Impact of Corporate Governance and Ownership Structure on the performance of SMEs in Mauritius.
1 LITERATURE REVIEW
This chapter gives an insight of the different studies that have been undertaken by many previous researchers in the context of corporate governance, ownership structure and SMEs around the world. In sum, the various concept and theories related to this study are discussed below namely the different theories of corporate governance and ownership structure and related findings; the different concepts of the board in relation to corporate governance and how it can be linked to performance of SMEs and finally various research studies examining the relationships between ownership structure, business growth and financial performance amongst smaller businesses.
1.2 Theories of Corporate Governance and Ownership Structure
Corporate governance has been a contemporary issue since the famous scandals and collapses of big organisations such as Enron and WorldCom, in relation to their accounting and management function (Jorge Farinha; April 2003). Top managers were being censured in that they were the ones bringing the companies to devastation and ultimate closure (Jorge Farinha; April 2003). In fact, the topic has been explored since long by various researchers, among the first ones being Berle and Means (1932), Jensen and Meckling (1976), and Fama (1980). However, the initial studies were made vis-à-vis large listed companies because it was presumed that the codes of best practice would only pertain to these corporations due to the wide dispersion between their ownership and management.
Small and medium enterprises (SMEs) are conversely small firms which are commonly owned and administered by the same person. Although SMEs are recognised worldwide as imperative for the economic development and boost up of many developing nations, a surprisingly small number of examiners have focussed on them in this context (Jaana Lappalainen and Mervi Niskanen, 2009). Various debates were made regarding the concern that corporate governance guidelines are futile and meaningless for SMEs because of the lack of agency problem existing in these firms (Business and Financial Times, Oct 2009). Gubitta (2002) explained that as long as the owner managed businesses are not intricate or complex to manage, the governance structure is pointless. However, some researchers concluded from their findings that corporate governance codes do have their implications for SMEs and they do help in value creation of entrepreneurial firms (Tan, 2004). These findings are described subsequently.
Ownership structure is basically how a firm is owned, by whom and their respective share of ownership. (Jaana Lappalainen and Mervi Niskanen, 2009) describe ownership structure as “ownership by different groups of shareholders or ownership concentration”. Out of the various analysis made to find any correlation between ownership structure and firm's performance, the statistics of Demsetz and Lehn (1985) and Demsetz and Villalonga (2001) revealed no relation between these two variables. On the contrary other researchers such as Morck, Shleifer and Vishny (1988), Hermalin and Weissbach (1991), Agrawal and Knoeber (1996), Andersson and Reeb (2003), Barontini and Caprio (2006), and Villalonga and Amit (2006), King and Santor (2008) concluded that the way a firm is owned does affects its profitability.
The first work started with the classic thesis of “Modern Corporation and Private Property”, by Berle and Means (1932) in which they found that one of the primary problem in modern firms is that of agency problem where there is a separation between ownership and control. In sum, they argued that the issue of corporate governance arises because of the “principal agent problem”. This means that the people owning the assets of the business (principals) are not the same as those managing these assets (agents). Therefore conflict of interest arises because both parties cater for their own interests and preferences.
Following the work of Berle and Means (1932), various theories have been developed in explaining the corporate governance issue. These include the agency theory, the stewardship theory, the resource dependence theory, the stakeholder theory and the legitimacy theory. Each of these theories is being extrapolated below:
1.2.1 Agency Theory
Agency theory explains the agency problem arises whenever the interest of the bodies managing the firm, clashes with those of the owners; Jensen and Meckling (1976) and Prevost et al. (2002). The separation of ownership and management make managers cater for their own personal benefits at the shareholders' expense; for example, awarding excessively huge remuneration and bonuses for the directors while declaring a small amount of dividend per share for the shareholders (Agrawal and Knoeber, 1996). In fact wherever management does not bear a substantial share of ownership in the firm, agency issue will exist (Jaana Lappalainen and Mervi Niskanen, 2009). According to Zahra (2007), insider and family ownership is more common in SMEs and this is why agency problems are less likely to crop up in small firms.
1.2.2 Stewardship Theory
Contrary to the agency theory which “criticises” the decisions taken by management, stewardship theory, according to Pei Sai Fan (2004), is based on the doctrine that managers are good stewards of the firm and they act in the best interest of their principals. In fact stewardship theory emerged from the field of psychology and sociology which incorporates the ‘human touch' as opposed to agency theory which is purely based on economics and on a materialistic world (K Olson 2008). As said by Donaldson and Davis (1994), “managers and directors are trustworthy and they work diligently to attain high corporate profit and shareholders' return”. In analysing the difference between agency theory and stewardship theory, Tian and Lau (2001) made use of the “CEO duality” concept (whereby the role of the CEO and chairman is performed by the same person) which according to them is a supporting feature of the stewardship theory.
1.2.3 Resources Dependence Theory
Resource Dependence Theory explains the relationship and interdependencies between an organisation and its various stakeholders like shareholders, managers, employees and society at large (Frooman, 1999). Pfeffer and Salancik, 1978, wrote in their book “The External Control of Organizations: A Resource Dependence Perspective” that resource dependence theory is based on the power of organizations in relation to the exchange of resources. Where one party has limited resources, it will have to rely on (be dependent on) the other party in order to obtain the needed resources. Resource dependence will be applicable wherever the stakeholder is more dependent on the organization or the organization is more dependent on the stakeholder for essential resources, thus creating a resource dependence power imbalance (Pfeffer and Salancik, 1978).
1.2.4 Stakeholder Theory
Stakeholder theory is an extended version of the agency theory (Newcombe, 2003). Following the publication of Freeman's (1984) seminal work ‘Strategic Management: A Stakeholder Approach', interest in stakeholders had started to grow considerably. The difference between these two theories is that while agency theory concentrates only on managers/directors and shareholders, stakeholder theory embodies various stakeholders of an organisation mentioned above into the relationship. According to Newcombe (2003), management decisions should not only focus on the benefits on shareholders but also on the community at large. He further argued that equal importance should be given to various groups of stakeholders as opposed to the traditional beliefs, that it is only shareholders' wealth which matters.
Similar to the corporate governance concept, stakeholder theory has also conventionally been associated with large listed companies (Kusyk, 2007). However, a recent article by World Bank Institute, (2004) and European Commission (2002) published that “even though individually SMEs are smaller power agents in the society, in a cumulative sense they represent anywhere from 97 to 99 percent of all enterprises and in some industry from 50 percent up to 80 percent of total employment.”
1.2.5 Legitimacy Theory
Legitimacy theory explains what can motivate management to voluntarily disclose environmental information and other corporate issues which affect the community (Dowling and Pfeffer, 1975; Meyer and Rowan, 1977; DiMaggio and Powell, 1991). The theory explains that there is a ‘social contract' between an organisation and the environment in which it operates; thus companies need to constantly ensure that they are operating in the defined norms and boundaries of their respective societies (Suchman, 1995). A company should report voluntarily on its activities and since SMEs too form part of the society, it is the responsibilities of the people administering them to take on a correct managerial structure and practices which comply with the norms and values of their respective surroundings (Meyer and Rowan, 1977).
1.3 Empirical Evidence on Corporate Governance in SMEs
It has been argued earlier that corporate governance can be explained by different theories but the issue is whether they mean the same thing for all countries. Just as different nations have developed different languages and customs, they also have adapted their own forms of corporate governance and board structures (Knowledge@Wharton, 2008). The Sarbanes Oxley Act in USA for example, defines Corporate governance as “the set of processes, customs, policies, laws and institutions affecting the way a corporation is directed, administered or controlled” (BNET Business Dictionary corporate governance and Sarbanes-Oxley Act 2002). The UK Cadbury Report simply defines corporate governance as “the system by which businesses are directed and controlled.” (UK Cadbury Report: The Financial Aspects of Corporate Governance). Contrasting this with Mauritius, “Corporate governance is the process and structure used to direct and manage the business and affairs of an institution with the objective of ensuring its safety and soundness and enhancing shareholder value (Bank of Mauritius, April 2001)”. The definitions of corporate governance may differ amongst countries but overall it can be seen that its aim is to give specific guidelines to companies in terms of their control.
Although the initial researches were made on big corporations, some scholars carried out similar studies on SMEs in an attempt to know whether or not corporate governance principles are suitable for them.
On one hand, researchers found out that SMEs have a small number of staff who are primarily the siblings and close relatives of the owner thus there is little or no separation of ownership and management; this does not necessitate the compliance with codes of best practice (Adjasi, 2007). Small entrepreneurs have established their businesses with their own fund. As a result, they are not accountable to the public and they do not essentially need to adhere to any sort of public disclosures (Abor, 2006; Biekpe, 2007).
Some examiners, on the other hand, asserted that principles which large listed companies are following after the collapses of Enron and WorldCom should also be adopted by small organisations to enhance their performance (Adjasi, 2007). The introduction of better management practices and stronger internal auditing can foster greater growth opportunities for SMEs (J Abor, 2006). Tan (2004) recommended that small enterprises should not restrict themselves to their internal management resources but should also consider external independent directors to take better strategic decisions. The members of a well structured board have the expertise and knowledge on choosing the best financing package of an organisation, thus dealing with the difficulties and credit constraints that small firms often have to encounter (Adjasi, 2007). Investors will perceive SMEs which follow corporate governance guidelines to be less risky to invest in (J Abor, 2006).
1.4 Corporate Governance and Board
The top management of a company is essentially its board of directors; which is acknowledged to be pivotal in corporate governance (Lappalainen and Niskanen, 2006). Zahra and Pearce, (1989), explained that board composition refers to how a board is structured and the number of members it comprises of. They further illustrated that board composition is the key determinant of the board's ability to discharge its responsibilities of providing strategic direction, control and performance. The board of directors is also considered to be the utmost link between management and shareholders (Adjaoud et al. 2007; Brunninge et al. 2007) and thus can be seen to resolve the agency problem (Agrawal, 1996).
According to Hermalin and Weissbach (1991) and Dalton et al. (1998), there is no correlation between how a board is structured and the performance of a company. Mak and Li (2001) conversely found the contrary. For SMEs, the role of board of directors is dissimilar. In fact the risk of management's taking decisions against the interests of owners is lower in small firms (Brunninge et al. 2007).
The existing empirical literature on corporate governance of SMEs laid much emphasis on different factors which includes board size, outside directors and board independence, board diversity, CEO duality, inside ownership, managerial ownership, family ownership, and foreign ownership. These are in turn discussed as follows:
1.4.1 Board size
The number of directors sitting on a board is known as the board size. Two issues regarding board size are how big a board should be and is board size a determinant of firm's performance. According to Bozec (2005), the size of the board depends on how large the company is. Smaller firms need to have a small board while big organisations would need a larger board but at the cost of incurring more agency costs. Regarding the effectiveness and efficiency with which company assets are used, Eisenberg (1998) and Yermark (1996) concluded that smaller boards perform better. However, in relation to board size and firm's profitability, Eisenberg (1998) and Pearce & Zahra (1992) reached opposing views. Eisenberg (1998) reported a negative correlation between board size and profitability and also that larger board size usually lead to the deterioration of corporate governance but Pearce & Zahra (1992) found a positive link between board size and firm's profitability.
1.4.2 Outside directors and board independence
Agency problem arises because the shareholders (who are not directors) are usually not involved in decision making. The opportunistic behaviours of inside directors can be monitored by introducing independent/outside directors on the board (Lappalainen and Niskanen, 2006). Outside directors are those who do not form part of management and day to day running of the organisation (Fama, 1980). They are also known as Non Executive Directors (NEDs). According to these researchers, outside directors act as a ‘check' on the executive directors and they can provide superior benefits to the firm (Bozec, 2005). They are considered as good governance mechanism and in order to make them more effective, NEDs often come from the existing pool of shareholders. In this way, the can represent shareholder interests and provided value added to the firm in the true sense (Ben-Amar and André, 2006). Other researchers such as Pearce and Zahra (1992) argued that the proportion of NEDs should be greater than inside directors in order to improve profitability. For SMEs however, Brunninge (2007) found that the owners, board, and top management are often the same parties.
1.4.3 Board Diversity
Board diversity may be considered to be a less important aspect of board composition and corporate governance; yet it has been explored by various examiners. Essentially board diversity refers to the different type of persons sitting on a board in terms of gender differences, different cultural and educational background, local or foreigners and so on. Fields and Keys (2003) looked at how board diversity can enhance corporate governance and firm's performance. Adams and Ferreira (2002), in using U.S. data, reported that gender diversity results in better board performance. Keys et al. (2003) presented sufficient empirical evidence to conclude that board diversity improves expected future cash flows. In his study to find out whether local directors or foreigners perform better, Ramaswamy and Li (2001) found that foreign directorship appears to have greater influence on board decisions.
1.4.4 CEO Duality
As explained above, a well structured board as per corporate governance guidelines should consist of both executive (inside) directors and non executive directors (NEDs). The head of executive directors is the CEO while that of the NEDs is the chairman. This separate leadership role is important for the chairman to act as an independent check on decisions made by the CEO. Unlike inside directors, the chairman is not involved in the day to day running of the firm. CEO duality refers to a board structure where the CEO is himself the chairman (Bozec, 2005). CEO duality is expected to be detrimental to firm's performance and profitability (Bozec, 2005).this view has also been supported by Ezzamel and Watson (1993). They argued that how can the CEO be monitored if he is himself the Chairman? In contrast Dehaene et al (2001) found a positive link between CEO duality and profitability. Further studies carried out by Andersson and Reeb (2003) revealed that profitability is positively linked to family CEOs. Due to the small number of persons present in the board of SMEs, CEO duality is often a characteristic of these organisations.
1.4.5 Inside ownership
Another common characteristic of SMEs is inside ownership that is the business is owned by the bodies inside the organisation, mostly top management and family members. As it is, the two forms of inside ownership are family ownership and managerial ownership which are in turn explained below. According to King and Santor (2008), increased inside ownership can boost up firm's performance. Since the owners are themselves the managers, the agency issue is not relevant and thus a reduction or rather elimination of agency costs (Jensen and Meckling, 1976). Further studies were made by Shleifer and Vishny (1997) and the latter concluded that the presence of a large shareholder improves shareholder performance since they have more motivation and incentive to monitor management and acquire inside information. Finally SMEs who are owned and managed by family members tend to make better investment and financing decisions since they have better knowledge on their business and they also pursue long term growth of the organization (King, 2008).
1.4.6 Managerial Ownership
One of the common characteristics of SMEs is managerial ownership where the firm is owned and managed by the same persons_ thus being the ultimate solution to the agency problem. Managerial ownership is thus expected to improve profitability to quite a great extent. Indeed Hermalin and Weissbach (1991) found that this form of ownership structure increases management's motivation and willingness in an attempt to consistently improve performance. However, a surprisingly number of other studies revealed that managerial ownership and firm's performance are positively correlated only at low levels of management shareholding. For instance McConnell and Servaes (1990) indicate that high managerial shareholding is negatively associated with profitability. Even Hermalin and Weissbach (1991) argued that stock return improves with an increase in shares held by managers but only at a low level of shareholding.
The statistics of Agrawal and Knoeber (1996) revealed a positive relationship between inside ownership and firm's performance and a negative correlation between outsiders on board and profitability. This view has also been supported by Yermack (1996). In contrast, Ben-Amar and André (2006) and Lasfer (2006) reported an enhanced firm's performance from the introduction of outside shareholders in the ownership structure of a company.
1.4.7 Family ownership
There is a major debate regarding the role of concentrated family ownership and firm's performance. Family ownership is essentially another form of inside ownership and is more commonly associated with SMEs. Having an owner-CEO or family CEO eliminate agency problems (Villalonga, 2006). Anderson and Reeb (2003) also supported the view that CEO should be a fonder family member and they concluded that family firms perform better than businesses with other forms of business structures. A positive relationship between performasnce and family control has also been reported by Barontini and Caprio (2006). Furthermore, King and Santor (2008) found that family-owned firms help in bringing value creation. Villalonga and Amit (2006) argued that an inside leadership role such as CEO or Chairman performs better than a ‘hired' CEO.
Family ownership has nevertheless been criticised by other scholars such as Ben-Amar and André (2006) who found that family ownership deteriorate firms' value and can bring even devastating consequences if family members perform the roles of CEO or chairman. Jaana and Mervi (2006) further explain that family CEOs or chairman need not necessarily have the required experience, competence and skills for these roles. In addition to this, unlike highly qualified and competent outside CEOs, family CEOs who may not be as professional as required, often do not care for their reputation in the executive labour market (Ben-Amar and André, 2006).
1.4.8 Foreign ownership
It is common to find foreign shareholders in the ownership structure of large companies but this is less likely with SMEs. The importance of foreign shareholders in relation to forms' performance is quite abstract (Douma, 2007). According to Douma (2007), foreigners are not quite interested in who manages the company or what decisions are being made. They invest in profit making companies and as soon as the company starts making loss, they adopt an exit strategy; in short they do not perform a monitoring role (Coffee, 1991; Aguilera and Jackson, 2003). Other researches studied on the relationship between foreign ownership and productivity improvements. Aitkin and Harrison (1999) made their research on a sample of Venezuelan small firms while Arnold and Javorcik (2005) carried out a similar research on a sample of Indonesian firms. Both studies concluded that foreign ownership is positively linked with productivity improvements. Petkova (2008) conducted a similar study on Indian small firms and according to him the above finding is applicable only for a three year horizon.