The current essay follows an approach similar to that developed in the first two essays to evaluate the quality of corporate governance of companies within the European context. The empirical evidence regarding the influence of ownership structure on the corporate governance structure and performance of European companies is rather unclear. In a similar vein, Belot et al. 2014) argue that board structure generally reflects the characteristics of their company and its environment.
They argue that using common governance indices such as Gompers et al. 2003) G-index or ISS governance measure (formerly Risk-Metrics) to assess the governance quality of non-US firms can lead to misleading conclusions. However, the authors suggest that improvements in the quality of firms' governance seem to have a smaller effect on their performance in companies with better shareholder protection and higher corporate governance rankings. This may be related to several reasons such as the complexity of corporate governance systems, endogeneity issues and differences in institutional and legal attributes around the world.
I use Thomson Reuter's Eikon as the main database to collect most of the required data.
Corporate Governance Index
Once again, the US dollar is chosen as the base currency to ensure data consistency with the data used in the construction of the Fama-French European portfolios.6 The annual exchange rates are taken from the Eikon database. In the executive compensation category, excess executive compensation is calculated as part of the executive's total compensation, which cannot be explained by the individual characteristics of the company or the director. It is hypothesized that well-governed companies are expected to be more successful in defining a well-designed compensation system that is not excessive, but sufficient to align the interests of managers and shareholders.
Nevertheless, it may be less relevant in the case where the firms' managers are also the owners of the company, such as in family or founder businesses. This study measures companies' financial performance using their industry-adjusted return on assets where companies'. To quantify companies' non-financial performance, I rely on ESG scores from the Thomson Reuters ASSET4 database.
I recognize that the ESG total scores include information on the three sustainability pillars of environmental, social and governance factors, and so using this metric to value governance will have a confusing effect. The social score, on the other hand, includes four categories of human rights, workforce (e.g. job satisfaction and safe workplace), community (e.g. business ethics) and product responsibility (e.g. high-quality goods) (Refinitive, 2019). To rule out the possibility that these measures are driven by other factors such as firm, industry or market characteristics, I first remove the influence of these variables and use the residuals from the regressions in the analysis.
The variables constructed from the residuals of each regression are treated as six governance sub-indices. The first principal component is used as the governance index, as it explains the largest percentage of total variation among the governance sub-indices. The null hypothesis of Bartlett's test, which states that the variables are not correlated and that the correlation matrix is not factorable, must be rejected for the data to be suitable for PCA analysis.
Corporate Governance and Boards Characteristics
Before performing PCA, the validity of this method is assessed using Bartlett's Sphericity and Kaiser-Meyer-Oklin's (KMO's) Sampling Adequacy tests. In addition, the KMO measure of sample adequacy, which measures the degree of common variance between the original variables, should be greater than 0.5 to ensure that the sample is sufficient and acceptable for further analysis (Tarchouna, Jarraya, & Bouri, 2017). In addition to Ordinary Least Squares (OLS), I conduct the regression analysis using fixed effects panel regression, dynamic OLS, and Generalized Method of Moments (GMM) to account for several endogeneity issues that may impact the findings.
Using a GMM model would likely have more power to account for various endogeneity issues such as unobserved heterogeneity, simultaneity, and dynamic endogeneity.
Stock Returns, Firm Value and Operating Performance
To have a better understanding of how much of the generated returns can be linked to management, portfolio returns need to be adjusted for various risk factors that may explain some of the differences in returns. According to Carhart (1997) and Fama and French (1993), apart from the impact of the overall market condition that can be captured by using the CAPM model, one will also have to take into account firm size, book-to-market -ratio and momentum factors. I calculate risk-adjusted excess returns by regressing the portfolio returns on the four risk factors, including 𝑀𝑘𝑡𝑡, 𝑆𝑀𝐵𝑡, 𝐻𝑀𝐿𝑡 and 𝑀𝑂𝑀, (High effect on the bear market) Low (value effect) and Momentum (winners minus losers) portfolios. respectively.
The return on the 10 portfolios as well as the market portfolio is calculated in addition to the risk-free interest rate. This study accounts for differences in countries' legal origins to examine whether outcomes differ within different institutional settings. Accordingly, the sample is divided into two groups of companies operating in either civil or common law systems11, and the portfolio analysis is repeated for the two samples separately.
Based on previous research, I expect to find relatively higher governance quality and better stock performance in the sample for firms established within common law legal systems. Finally, to investigate whether governance quality can positively influence firms' value and operating performance, I run several regression models using the measure of. 9 Because companies are assigned to portfolios at the end of each year (i.e. quarter 4), HPRs are calculated for 1, 2, 3 and 4 quarters of the following year.
11 Initially I wanted to divide the companies into four groups based on their legal origins: English common law origin (United Kingdom and Ireland); Scandinavian civil law origin (Denmark, Finland, Norway and Sweden); However, due to data availability, the sample size became too small, making it incompatible for further analysis. I also consider other company-specific factors that can affect performance by controlling for company size (Size), age (Age), and market-to-book value (MB).
Empirical Results
Governance Index and Board Characteristics
Based on the PCA result, the first principal component explains 44 percent of the variation among the original variables. To empirically test the possibility that unexpected signs are related to the institutional quality of countries, the sample is divided into two parts according to the legal origin of the country, and the PCA is conducted separately for firms based in common and civil law countries. As shown in the equations above, the unexpected signs are observed only in the civil law sample.
After compiling the governance index, this study examines whether different characteristics of the board can influence their effectiveness. On average, 53 percent of the directors are independent and 17 percent of the directors are female. Board members attend 93 percent of board meetings and 75 percent of CEOs also hold the position of board chairman.
Finally, statistics regarding board structure show that only 34 percent of companies have a two-tier board structure. These statistics are relatively comparable (albeit with some divergence) to the sample of US companies used in the first essay. For example, for the sample of US companies, the results showed that the average US board of directors consisted of nine members, of which 75 percent were independent and 11 percent were female directors.
The results of the OLS estimation show that almost all board characteristics produce statistically significant effects on the company's governance index. 14 We use two lags of governance in the model and include variables lagged three and four periods as instruments for the endogenous variables. This table contains the results of OLS, Fixed-effects, dynamic OLS and system GMM estimates of the relationship between management quality and board structure.
Governance Quality, Stock Returns and Operating Performance .1 Summary Statistics
- Portfolio Returns
The higher the value of the index, the better the management quality of the firm. As shown in Panel A, the HQ portfolio (portfolio #10) representing companies with the highest management quality index offers higher raw (risk-adjusted) returns compared to the LQ portfolio (portfolio #1) which contains companies with the lowest management quality in the sample. The first portfolio includes companies of low management quality (LQ), while the 10th decile portfolio contains companies of high quality (HQ).
In Table 3.5, the intercept (α) represents the portfolio return that exceeds the return offered to investors to compensate for the risk. Risk-adjusted returns appear to be relatively higher in portfolios of firms with better governance quality. This confirms that even after controlling for common risk factors, firms with better governance quality still enjoy a better condition.
The results show that, on average, firms operating in countries with common law legal systems tend to have better firm-level governance quality as measured by the governance index. However, the difference between the performance of the two extreme portfolios (HQ-LQ) is generally greater within the common law countries. These findings are consistent with our expectations that countries' institutional settings influence the quality of governance oversight at the firm level, which will then be reflected in firms' stock market performance.
The average quarterly returns of the equal and value-weighted portfolios constructed from the governance index (Index). To examine whether firms' management quality can positively influence their performance, various proxies for firm profitability are regressed on the measure of management quality, controlling for other firm-specific factors that may affect performance. More specifically, the results show that after controlling for firm, industry, and time fixed effects, a one-unit improvement in firm management quality can improve their Tobin's Q, ROE, ROA, NPM, and Return by 0.33 units, respectively.
Tobin's Q is defined as the ratio of the market value of assets over the book value of assets. Return represents quarterly stock returns calculated as the geometric mean of the monthly stock returns within each quarter.
Conclusion
The New European Corporate Governance Model: Anglo-Saxon, Continental or Still the Century of Diversity.
