The corporate governance consequences of small shareholdings: Evidence from sovereign wealth fund cross‐border investments

• Published date: 01 November 2022
• Author: Ruiyuan (Ryan) Chen,Sadok El Ghoul,Omrane Guedhami,Feiyu Liu
• Date: 01 November 2022
• DOI: http://doi.org/10.1111/corg.12445

SPECIAL ISSUE ARTICLE

The corporate governance consequences of small

shareholdings: Evidence from sovereign wealth fund cross-

border investments

Ruiyuan (Ryan) Chen

1

| Sadok El Ghoul

2

| Omrane Guedhami

3

| Feiyu Liu

1

1

West Virginia University, Morgantown, West

Virginia, USA

2

University of Alberta, Edmonton, Alberta,

Canada

3

University of South Carolina, Columbia, South

Carolina, USA

Correspondence

Omrane Guedhami, University of South

Carolina, 1014 Greene Street, Columbia, SC

29206, USA.

Email: omrane.guedhami@moore.sc.edu

Abstract

Research Question/Issue: Existing research on sovereign wealth funds (SWFs) has

largely explored how they affect target firm value, overlooking the role they play in

corporate governance. This paper examines the impact of SWFs' cross-border equity

acquisitions on targets' corporate governance and the role the institutional environ-

ment of SWF countries plays in shaping this impact.

Research Findings/Insights: We use a difference-in-differences approach and find

that, on average, SWF investments are negatively related to target firms' corporate

governance. This impact holds for small SWF cross-border equity investments only

and is stronger for firms that are weakly governed and for those located in jurisdic-

tions with weak shareholder protection. The negative relation is more pronounced

when SWFs' home countries have lower-quality investor protection, corruption con-

trol, governmental effectiveness, and law enforcement than their host countries. We

find further that SWF investments are positively associated with target firms' earn-

ings management and negatively associated with investment efficiency. Finally, tar-

get firm value is found to decrease after SWF investments.

Theoretical/Academic Implications: The evidence that SWFs' small equity invest-

ments are detrimental to target firms' corporate governance is broadly consistent

with the view that SWFs are passive investors. Managers can exploit this passivity,

as evidenced by higher earnings management, reduced investment efficiency, and

lower firm value.

Practitioner/Policy Implications: This study has important policy implications for

investors, SWF managers, and policymakers. The passive role of SWFs in corporate

governance should prompt minority shareholders to look for alternative monitoring

mechanisms. Moreover, SWF managers may realize the need to target firms with

strong corporate governance at the outset to compensate for the post-acquisition

decline. Host country policymakers may need to condition SWF investments on com-

mitments to improve the corporate governance of investee firms, which would be

akin to the performance requirements imposed on inward foreign direct investment

Received: 1 December 2020 Revised: 4 February 2022 Accepted: 23 February 2022

DOI: 10.1111/corg.12445

This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs License, which permits use and distribution in any

medium, provided the original work is properly cited, the use is non-commercial and no modifications or adaptations are made.

© 2022 The Authors. Corporate Governance: An International Review published by John Wiley & Sons Ltd.

656 Corp Govern Int Rev. 2022;30:656–685.

wileyonlinelibrary.com/journal/corg

(FDI). This is particularly relevant for SWFs from countries with weak institutions that

are targeting countries with strong institutions.

KEYWORDS

corporate governance, cross-border SWF acquisitions, institutional environments, sovereign

wealth funds

1|INTRODUCTION

The Sovereign Wealth Fund Institute defines a sovereign wealth fund

(SWF) as “a state-owned investment fund or entity that is commonly

established from balance of payments surpluses, official foreign cur-

rency operations, the proceeds of privatizations, governmental trans-

fer payments, fiscal surpluses, and/or receipts resulting from resource

exports.”SWFs' assets under management (AUM) have increased dra-

matically, from $9.8 billion in 1980 to $7.9 trillion in 2019. In compari-

son, private equity funds and hedge funds have AUM of about $3.9

trillion and $3.2 trillion,

1

respectively. Despite SWFs' importance as a

new type of institutional investor, their impact on firm performance

and corporate governance remains unclear.

Prior literature finds mixed evidence on the relation between

SWF equity investments and firm value. Dewenter et al. (2010), for

example, argue that such investments increase target firm value

because of monitoring benefits. They find that SWF investments lead

to positive abnormal stock returns. Similarly, Fernandes (2014) shows

that SWFs, as long-term holders, provide a stable source and deep

pool of financing and serve as politically well-connected strategic

investors. This results in positive effects on corporate performance. In

contrast, Bortolotti et al. (2015) find positive announcement-period

abnormal returns for SWF investee firms, but lower than those for

comparable private investments. More importantly, they note that tar-

get firms tend to suffer from declining returns and decreasing firm

value in the long run. Kotter and Lel (2011) find that the selection and

performance effects on targets are similar to those on passive institu-

tional investors. More recently, Boubaker et al. (2018) find that tar-

gets' cost of equity capital increases following SWFs' equity

acquisitions. The effect is more pronounced in targets with better cor-

porate governance as proxied by board size. However, similar to other

studies, Boubaker et al.'s (2018) main focus is not on the impact of

SWF acquisitions on governance. This paper contributes to the litera-

ture by examining the impact of SWFs' equity acquisitions on targets'

corporate governance. We explore whether the difference in institu-

tional environments between SWF home and host countries influ-

ences this impact. Specifically, we focus on cross-border deals made

by SWFs because concerns about political agendas and corporate

governance consequences are more relevant in this arena.

One way to assess the impact of SWFs on target firms' corporate

governance follows the literature on large blockholders (Dewenter

et al., 2010; Kotter & Lel, 2011). SWFs are akin to other institutional

investors in terms of “structure and expressed objectives”

(Megginson & Fotak, 2015, p. 736). Thus, they have the incentive and

ability to enhance the corporate governance of target firms through

active monitoring (e.g., Dewenter et al., 2010). Alternatively, SWFs'

equity investments in target firms may have adverse effects on corpo-

rate governance. For example, the privatization literature suggests

that government ownership is associated with agency conflicts and

weak corporate governance (e.g., Boubakri et al., 2005; Chen

et al., 2018,2021; Megginson & Netter, 2001; Nash, 2017). Relatedly,

SWFs have non-financial objectives (Knill et al., 2012b) and may

refrain from actively engaging in corporate governance to avoid politi-

cal opposition (Bortolotti et al., 2015).

We examine the relation between SWF ownership and corporate

governance using comprehensive data on transactions made by SWFs

in listed firms from 43 countries from 2002 through 2015. We find

robust evidence of a negative and statistically significant impact on

the corporate governance performance of target firms relative to

those that were not acquired by SWFs. SWF acquisitions are associ-

ated with a 3.4% decrease in corporate governance score on average,

after controlling for a rich set of firm characteristics and host country-

level factors.

2

Looking at the effect of acquiring stakes, we find that

only small-stake SWF acquisitions significantly decrease firms' corpo-

rate governance. If we restrict our benchmark samples to private

financial mergers, the decrease in the corporate governance score

after an SWF acquisition is 15.9%.

We next investigate how the institutional environment impacts

the relation between SWF ownership and target firm corporate gover-

nance. We construct indicators of investor protection, corruption con-

trol, government effectiveness, and the rule of law based on the

differences between acquirer and target countries. We then estimate

a corporate governance model by interacting these institutional vari-

ables with the post-SWF acquisition indicator. We find that the esti-

mated coefficients of the interaction terms are significantly positive.

This result suggests that the negative effect of SWFs on target firms'

corporate governance is stronger when SWF home countries have a

lower quality of investor protection, corruption control, governmental

effectiveness, and law enforcement than the host countries.

Finally, we investigate the effect of declining corporate gover-

nance of targets on firm valuation. We show that targets generally

experience a decrease in firm value post-acquisition. Specifically, a

regression analysis shows that SWF acquisition causes a 2% decrease

in Tobin's q. This suggests that the negative effect of SWF invest-

ments on the corporate governance of the target is material and eco-

nomically significant.

Our results hold when we control for additional firm characteris-

tics, such as financial and ownership variables, transaction

CHEN ET AL.657