CGR Model to explore relationship between governance and performance in family and non-family businesses

  1. Introduction

The Corporate governance literature affirms that Corporate governance is one of the important factors influencing performance (Morck et al., 1988, Emmons and Schmid, 1999, Gompers et al. 2001, Severin, 2001, Drobetz et al., 2004, Klapper and Love, 2004, Brown and Caylor, 2006, Bistrova and Lace, 2011, Walls et al., 2012).

There are many different features describing corporate governance system, in each Country.

Differences regard, mainly, stage of economic development, country’s legal tradition (common or civil law), development of stock market, capital and ownership structure and business practices.

In Italy, the corporate governance system has two typical characteristics:

- the first concerns the combination of two fundamental aspects of governance such as the shareholding structure and the degree of stability of the structure;

- the second concerns the legislative model of governance adopted by the company.

Regarding the analysis of the governance model, the Italian company is strongly characterized by centralized and unitary ownership (in the figure of the entrepreneur) and by stability of this. In terms of ownership concentration, the average share of the largest shareholder at 67%, the average share of the top three shareholders is 92%, the median number of shareholders is 3 (Bianchi et al., 2006).

In Italy there are particular types of companies called family businesses or “companies in which one or more families, linked by kinship or allied, holding a share of the capital likely to exercise control" (Montemerlo, 2000).

The family business is a type of company spread around the world but it’s the most common form in the reality of Italian companies, a study shows that 85% of Italian companies is family businesses (Ravasi and Zattoni, 2000).

Among the factors that may explain, in part, the prevalence of family-type businesses in Italy, we find in particular:

- a concentration of financial resources in the hands of a few families;

- the ability to use instruments such as shares without voting rights;

- the ability to create "networks" of share connections between large business families. (De Mattè and Corbetta, 1993).

Among the models of governance introduced in Italy in 2003 alongside the traditional model there are two additional governance models (monistic and dual systems). The traditional model is, nevertheless, still the favorite and the most adopted by Italian companies.

This system provides an management organ, appointed by the shareholders meeting, said “board of directors” and a control organ as defined in the board of statutory advisors, also appointed by the shareholders.

This model is the best to split the function of control from that of management, control that is both legality and merit control. In the two-tier model control is performed by the “supervisory board” while in the one-tier model by the “management control committee”, no organ is in charge of the legality review.

It therefore seems that the traditional model ensures greater control and give more representation to owners who are required to elect both the members of the management body (Board of Directors) and those of control organ (board of statutory advisors).

In this study, in order to analyze the typical characteristics of corporate governance in Italian companies we used the Corporate Governance Rating (CGR).

The CGR reflects how an organization accepts and follows laws and guidelines of corporate governance practices and policies.

In our study we show, firstly, the steps for building the Italian CGR model by identifying and defining all the variables considered important in the assessment of corporate governance.

We believe that our rating model draws greater attention to the important features peculiar to the Italian governance system than other models. Within the CGR model parameters, in fact, we can observe information on peculiar control organs of the traditional model of governance (not found in other scoring systems), more information on the transparency and on the protection of minority rights as set forth in the Code of Conduct for Italian listed companies.

Main objective, in our analysis, of applying our CGR model is to test the major capacity of this model to highlight the Italian corporate governance features.

In a second step we analyzed, also, the relationship between governance and performance.

This analysis is to determine whether the Italian family business, better represented by the new scoring model, develops a better governance which is able to produce better performance.

For these reasons we will test this relationship and the peculiarity of Italian corporate governance responding to the following hypothesis:

  1. good governance affects good performance;
  2. family firms have a better governance.

In order to prove what above, the study continue with a multi case studies analysis in which we analyze, firstly, the good governance, through the CGR model, in a random sample of Italian family and non family firms and then the relationship between governance and performance.

  1. Theoretical overview and research hypothesis

The literature on corporate governance and business value analyzes, for most of the contributions, weather governance affects performance. These studies examine how different governance mechanisms and characteristics affect performance and they can be clustered into six groups, which are:

1) studies on ownership structure (Shleifer and Vishny, 1997, Lauterbach and Vaninsky, 1999, Demstez and Villalonga , 2001, Fama and Jensen, 1983, Weich, 2003, Grant and Kirchmaier, 2004, Demsetz and Lehn, 1985, Morck et al., 1988, McConnell and Servaes, 1990);

2) studies on the type of shareholder (Pound, 1988, Chaowarata and Jumreornvongb, 2010, Jaskeiwicz et al., 2005, Anderson and Reeb, 2003, Villalonga and Amit, 2006, Sharma et al., 1997, Burkart et al., 2003, Lee , 2004 and 2006, Danes et al., 2007, Shleifer and Vishny, 1988, Hermalin and Weisbach, 1991);

3) studies on the size of the board (Yermack, 1996, Conyon and Peck, 1998, Eisenberg et al., 1998, Bhagat and Black, 2002);

4) studies on the composition of the board (Baysinger and Butler, 1985, Klein, 1998, Bhagat and Black, 2002, Hermalin and Weisbach, 1991, Agrawal and Knober, 1996, Coles et al., 2001, Baysinger and Butler, 1985, De Andres et al., 2005);

5) studies on the presence of independent directors on the Board (Bhagat and Black, 2001, Coles and Hoi, 2003, Giovannini, 2010);

6) studies on the duality (Fama and Jensen, 1983, Berg and Smith, 1978, Rechner and Dalton, 1989, Baliga et al., 1996, Brichley et al., 1997, Lazarides, 2009, Dalton and Dalton , 2010, Boyd, 1995).

The scholars, that study which the ownership affect the performance, show results conflicting, few authors (Sheifer and Vishny, 1997, Lauterbach and Vaninsky, 1999) find that family firms show poor performance while Grant and Kirchmaier (2004), studying the same correlation in public company, the results obtained can show that companies without a shareholder of reference tend to develop negative performance.

In contrast there are more studies (Sharma et al., 1997, Anderson and Reeb, 2003; Burkart et al., 2003, Lee, 2004 and 2006, Villalonga and Amit, 2006 and Danes et al., 2007) that argue that a family firm produces more positive effects on performance just because the pourpose of the company is medium and long-term business continuity instead of obtaining short-term profit. Anderson and Reeb in 2003 and Villalonga and Amit in 2006 showed that the company's performance increases when a member of the family coincides with the company's CEO.

The above studies show that increased size of the Board of Directors may provide a more effective control over the management and combat more adequately the power of the CEO; in contrast, however, a large number of Board members generates a safe increase in costs (often not correlated with benefits) and may cause difficulties in coordinating and slowness in decision-making.

The results, even in this analysis are mixed, according to some scholars, in fact, the performance is positively influenced by the greater size of the board whereas others will be negatively affected.

Another important line of research is the board composition; according to some scholars (Fama, 1980) the presence of executive directors on the board is essential to obtain a good performance, others, instead, found a positive correlation between outsider directors and performances (Baysinger and Butler, 1985, Klein, 1998, Bhagat and Black, 2002, Hermalin and Weisbach, 1991)

Even the analysis of the duality leads to different results, according to Jensen in 1983 and Smith and Bergh in 1978 duality leads to a deterioration in performance, only a few studies (Boyd, 1995, McWilliams and Sen) find positive financial results, in contexts characterized by high complexity.

The above studies show that corporate governance affects performance. Beiner, Drobetz, Schmid and Zimmermann affirm that ‘good’ governance has a positive impact on firm valuation.

From a theoretical point of view, agency problems affect the value of firms through the expected cash flows growing the cost of capital. Therefore, good corporate governance decreases the cost of capital to the extent that it reduces shareholders monitoring and auditing costs (Lombardo, Pagano 2002); La Porta et al, (2002) confirm that better protection of minority shareholders support higher valuation of firms. Durnev and Kim (2005) document that firms with better governance and better disclosure standards exhibit higher Tobin’s Qs. Bauer et al. (2004) find that higher ratings lead to higher common stock returns and increase firm value. Gompers et al. (2003), document that firms with better governance receive superior market valuations and have better operating performance and lower capital expenditures.

Studies on the correlation of governance-performance seem to lead to conflicting results. We believe that the use of a rating method best suited to the characteristics of Italian companies can better communicate, if there is, good governance and for this reason in our study we will explore the hypothesis:

Hypothesis I: “Good governance affects good performance”.

In family businesses, the agency theory is replaced by stewardship theory, according to which in family firms the objectives of owners and managers are closely aligned because they are usually part of the same family. Therefore these firms have lower agency costs (Gomez Mejia et al. 2002:81-95, Shulze et al. 2001:99-116, Davis et al. 1997:20-47, Fama and Jensen 1983:301-326) and an approach that is based on participation.

Moreover, in family-owned businesses, ownership is uniquely important and influential to the system of governance, where its values and vision are crucial elements in the financial success of the company (Ward, 2003). In the non-family firm, conversely, governance is left to the board, to management, to the financial markets and to government regulation. For family firms it is the special role of ownership that makes the difference.

In addition, family businesses historically exhibit a strategic approach based on long-term economic performance, because they consider the firm a family asset for generations to come. The logic in this case is different from non-family companies, which exhibit a style that has been termed ‘managerial myopia’ (Merchant, Burns 1986), i.e., behaviours that promote short-term results instead of taking into consideration medium- and long-term effects.

For all these reason an evaluation of family firm corporate governance system can bring to light a better effectiveness of management and control processes and the ability to contribute actively to the creation of value by the firm's medium- to long-term balancing of different needs and interests.

Better effectiveness of management and control processes and medium – long term vision bring family firm toward a better accountability.

Accountability is an important part of corporate governance; in governance accountability has expanded beyond the basic definition of "being called to account for one's actions” ( Mulgan, 2000, Sinclair,1995).

Because the family business has, for its characteristics, greater accountability and since accountability is an important part of governance, it is argued that a family business has better governance.

Our second hipothesis is, therefore:

Hypothesis II:“Family firm have a better governance”.

  1. Research methodology and model application

In our study we choose to use multi case study, because we believe it is appropriate methodology when investigating a complex phenomenon that evolves over time, and also has many variables (Yin, 1995, Eisenhardt, 1989).

In fact Sacristan-Navarro, Gomez-Anson, Cabeza-Garcia (2011) affirm that empirical studies are inconclusive as to whether family firms outperform nonfamily firms, and they suggest that new information that enhances understanding of this disparities should be valuable.

They highlight that the contradictory results could be explained by differences in definitions, institutional settings, variables, or methodologies.

For this reason we use a new model that considers all corporate governance variables, in a specific institutional setting. We use a different methodology which can explain better a complex phenomenon like corporate governance.

The multi case study allows to explore processes and allows us to consider different methods of data collection (Van Maanen, 1983). With the application of the so-called "triangulation" of the sources, it will be possible to explain better the phenomenon investigated. Although the multi-case study can not generate statistical information, we can obtain a "analytical generalization" of the phenomenon studied. (Yin, 1995).

As previously described, the analysis was conducted on a sample of 15 companies selected from the FTSE MIB index. Data are relative to corporate governance and accounting performance for the year 2009. Data for the implementation of the corporate governance rating model are extracted from the annual reports published by the company on its official website, under "Corporate governance", or found on the website of the Italian Stock Exchange and Consob. Data related to performance indicators (ROI, ROE, ROS and EBIT) are extracted from companies’ financial statements in the database AIDA Bureau Van Dijk.

  1. Description of Sample

The examined companies are selected from the FTSE MIB index

For the purposes of this analysis it is important to underline that companies operating in the financial sector (banks and insurance companies) have been excluded.

The analyzed index can be assimilated to a sort of ascending numerical data. The range of variation (Leti 1983) of the series was determined by the difference between the capitalization of ENI SpA of €61,825 million, and Impregilo SpA, amounting to €791 million, respectively the largest and smallest companies by capitalization.

The cumulative distribution (Abramowitz and Stegun 1971:925-964) is calculated by totaling the capitalization of all companies in descending order. The companies are selected on the cumulative distribution from a random number chosen by the random function “start” of Excel, and selecting the company at each interval equal to the average market capitalization calculated by the method described above. Such selection has allowed us to identify a random sample of companies for our analysis.

The table below gives the selected companies.

Table 1 - Sample

Item / company / capitalization (€ millions)
1 / ENI / 61825
2 / ENEL / 34244
3 / TENARIS / 19137
4 / SAIPEM / 14282
5 / FIAT / 13949
6 / SNAM RETE GAS / 13124
7 / TELECOM ITALIA / 12747
8 / LUXOTTICA GROUP / 9567
9 / ATLANTIA / 9182
10 / PARMALAT / 6340
11 / MEDIASET / 5094
12 / FINMECCANICA / 5062
13 / A2A / 3113
14 / AUTOGRILL / 2538
15 / CIR / 1109

For our analysis we divided the sample into two sub-samples representing family businesses and non-family business.

Table 3 – Sub Samples: family and non-family businesses

Family Businesses / Non-Family Businesses
Atlantia / A2A
Autogrill / Enel
Cir compagnie industriali riunite / Eni
Fiat / Finmeccanica
Luxottica group / Saipem
Mediaset / Snam rete gas
Parmalat / Telecom
Tenaris
  1. Description of Corporate governance rating model

Apart from economic and financial indicators, the company’s value also depends on effective control mechanisms designed to protect shareholders and the market.

A good system of governance is, therefore, a critical issue in management because it boosts the effectiveness of control and decision-making processes while reducing the risk of opportunistic behavior by shareholders and managers (Musaio 2002:485-495).

In this context, corporate governance is viewed as a company unit that provides input into the creation of value, allowing the establishment of structures and processes that facilitate the pursuit of strategy and improve performance (Fazzini and Terzani 2010:400-405). For this reason, the evaluation and measurement of the quality of corporate governance becomes a key factor.

All over the world, rating agencies have arisen with the new task of assigning a rating to the system of corporate governance, highlighting merits and defects. The expansion of the stock market, the weight and size of institutional investors have all led to a diffusion of this service.

The objective of the Corporate Governance Rating (CGR) is to analyze the goodness of corporate governance. Here we will discuss the steps for building the model by identifying and defining all the variables considered important in the assessment of corporate governance.

To achieve the complete construction of our model we first made reference to the rating models used by the top rating agencies (Governance Metrics International (GMI), Institutional Shareholders Services (ISS), Standard and Poor's (S&P), Corporate Library) (Nobolo et al., 2009).

The model[1] consists of 177 parameters, or metrics, which represent a summary of the management and governance procedures adopted by a company.

The three main categories analyzed are:

• ownership;

• governance;

• corporate disclosure.

Each of these categories is assigned a different weight in relation to the relevance for corporate governance and is divided into subclasses/sections.

Ownership:

The first category examines the company ownership structure and includes 56 questions/metrics grouped into three subclasses:

Section / Metrics no. / Weights
Shareholder composition / 37 / 33.3%
Shareholders’ meeting / 8 / 33.3%
Shareholder protection / 11 / 33.3%

Shareholder composition

This section focuses on the structure of corporate stock and underlines the existence of shareholders’ rights and powers. It shows the presence of a blockholder highlighting the number of shares owned. The analysis continues by checking the type of shares (ordinary shares, treasury shares, shares with special rights) and stresses any limits or conditions on their transfer or movement. The variables in the model investigate also the presence of shareholders' agreements within the company (indicating the quota value), the priorities in the distribution of profits and the possibility of hostile takeovers by analyzing the share of floating stock in the market.