Elsevier

Journal of Corporate Finance

Volume 31, April 2015, Pages 220-245
Journal of Corporate Finance

Family control and corporate cash holdings: Evidence from China

https://doi.org/10.1016/j.jcorpfin.2015.02.007Get rights and content

Highlights

  • We examine effect of family control on cash holding in China.

  • High cash holding are tunneled other than being invested or paid to shareholders.

  • Multiple large shareholders tend to collude with controlling family.

  • NTS reform helps to alleviate the issue of family firms’ high cash holding.

  • Founders with one child, politically connected and involved in management hold more cash.

Abstract

This study examines the effect of family control on the cash holding policy in China. We find that family firms with excess control rights tend to have high cash holdings that are tunneled rather than being invested or paid to shareholders. We further show that the incentive for controlling families to hold cash and for tunneling is exacerbated by the agency conflict between controlling and minority shareholders, i.e., it is weakened after the Chinese Non-tradable share (NTS) reform and strengthened by the presence of multiple large shareholders who probably play no monitoring role in Chinese family firms. Furthermore, family firms’ incentive to hold cash for tunneling is influenced by the unique characteristics of Chinese firms in the following ways: the incentive is stronger when the family founder has one child and face family succession problem, and when the founder has political connections and directly involves in firm’s management; while it is weakened by family founder’s social interpersonal trust with other entrepreneurs through their membership of Chambers of Commerce. Overall, we argue that family firms in China tend to hold high levels of cash for tunneling, which harms firm value, while the severe controlling-minority shareholder agency conflicts and unique Chinese family characteristics only make this situation worse.

Introduction

The record level of high cash holdings held by so many corporations worldwide has led to a fierce debate from both practice and research, regarding the motives for firms’ holding so much cash. There are two classic explanations for corporate cash holding: operational considerations and the agency issue. The former argues that firms adjust their level of cash holdings according to the investment opportunities and financial constraints,1 while the latter argues that the cash holding policy is mainly affected by agency conflicts between managers and shareholders, because managers have an incentive to hold more cash to pursue their private benefit.2 However, little attention has been paid to the question of whether cash holding is affected by agency conflicts between controlling and minority shareholders, especially in family controlled firms (family firms thereafter) that are typically controlled by a few controlling families (Claessens et al., 2002, Faccio et al., 2010, La Porta et al., 1999).

Family firms are a significant and common business feature around the world (Anderson and Reeb, 2003, Bunkanwanicha et al., 2013, Claessens et al., 2000, Faccio and Lang, 2002, La Porta et al., 1999, Shleifer and Vishny, 1986, Villalonga and Amit, 2006), but whether family ownership, including founding-family ownership creates value to those firms is still a controversial issue. Anderson and Reeb (2003); Villalonga and Amit (2006) find that founding family firms in the US perform better than non-family firms where ownership is widely dispersed. They argue that the founding family can reduce agency conflict between managers and shareholders, but recent studies have found that in emerging markets controlling families have strong incentive to pursue private benefit and expropriate minority shareholders and pursue activities that inevitably discredit the value of family firms (Claessens et al., 2002, Cronqvist and Nilsson, 2003, Faccio et al., 2010, La Porta et al., 1999).

Previous studies have also confirmed that controlling shareholders with excess control rights tend to expropriate minority shareholders through higher levels of debt (Faccio et al., 2010), but there is still not enough evidence3 to prove whether a controlling family with excess control rights also retains high levels of cash to facilitate their expropriation given that cash and cash equivalent assets are easier to convert to private benefits at lower costs than other assets (Myers and Rajan, 1998). By investigating the effect of excess control on the corporate cash holding policy of Chinese family firms, this study aims to provide new explanations for the corporate cash holding policy of family firms in emerging markets. More specifically, this study aims to provide empirical evidence to answer the following questions: Do family firms hold more cash to tunnel? Does controlling families’ incentive to hold cash for tunneling differ under different levels of the agency conflict between controlling and minority shareholders? How is the incentive for controlling families to hold cash and practice tunneling influenced by unique characteristics of Chinese family firms such as the Chinese one child policy and the associated family succession problem, family social networks and political connections, and family’s direct involvement in management?

This study mainly focuses on family firms in the Chinese capital market but it also uses non-family firms as a control sample to reveal variations in the relationship between excess control rights and cash holdings in family and non-family firms. A potential endogeneity issue may arise from the fact that corporate cash holdings and other capital structure policies such as leverage, debt maturity, and dividend payouts are jointly determined (Al-Najjar, 2013, Harford et al., 2014), so we use a three-stage least square (3SLS) simultaneous regression model to account for the endogeneity issue of cash holding. We also address the endogeneity issue by taking advantage of Chinese NTS reform as a natural experiment to see whether Chinese family firms adjust their cash holding policy when agency conflicts between controlling and minority shareholders were alleviated.

This study takes advantage of Chinese listed firms because of the unique features of Chinese family firms and the unique institutional settings in China. Family businesses are a significant and common business feature in the Chinese capital market. In the 2012 Forbes Chinese Family Business Report, family firms accounted for 49% of privately owned firms listed on the Chinese capital market, and unlike family firms in other countries, Chinese family firms are more liked to be expropriated by controlling families because the agency conflicts between controlling and minority shareholders are high due to the weak protection of minority shareholders. In reality the legal system in China is weak and it offers fewer options for minority shareholders to take private enforcement actions against block holder’s misconduct, while public enforcement such as fines and prison terms for tunneling are hampered by the limited authority of security market regulators. All of this increases the risk of tunneling from controlling shareholders (Jiang et al., 2010), while the wide existence of excess control rights and the split share structure before the NTS reform only make the situation worse (Liu and Tian, 2012).

As Bennedsen et al. (2015) pointed out; family firms are an adaption to environmental opportunities and constraints, which makes it interesting to explore how the corporate cash holding policy of Chinese family firms are influenced by the following unique characteristics of Chinese family firms.

First, the Chinese government still intervenes into the operations of family firms even if they do not have ownership over them. This means the property rights of family founders have weak protection and founders of family firms face the very high risk of being taken over by large state controlled firms under the pressure of government intervention.4 This may cause potential succession problems for family firms because most controlling families may be unwilling to pass the firms on to their descendants (instead family firms have a strong incentive to transfer their wealth to their descendants in western countries such as the US) and therefore intend to be actively involved in expropriation activities. Moreover, the family succession problem in Chinese family firms is also strengthened by the one child policy in China. Most Chinese family firms are run by the founders who are the first generation of these firms, but due to the one child policy, there is only one potential heir to most family firms. The potential succession problem arises from this unique policy (Bennedsen et al., in press, Cao et al., in press) because culturally, outsiders are usually not trusted in China, so having only one child significantly decreases the founder’s expectations of having a young heir for succession (Cao et al., 2015). Thus most family businesses in China are likely to be sold because no direct family members would take care of the business after the first generation. Taken together, the potential family succession problem may have important impact on controlling shareholders’ incentive to expropriate and corporate cash holding decisions of Chinese family firms.

Second, the US market is based on formal legal contracts whereas the Chinese business environment is mainly dominated by informal personal ties such as relationships and networks (so called ‘Guanxi’). Under this institutional setting, it is very important for family founders to establish and maintain a good relationship with other entrepreneurs (social trust and connections), and with the government (political connections). Obviously then the personal characteristics of Chinese entrepreneurs may also influence corporate cash holdings of family firms given that they greatly influence the personal incentives of these entrepreneurs, who are usually controlling shareholders and founders of Chinese family firms.

Lastly, Chinese family firms are characterized by the deep involvement of family members in both management and the board of directors, which means they have enormous controlling power over the listed firms and there are fewer alternative views from other board directors; this often results in a poorer corporate governance mechanism. Therefore controlling families usually face less monitoring, and thus the risk of expropriation increases in family firms.

Our empirical results show that the excess control rights of controlling shareholders is positively associated with the corporate cash holdings of Chinese family firms. Furthermore, the large cash holdings in family firms with excess control rights are associated with more inter-corporate loans to controlling shareholders, more tunneling related party transactions (RPTs) and less capital expenses or distribution of dividends. This confirms our expropriation story that unlike other private firms, minority shareholders in family firms are more likely to be tunneled and the high level of cash holdings is a channel through which controlling shareholders tunnel resources from listed firms. Our empirical evidence further shows that the NTS reform which alleviated the agency problem between controlling and minority shareholders, effectively reduced the incentives of controlling families to hold cash for tunneling, while multiple large shareholders do not play a monitoring role in mitigating agency conflict between controlling and minority shareholders, they actually collude with the controlling shareholders.

By investigating how corporate cash holding and tunneling by controlling shareholders are influenced by the unique characteristics of Chinese family firms, we find that the incentive to hold cash for tunneling is exacerbated by the one child policy and associated succession problems, the family founder’s political connections and direct involvement in management, but it is alleviated by family founders’ interpersonal connections with other entrepreneurs who are also members of the Chinese Chamber of Commerce.

Finally, the evidence of robustness is provided to show that controlling shareholders are more likely to hold more cash for tunneling when firms have a sound financial condition even though they have no need to hold so much cash, and the marginal value of family firms with excess control rights that hold large amounts of cash is negative. Overall our additional findings all support our main argument that Chinese family firms tend to hold high levels of cash for tunneling, and it destroys firm value.

Our paper contributes to current literature in the following ways:

First of all, we contribute to literature on family firms; existing literature on family firms mainly focuses on the implications of family control on their value, and most studies use samples of US family firms (Bennedsen et al., 2015). But when listed firms in emerging markets such as China are used, where most family firms are run by the founders and the second type of agency issue dominates, our study reveals that family firms usually hold high levels of cash for tunneling, which harms firm value. Moreover, previous studies have documented the discounted value of family firms in some emerging markets, especially when the controlling families have excess control rights (Amit et al., 2009, Cronqvist and Nilsson, 2003), while our study confirms this discounted value in China.

More importantly, we find that the corporate cash holding policy and tunneling by controlling families are shaped by the unique characteristics of Chinese family firms, such as the potential family succession problems arising from the one child policy. Thus our study complements previous studies such as Bennedsen et al. (2007); Cao et al. (2015) who both find that the family succession problem has a negative effect on firm performance. By providing empirical evidence that the cash holding policy of Chinese family firms is shaped by the unique characteristics of Chinese family firms, our study also supports the argument that family firms are an adaptation of environmental opportunities and constraints (Bennedsen et al., in press, Jiang et al., in press).

We also contribute to literature related to corporate cash holdings; previous studies mainly focus on the determinants of corporate cash holding policy, whereas we have extended the literature by investigating how corporate cash holdings differ in family and non-family firms and how cash holding policy is impacted by corporate ownership structure under the controlling-minority shareholders agency conflict framework. From this point of view we also contribute to literature on agency theory.

Finally, our findings have implications on our understanding of corporate cash holding policy in an emerging market. We document that firms’ cash holding policy in an emerging market is mainly dominated by agency conflict between the controlling and minority shareholders, especially in family firms, although the incentive for controlling families to hold high levels of cash for tunneling is alleviated after the NTS reform due to the easing of agency conflicts between controlling and minority shareholders. However, having multiple large shareholders does not alleviate agency conflicts because they do not play an active monitory role in the tunneling behavior of controlling families like they do in developed markets (Bennedsen and Wolfenzon, 2000, Bolton and Von Thadden, 1998, Maury and Pajuste, 2005).

The remainder of this paper is organized as follows: Section 2 develops our hypotheses. Section 3 describes our sample, data, variable measures, and chosen methodology. Section 4 presents the empirical results and interpretations, and Section 5 summarizes and concludes the paper.

Section snippets

Excess control rights, corporate cash holding, and controlling shareholders’ tunneling in family firms

As discussed above, excess control rights in emerging markets usually destroy firm value because controlling shareholders tend to expropriate the interests of minority shareholders, especially in countries with poor shareholder protection system (Claessens et al., 2002, Faccio et al., 2010, Lemmon and Lins, 2003, Lin et al., 2012, Liu and Tian, 2012). Thus we expect that controlling shareholders of firms with excess control rights are likely to hold more cash to pursue their private benefits

Sample

The sample used in this paper consists of all privately controlled firms (non-state owned firms, so called non-SOEs) listed on the Shanghai and Shenzhen stock exchanges from 2004 to 2011, which is the largest sample we could obtain when we conduct our study.5

Sample description and univariate tests

Table 1 presents the descriptive statistics and univariate test of our sample. Panel A of Table 1 presents the descriptive statistics for our whole sample, and panels B and C report the univariate tests of our main dependent variables based on different subsamples. The difference–in-difference method is used to test the changes in corporate cash holding policy and controlling shareholders’ tunneling incentive before and after the NTS reform. The results in panel A show that the average cash to

Conclusions

This study investigates the effect of excess control rights on the cash holdings of family firms in China, using non-family firms as a controlling sample. We find that family firms with more excess control rights hold more cash and these high levels of cash are mainly tunneled by controlling shareholders rather than be invested or paid to shareholders as dividends. We also find that controlling shareholders’ incentive to hold cash for tunneling in family firms depends on the degree of the

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    We appreciate the comments from the both the editor and the reviewers. We acknowledge the valuable suggestions and comments on this paper by Yasuhiro Arikawa, Jing Shi, Sinclair Davidson and other participants of the Asian Finance Association annual conference in Bali Indonesia, between June 24 and June 27, 2014 and the seminar organized by the School of Economics, Finance and Marketing, RMIT, Australia on June 30, 2014.

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