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Capital-Market Apartheid?
Professor plumbs separate and unequal dual-class shares.
Berkshire Hathaway, Comcast and Google. Each of these companies is controlled by entrepreneur founders or a founding family, and each lately has given shareholders a double-digit return. The value Google's stock, of course, doubled between its ballyhooed public offering in August and mid-February.
Like many public companies run by the entrepreneurs who created them, the members of this trio have something else in common. They each have two classes of stock — one super-voting class for entrepreneur-founders and a common class for everyone else. An arrangement like this protects the founders from having to cede control. Call it capital-market apartheid: The shares are separate and unequal.
Even so, judging by the performance of these three, it wouldn't seem a bad deal for shareholders. Sure, it limits their ability to influence a company's direction. But who wouldn't want billionaire investor Warren Buffett leading Berkshire? Ditto for the Sergey Brin and Larry Page, founders of Google, the most popular Internet search engine.
But these three companies are exceptions when it comes to companies with dual classes of stock, according to Andrew Metrick, a Wharton finance professor, and two Harvard University co-authors, Paul Gompers and Joy Ishii.
In a study of hundreds of dual-class companies, Metrick, Gompers and Ishii found that voting control by insiders undermines the value and performance of dual-class firms, while insiders' economic ownership, defined as rights to cash flows such as dividends, bulwarks it.
To appreciate the distinction, you have to understand the organization of dual-class companies. A common setup gives the super shares 10 votes for every one vote of the common shares. An executive therefore can have a relatively small number of shares, but if they're mostly super shares, he would end up with disproportionate control.
That, in turn, can undercut the executive's incentive to operate the company in the interest of the common shareholders. The executive might prefer to retain control rather than take steps that would help the company grow, but would dilute his control. In other words, the executive wants to make sure that he remains boss, rather than make sure the shareholders make money.
That's exactly what Metrick and his co-authors found. As insider control of dual-stock companies rose, the firms invested less and spent less on research and advertising. Likewise, these companies' sales growth tailed off as insiders' control grew.
Economic ownership had the opposite effect. As it increased, sales, investments, R&D and advertising spending rose.
If you roll these results together, they suggest that dual-class firms would be less valuable than single-class firms.
Once again, Metrick and his co-author's analysis yielded the expected result. They measured the firms' values and determined that values rose as insiders' economic ownership increased, with the effect peaking at 33 percent ownership. They hypothesize that, above that level, managers want to preserve their wealth rather than continue to invest in growth.
Lots of voting control gave the opposite result: As insiders' control increased, firm values fell.
Metrick and his co-authors also discovered that dual-class companies are more likely to issue debt than single-class firms. "A potential explanation for dual-class firms' heavier reliance on debt financing is that investors may be reluctant to purchase the inferior voting stock of these firms," the paper says.
In the wake of scandals such as Enron and WorldCom, much attention has been paid to corporate governance; another paper by Metrick and his co-author constructs an index for rating firms' governance.
Metrick and his co-authors apply their index to dual-class companies and find that, paradoxically, their managers have less power than single-class companies. They point out that their index mainly measures the strength of takeover protections. "Since a dual-class structure is perhaps the most powerful anti-takeover protection possible, firms with a dual-class structure may find most other protections to be superfluous," they write.
How does one make sense of all of these results? "The most plausible explanation is that some firms adopt dual-class structures when their original owners are reluctant to cede control," Metrick and his co-authors wrote. "Later, these firms are less likely to tap capital markets (so as to avoid diluting control) and thus invest less, grow slower, and are valued lower."
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