We present a model of the effects of legal protection of minority shareholders and of cash-flow ownership by a controlling shareholder on the valuation of firms. We then test this model using a sample of 539 large firms from 27 wealthy economies.

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We present a model of succession in a ¢rm owned and managed by its founder. The founder decides between hiring a professional manager or leaving management to his heir, as well as on what fraction of the company to £oat on the stock exchange. We assume that a professional is a better manager than the heir, and describe how the founder’s decision is shaped by the legal environment. This theory of separation of ownership from management includes the Anglo-Saxon and the Continental European patterns of corporate governance as special cases, and generates additional empirical predictions consistent with cross-country evidence. MOST FIRMS IN THE WORLD are controlled by their founders, or by the founders ’ families and heirs. Such family ownership is nearly universal among privately held ¢rms, but is also dominant among publicly traded ¢rms. In Western Europe, South and East Asia, the Middle East, Latin America, and Africa, the vast majority of publicly traded ¢rms are family controlled (La Porta, Lopez-de-Silanes,

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The statistical analysis of firm-level data on U.S. multinational companies was conducted at the International Investment Division, Bureau of Economic Analysis, U.S. Department of Commerce under arrangements that maintain legal confidentiality requirements. The views expressed are those of the authors

We measure a country’s growth opportunities by investigating how its industry mix is priced in global capital markets, using price earnings ratios of global industry portfolios. First, we find that these exogenous growth opportunities strongly predict future changes in real GDP and investment in a large panel of countries. This relation is strongest in countries that have liberalized their capital accounts, equity markets, and banking systems. Second, we re-examine the link between financial development, investor protection, capital allocation, and growth. We find that financial development and investor protection measures are much less important in aligning growth opportunities with growth than is capital market openness. Third, we formulate new tests of market integration and segmentation. Under integration, the difference between a country’s local P E ratio and its global counterpart should not predict relative growth, but the difference between its exogenous global P E ratio and the world market P E ratio should predict relative growth.

We provide a rationale for the use of pyramidal ownership (the control of a firm through a chain of ownership relations) that departs from the traditional argument of separating ownership and control. With a pyramidal structure a family uses a firm it already controls to set up a new firm. This allows the family to access the entire stock of retained earnings of the firm it controls and to share the security benefits of the new firm with the other existing shareholders of the original firm. Therefore, pyramids are more attractive when internal funds are important (e.g., due to the poorly functioning capital markets) and when the security benefits of the new firm are low; conditions that we show hold in an environment with poor investor protection. We also analyze the creation of family business groups (a collection of multiple firms under the control of a single family). Business group flourish when external markets are poorly developed because, in such cases, internal resources from the existing firms provide the family with a financing advantage vis-a-vis other competing entrepreneurs. Thus, the model predicts that in countries with poor investor protection family business groups should be common and they should be organized as pyramids. Because our model departs from the traditional argument for pyramids as a device to separate ownership and control, it can differentiate between pyramids and dual class shares even in situations in which the same deviation from one share-one vote can be achieved with either method. Unlike the traditional argument, our model is consistent with recent empirical evidence that some pyramidal firms are associated with small deviations between ownership and control. We also argue that pyramids can be an efficient organizational structure for the family if the availability of internal funds is sufficiently important, even though pyramids are associated with high levels of cash flow diversion. Other predictions of the model are consistent with systematic and anecdotal evidence on pyramidal business groups.

for providing us with his data. Pinkowitz and Williamson thank the Capital Markets Research

Managers make different decisions in countries with poor protection of investor rights and poor financial development. One possible explanation is that shareholder-wealth maximizing managers face different tradeoffs in such countries (the tradeoff theory). Alternatively, firms in such countries are less likely to be managed for the benefit of shareholders because the poor protection of investor rights makes it easier for management and controlling shareholders to appropriate corporate resources for their own benefit (the agency costs theory). Holdings of liquid assets by firms across countries are consistent with Keynes transaction and precautionary demand for money theories. Firms in countries with greater GDP per capita hold more cash as predicted. Controlling for economic development, firms in countries with more risk and with poor protection of investor rights hold more cash. The tradeoff theory and the agency costs theory can both explain holdings of liquid assets across countries. However, the fact that a dollar of cash is worth less than $0.65 to the minority shareholders of firms in such countries but worth approximately $1 in countries with good protection of investor rights and high financial development is only consistent with the agency costs theory. 2 1.

We develop an equilibrium model to understand how the efficiency of capital allocation depends on outside investor protection and the external financing needs of firms. We show that when capital allocation is constrained by poor investor protection, an increase in firms’ external financing needs may improve allocative efficiency by fostering the reallocation of capital from low to high productivity projects. We also find novel empirical support for this prediction.