertrand and Mullainathan (2003), Bertrand et al. (2003) and Bebchuk et al. (2000) argue that pyramids provide controlling shareholders the ability (due to high control rights) and incentive (due to low cash flow rights) to tunnel corporate resources from the lower end of the pyramid to the higher end where they have higher cash flow rights. Bertrand and Mullainathan (2003), Bertrand et al. (2003) and Bebchuk et al. (2000) argue that pyramids provide controlling shareholders the ability (due to high control rights) and incentive (due to low cash flow rights) to tunnel corporate resources from the lower end of the pyramid to the higher end where they have higher cash flow rights. Woojin Kim (2007) Woojin Kim (2007) Bebchuk et al. (2000) Bebchuk et al. (2000)

8. 2. Literature Review Bertrand and Mullainathan (2003) Bertrand and Mullainathan (2003) Bertrand et al. (2003) Bertrand et al. (2003) Stein (1997): Using a pyramid structure to build an internal capital market may mitigate the reliance on external financing. Stein (1997): Using a pyramid structure to build an internal capital market may mitigate the reliance on external financing. Almeida and Wolfenzon (2006): When the external financing market has greater constraints, the internal capital market becomes more convenient. Almeida and Wolfenzon (2006): When the external financing market has greater constraints, the internal capital market becomes more convenient.

9. 2. Literature Review Holmen and Hogfeldt (2005): The overinvestment hypothesis for pyramids argues that discounts are primarily for inefficient investment decisions due to leveraged control over firms ’ internal cash flows. The overinvestment hypothesis for pyramids argues that discounts are primarily for inefficient investment decisions due to leveraged control over firms ’ internal cash flows.

10. 2. Literature Review Richardson (2006) uses accounting information to measure overinvestment of free cash flows. He finds a positive relationship between overinvestment and free cash flow for firms with positive free cash flow. Specifically, he documents that the average of firm with positive cash flow overinvest 20% of its cash flow.

11. Hypotheses Concerning the influence of corporate pyramid on capital investment, longer layers in the pyramid may restrict the overinvestment of listed firm. Thus, increasing layers in the pyramid mitigate the likelihood of overinvestment for both SOEs and NSOEs. Concerning the influence of corporate pyramid on capital investment, longer layers in the pyramid may restrict the overinvestment of listed firm. Thus, increasing layers in the pyramid mitigate the likelihood of overinvestment for both SOEs and NSOEs.

12. Hypotheses For SOEs, shorter layers in the pyramid means more direct intervention from the government. For SOEs, shorter layers in the pyramid means more direct intervention from the government. The executives of listed SOEs are more likely to be appointed by the government. For meeting their political performance and avoiding their future political career in jeopardy, those government officers- executives have incentives to build and expand their empires, which may lead to overinvestment. The executives of listed SOEs are more likely to be appointed by the government. For meeting their political performance and avoiding their future political career in jeopardy, those government officers- executives have incentives to build and expand their empires, which may lead to overinvestment. If the purpose of creating a pyramid is to reduce the influence by the government and increase the managerial control of the firm, the incentive for creating an empire is much lower than that of the executive directly appointed by the government. Therefore, as the increase of pyramid in SOEs, capital investment tends to be lower and is less likely to be overinvested. If the purpose of creating a pyramid is to reduce the influence by the government and increase the managerial control of the firm, the incentive for creating an empire is much lower than that of the executive directly appointed by the government. Therefore, as the increase of pyramid in SOEs, capital investment tends to be lower and is less likely to be overinvested.

13. Hypotheses For NOSEs, creating a pyramid aims to create an internal capital market to reduce the reliance on external financing (Stein, 1997). The internal capital market is convenient for resource and capital transfers among those portfolio firms to meet the requirement of strategic development of the ultimate shareholder. For NOSEs, creating a pyramid aims to create an internal capital market to reduce the reliance on external financing (Stein, 1997). The internal capital market is convenient for resource and capital transfers among those portfolio firms to meet the requirement of strategic development of the ultimate shareholder.

14. Hypotheses The decision for NSOEs, to build an empire is not under the control by the management of the listed firm. Thus, the listed firm cannot expand its size through an internal capital market. The ultimate shareholders may deprive resources from their listed firm whenever they need capital. This behavior is known as “ tunneling ”. Thus, investments in listed firms are restricted by the need of ultimate shareholders. Overinvestment is easier to control through longer layers in the corporate pyramid. The decision for NSOEs, to build an empire is not under the control by the management of the listed firm. Thus, the listed firm cannot expand its size through an internal capital market. The ultimate shareholders may deprive resources from their listed firm whenever they need capital. This behavior is known as “ tunneling ”. Thus, investments in listed firms are restricted by the need of ultimate shareholders. Overinvestment is easier to control through longer layers in the corporate pyramid.

15. Hypothesis 1 The Pyramid will restrict the capital investment of listed firms and reduce the overinvestment for both SOEs and NSOEs. The Pyramid will restrict the capital investment of listed firms and reduce the overinvestment for both SOEs and NSOEs.

16. Hypothesis 2 Overinvestment (underinvestment) will lower the accounting performance. Overinvestment (underinvestment) will lower the accounting performance.

17. Hypothesis 3 For SOEs, pyramid is positively related to performance, while for NSOEs, the relation is negative. For SOEs, pyramid is positively related to performance, while for NSOEs, the relation is negative.

18. Variable – Pyramidal Ownership Structure The pyramidal ownership structure (CHAIN) is the number of layers between the listed company and the ultimate shareholder. The pyramidal ownership structure (CHAIN) is the number of layers between the listed company and the ultimate shareholder.

19. Variable – Capital Investment Capital investment is a proxy using the following two different measures: Capital investment is a proxy using the following two different measures: I1 is the increase of long term assets standardized by the beginning assets. I1 is the increase of long term assets standardized by the beginning assets. I2 is the cash purchase in long-term equity investment, debt investment, fixed assets, intangible assets and other assets, then minus the cash flow from selling of fixed assets, intangible assets and other assets standardized by the beginning assets. I2 is the cash purchase in long-term equity investment, debt investment, fixed assets, intangible assets and other assets, then minus the cash flow from selling of fixed assets, intangible assets and other assets standardized by the beginning assets.

20. Variable – Firm Performance Performance is the accounting performance measured by the net income and income before extraordinary items. ROE is the net income divided by the ending of period equity. AveROE is the net income divided by the average equity. EXBIOE is the income before extraordinary items divided by the ending of period equity, and AveEBXIOE is the income before extraordinary items divided by the average equity. Performance is the accounting performance measured by the net income and income before extraordinary items. ROE is the net income divided by the ending of period equity. AveROE is the net income divided by the average equity. EXBIOE is the income before extraordinary items divided by the ending of period equity, and AveEBXIOE is the income before extraordinary items divided by the average equity.

21. Control Variables I t-1 is the capital investment of the prior year; I t-1 is the capital investment of the prior year; CF is the beginning cash flow from operation divided by beginning assets; CF is the beginning cash flow from operation divided by beginning assets; LEV, the debt ratio at the beginning of year; LEV, the debt ratio at the beginning of year; Size is the nature log of beginning assets. Size is the nature log of beginning assets. Q is prior year end Tobin ’ s Q, which is calculated as the market value of assets divided by book; Q is prior year end Tobin ’ s Q, which is calculated as the market value of assets divided by book; Sale is the prior year ’ s sales revenue divided by beginning assets; Sale is the prior year ’ s sales revenue divided by beginning assets; Ret is the prior year ’ s market return; Ret is the prior year ’ s market return; Age is the time span from IPO year; Age is the time span from IPO year;

22. Control Variables State, dummy variable, 1 = SOE and 0 otherwise; State, dummy variable, 1 = SOE and 0 otherwise; V, the total voting rights of the ultimate shareholder in the listed company; V, the total voting rights of the ultimate shareholder in the listed company; CV is the deviation of cash flow right from voting right, measured by the cash flow right divided by voting right; CV is the deviation of cash flow right from voting right, measured by the cash flow right divided by voting right; Years is year dummy (5 yearly dummies); Years is year dummy (5 yearly dummies); Inds is the industry dummy (11 industrial dummies). Inds is the industry dummy (11 industrial dummies).

23. Control Variables FCF, the free cash flow, equals to prior year’s cash flow from operation minus expected capital investment derived from Richardson (2006) expected investment model; FCF, the free cash flow, equals to prior year’s cash flow from operation minus expected capital investment derived from Richardson (2006) expected investment model;

24. Cash flow-investment sensitivity

25. Expected Capital Investment

26. Overinvestment: Residual Investment

27. Data and Samples We choose all listed firms in China ’ s A-share market from 2001 to 2006. Then, we exclude those firms (1) without the information of ultimate shareholders, (2) in finance industry, (3) not listed yet in the previous year, (4) issued other kind of shares, like B/H/S/ADR, (5) with leverage ratio greater than 5 in the previous year. We choose all listed firms in China ’ s A-share market from 2001 to 2006. Then, we exclude those firms (1) without the information of ultimate shareholders, (2) in finance industry, (3) not listed yet in the previous year, (4) issued other kind of shares, like B/H/S/ADR, (5) with leverage ratio greater than 5 in the previous year. Finally, we have 6213 firm-year observations. Finally, we have 6213 firm-year observations.

28. Data and Samples In order to avoid the influence of outliers, we winsorize observations of the top and bottom 1% for capital investment, I1 and I2, and top and bottom 2% for accounting performance, ROE, AveROE, ROA, and AveROA. In order to avoid the influence of outliers, we winsorize observations of the top and bottom 1% for capital investment, I1 and I2, and top and bottom 2% for accounting performance, ROE, AveROE, ROA, and AveROA.

32. Cash flow-investment sensitivity

33. Cash flow-investment sensitivity-Robust Tests

34. Overinvestment Measure

35. Pyramid, Investment and Firm Performance

36. Different Ultimate Shareholder

37. Robust test-cash capital investment and other performance proxies

38. Conclusions We investigate the relationships among capital investment, firm performance, and pyramidal ownership structure in China. We investigate the relationships among capital investment, firm performance, and pyramidal ownership structure in China. Longer layers in the pyramid reduce the likelihood of overinvestment. The negative relations between pyramidal ownership structure and overinvestment exist for SOEs and NSOEs. Longer layers in the pyramid reduce the likelihood of overinvestment. The negative relations between pyramidal ownership structure and overinvestment exist for SOEs and NSOEs.

39. Conclusions Different incentives for creating a pyramid structure may induce different effects on performance for SOEs and NSOEs. Different incentives for creating a pyramid structure may induce different effects on performance for SOEs and NSOEs. For SOEs, the creation of corporate pyramid results in less government interferences and offers more freedom for firms to operate in a free market. Therefore, pyramiding may enhance the profitability of SOEs. For SOEs, the creation of corporate pyramid results in less government interferences and offers more freedom for firms to operate in a free market. Therefore, pyramiding may enhance the profitability of SOEs.

40. Conclusions While for NSOEs, although corporate pyramid may impose more restrictions on overinvestment, higher agency costs dominate the positive effect of pyramid on overinvestment and lead to lower accounting performance for NSOEs. While for NSOEs, although corporate pyramid may impose more restrictions on overinvestment, higher agency costs dominate the positive effect of pyramid on overinvestment and lead to lower accounting performance for NSOEs.