April 25, 2020
This memo addresses the relationship between the ownership structure of a company and its performance. In addition, how the two interact and if there is a relationship that exist between the ownership structure and corporate performance. It focuses on a research conducted by Demsetz and Lehn. The information is retrieved from a paper by Demsetz and Lehn on the relationship between the two.
Unlike previous researchers on this subject, Demsetz and Lehn did not agree with the notion that a companies’ ownership structure was inversely proportion to that companies’ performance, to they had a different argument. They saw that the decisions made by the current owners had more impact on the companies’ performance. Their examination of previous findings showed that none of the studies conducted before had treated ownership structure appropriately. To them ownership structure should not be seen as a single entity but should be seen as a representative of shareholder’s interest and each of these interests should be considered in the study.
2.1 The study
Demsetz and Lehn took a different approach in addressing the ownership structure. In their study, they separated the ownership structure into shares that are held by management and the other outside shareholders. This was so at to represent the shareholders’ different interests. For the outside shareholders, they took the five largest shareholders to represent the interest of the other shareholders apart from those from management. They used Tobin’s Q and accounting profit to measure the performance of the company as compared to other studies that used only one as a variable. Their main reason for using Tobin’s Q was that it was more representative of shareholder’s interest than the accounting profit, which reflected more on accounting practices and accountant’s interest.
Their sample was a number of 223 firms in the United States, selected randomly. Their ownership structure and performance information were retrieved from the Corporate Data Exchange (CDE) and the Fortune 500. (Demsetz and Villalonga, 2001).The sample also contained a number of firms that are regulated meaning firms that are utility and financial institution. The sample also contains non-regulated firms, therefore, making the sample more varied.
They used two variables, the dependent variable which is the firm performance measured by Tobin’s Q and accounting profit and the explanatory variable which is the ownership structure divided into two. The shares held by management and those held by the five largest shareholders outside management. These two variables form equations, which are used in their study to show the relationship between the two.
The findings confirmed that ownership structure is clearly chosen with a view of improving the performance of the company. The results also showed that management tends to hold lesser shares in larger firms as compared to smaller firms (Demsetz and Villalonga, 2001).There is also a significant note on the influence of the market risk on the ownership structure. A firm with higher market risk is owned more by management than outsiders. There is also finding that a firm’s performance is always dependent on either one of the ownership structures be it management or outside majority shareholders. There is also a finding contrary to what most people would believe, that those companies with more management involved as shareholders tend to do better than those with shareholding from the majority shareholders.
The study concludes that those studies that did not take into account the interests of various shareholders were biased. The equations that they used give no evidence that variation in ownership results to variations in the firms’ performance. To them the firms’ performance is more influenced by the environment in which the firm is in. The market forces create a firm’s ownership structure. This ownership structure is then appropriate, and useful to that particular firm. In addition, the notion that there is a direct relationship between ownership structure and a firm’s performance is biased.
I think that a firm should not create an ownership structure or change their existing one simply because they aim at improving their performance. They should instead look at the surrounding factors, like market forces, and the risks surrounding the firm then create a structure that will suit the firm, and from there on they can maybe start recognizing change in their performance.
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