In this paper we examine the relation between ownership structure and overinvestment decisions by Chinese state owned enterprises (SOEs). We hypothesize that state owners, the largest block holders, are more committed to pursue their own sociopolitical agenda than maximizing wealth of its shareholders and show that the relation between state ownership and overinvestment is positive. We also hypothesize that managerial owners, who too receive non-negotiable shares, would discourage overinvestment lest it should inhibit the firm’s ability to pay dividends. Consistent with this hypothesis, we find a negative relation between management ownership and overinvestment. Conversely, our results show that the state ownership has a negative impact while managerial ownership has a positive effect on underinvestment decisions.

Introduction

Overinvestment occurs when the management of a firm invests its free cash flows in negative NPV projects to maximize its personal benefits (“empire building”) instead of paying dividends or repurchasing stocks. The higher the level of free cash flows at the disposal of the managers, the greater is their incentive to over invest, and therefore, the larger is the firm’s value destruction (Jensen, 1986). Consistent with this expectation, Titman et al. (2004, 2010) find that the negative association between capital investments and future stock returns is stronger in firms with higher free cash flow and lower leverage.1 They interpret the evidence as investors’ under-reaction to the over investment behavior by managers who have incentives to put the best spin on the firm’s investment opportunities as well as on its overall business prospects when making high capital investments. If investors fail to recognize the over investment behavior, or are fooled by the rosy picture painted by managers, the subsequent-period stock returns of firms that make excessive investments may deteriorate with lower than expected performance resulting from overinvestment. Considering that the conflict of interests between owners and managers is at the root of value-reducing overinvestment problems, a good corporate governance system is expected to employ measures that would mitigate this conflict by aligning the interests of the affected parties. Ownerships by insiders or blockholders are often included in literature as attributes of a good governance system. Empirical work generally suggests that the relation between insider ownership and the firm value is positive at least at the lower level (Morck et al., 1988; McConnell and Servaes, 1990; Hadlock, 1998; Gedajlovic and Shapiro, 1998; Claessens and Djankov, 1999; Mitton, 2002; Li et al., 2007). Consistent with the literature, researchers report that the relation between managerial ownership and overinvestment is, to a large extent, negative. For example, Cho (1998) shows that the level of investment rises as insider ownership increases up to 7%, decreases as insider ownership rises from 7% to 38%, and remains unaffected by insider ownership beyond 38%. Hadlock (1998) finds an inverted U-shaped relationship which implies that investment efficiency exists when insider ownership is at a lower level, but overinvestment abounds when high insider ownership gives rise to entrenchment. Stiglitz (1985) points out that a higher concentration of ownership is likely to be associated with more control over managerial behavior, given the decrease in monitoring incentives when there is no controlling shareholder. Although a large body of empirical work finds that concentrated ownership with large blockholders leads to better monitoring and alignment of interests between the controlling and minority shareholders (for example, Shleifer and Vishny, 1986, 1997; Kaplan and Minton, 1994; Gomes, 2000; and Lins (2003), the opposing viewpoint is that an extremely high ownership concentration may not necessarily indicate better shareholder protections, but might instead signify exploitation by entrenched controlling shareholders of minority shareholders (Morck et al., 2000; Claessens et al., 2002; Fan and Wong, 2002; Ducassy and Guyot, 2017; La Porta et al., 1999), and La Porta et al. (2002) document that the concentrated ownership is negatively related to the interests of minority shareholders in countries that fail to protect their rights.