In the regression analysis, a set of control variables should be included. By following prior literature, the following four control variables will be used: AGE, SIZE, EXPENDITURE and SUBSIDY. A detailed definition of these control variables is also provided in Table 5-5.
Firstly, according to Mikkelson et al. (1997), firm age may explain the variation in the post-IPO operating performance. They argue that relatively young companies are likely to report lower performance figures in their early years due to low volume of sales, high initial operating costs, and/or an aggressive pricing strategy, however, matured firms tend to have better performance relative to young firms, because well-recognised brands names and a large group of loyal customers. Take a start-up firm for a typical example: the start-up firm has low sales at its early
stage of business, but incurs higher production and selling costs, because of inexperience, a small scale of operations, and/or extraordinary one-time start-up costs. In order to attract customers, the firm may also price the products at a smaller profit margin then matured companies do. All above make young firms unlikely to report operating performance as good as mature companies do. Mikkelson et al. (1997) further find that the level of operating performance differs greatly between firms of different lengths of operating history, and older firms have substantially higher median operating performance both before and for five years after going public. So, in this sense, a control variable 'AGE is included in order to control for the influences of the age of the firm, which is measured as the difference between establishment year and the IPO year.
A second control variable, ‘SIZE, may also explain the variation in the post-IPO operating performance (Mikkelson et al., 1997). Smaller firms often tend to young firms, which usually hold a tiny proportion of the market share and operate in a very difficult circumstance. Small firms always face low volume of sales, and/or high initial operating costs. They may also price their products at a smaller profit margin in order to get customers’ attention. This conjecture is confirmed by Fama and French (1995), who provide evidence that smaller firms generally had lower profitability. Moreover, Mikkelson et al. (1997) also find that larger firms have substantially higher median operating performance both before and for five years after going public. So, a control variable ‘SIZE’ is included to control for the influences of the size of the firm, which is measured as the natural logarithm of beginning-year total assets.
EXPENDITURE is a variable to control for the influence of capital expenditure on firm operating performance. EXPENDITURE is calculated as the capital investment (adjusting for depreciation charges) scaled by lagged (-1) total assets. Capital investment is one of the important determinants of corporate performance
(Morck et al., 1988). In order to keep the firm’s operations normal and stable, the management has to maintain a required level of capital expenditure. If the managers fail to do so, the scale of the operation may be affected, along with the decrease in capital expenditure.
Then, a control variable ‘SUDSIDY will be introduced. It is measured as the government subsidy received by listed firms, including tax refunds, and project-specific government grants. According to Chinese GAAP, tax refunds and government subsidies are recognised immediately as gains when received (CMOF 2001, Article: 106.4). Since most Chinese firms are state-controlled, they may receive government subsidies, and their profit and loss account may be affected by government subsidies in the year when received. It is expected that the administrative government may also offer financial assistance directly to pre-issue firms to support them to go public, and government subsidies can be one of the ways to boost the reported earnings of pre-issue firms. In order to push the SOEs to go public, SOE managers often lobby for as much financial assistance as possible from the administrative government. Financial assistance, such *=as a government subsidy, may be made available for some pre-IPO firms: for example, firms engage in some designated industry sectors on the National Development Programme, such as agriculture, mining, water, electricity and gas supply etc, are more likely to obtain financial assistances from the government, such as tax relief and so on. The financial assistance is often made as a temporary policy for 3 consecutive years or less, and not automatically renewable.
In addition, another 3 control variables are also introduced to control for the effects resulted from ownership structure and corporate governance characteristics. Prior literature, for example La Porta et al. (1998) and Berglof (1995), shows that highly concentrated ownership structure in emerging markets may result in a concern of being expropriated by controlling shareholders, if investors are not well protected.
This may give a rise to operating performance declines of listed subsidiaries. Johnson and Shleifer (2004) further argue that effective corporate governance is likely to monitor the behaviours of large shareholders and/or top managers, and protect small investors from the danger of expropriation. However, Shleifer and Vishny (1997) argue that in a case of concentrated ownership, corporate governance is typically exercised by large shareholders. Without legal protection of small investors, concentrated ownership can be described as potential expropriation by large shareholders in the firm.
Take an emerging market, like China, for example. The extensive presence of concentrated ownership and weak corporate governance highlights the high likelihood of expropriation conducted by controlling shareholders. Chen and Shih (2004) insist that poor governance characteristics and highly concentrated ownership may affect the long-run operating performance of Chinese firms. They further point out that a strong control retained by controlling shareholders, particularly those state-owned shareholders, may lead to too much administrative interference so that their listed subsidiaries may suffer the consequences in terms of operating performance.
So, there are two ownership variables to be introduced in this study: one is
'OWNERSHIP CONCENTRATION’, which is measured as the proportion of
ownership held by the controlling shareholder at the end of the IPO year; the other ownership variable 'OWNERSHIP TYPE’ measures the type of the controlling shareholder, which is a dummy variable taking the value of 1 if the controlling shareholder is ultimately owned by the state at the end of the year; 0 otherwise.
Finally, a corporate governance variable will also be introduced. Fama and Jensen (1983) argue that the corporate board is a major monitoring mechanism of corporate governance to alleviate agency problems. They point out that a
well-balanced effective board would be largely comprised of outside independent directors to ensure better monitoring. UK Combined Code (2003) also highlights the importance of the corporate board: 'every company should be headed by an effective board, which is collectively responsible for the success of the company'.
OECD (Corporate Governance Principles, 2003) further points out that the corporate board would be mainly responsible for protecting minority shareholders from expropriation by a controlling shareholder and the management team.
So, the governance variable used in this study is the composition of the board of directors 'BOARD COMPOSITION. In prior literature, board composition is normally measured as the proportion of independent directors in the board. However, independent directors were not introduced into Chinese firms until the promulgation of the Code o f Corporate Governance in 2002. In fact, the majority of directors in Chinese corporate boards represent controlling shareholders, and the rest may represent small investors or be independent from any shareholders It is believed that directors representing smaller investors in the boardroom are likely to protect smaller investors from being expropriated by controlling shareholders. So, the variable 'BOARD COMPOSITION is measured as the proportion of the directors in the board representing controlling shareholders, who hold a senior management position simultaneously in controlling shareholders’ entity, at the end of the IPO year. This variable measures the percentage of board seats held on behalf of controlling shareholders. If controlling shareholders retain a strong control over the corporate board, the risk of expropriation by controlling shareholders is expected to be high.
5.7 Summary
This chapter presents variable measurement: operating performance is measured as asset-scaled earnings performance (EBITDA on total assets) and/or
asset-scaled cashflow performance (Operating cashflow on total assets) minus the median contemporaneous operating figures of 2-digit SIC-code industry-matched publicly traded firms. Long-run stock performance is measured as the 5-year benchmark-adjusted CAR (Cumulative Abnormal Return) and/or BAHR (Buy and Hold Return) in event time, and the benchmark to be used is the median stock performance of 2-digit SIC-code industry-matched publicly traded firms.
Explanatory variables in this study include managerial ownership (the proportion of shares by corporate executives and directors); discretionary accruals (the level of accruals management that is calculated by using modified Jones (1991) model) and the two RPT variables: the aggregate amount of operating RPTs (non-loan) and the net amount of cash loans respectively. Moreover, a set of control variable is also introduced: for example firm s’ size and age, capital expenditure, government subsidy, and ownership and governance variables. In Table 5-4 and 5-5, a detailed variable definition for explanatory variables and control variables is also presented.