Political Connections and the Cost of
Equity Capital
Narjess Boubakri (HEC Montreal)
Omrane Guedhami (University of South Carolina)
Dev Mishra (University of Saskatchewan)
Walid Saffar (University of Southern Indiana)
EFMA Symposium
April 10, 2009
Presentation Outline
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Introduction
Objectives and Contributions
Research Design
Data and Variables
Summary of the Results
Conclusion
Introduction
 Anecdotal evidence indicates that politically connected firms in different
countries around the world benefit from their relationships with
politicians;
 In Indonesia, relatives of ex-President Suharto, especially his sons,
enjoyed easy access to cut-rate credit and import licenses;
 In Malaysia, investors interpreted the imposition of capital controls
following the 1997 Asian financial crisis as preferential treatment for
firms that were politically linked to Prime Minister Mahathir;
Introduction
 This evidence is empirically supported by recent studies showing that the
political connection phenomenon is prevalent in both developed and
developing countries;
 Faccio et al. (2006) finds that politically connected firms are more likely
to be bailed out when faced with financial distress as compared to their
non-connected peers;
 In Indonesia, Fisman (2001) finds a correlation between reports on
Suharto’s state of health and the value of the firms connected to his
regime;
Objectives and Contributions
 The objective of this study is to examine the net effects of political
connections by focusing on the cost of equity of PCFs rather than on
performance or value measures;
 This approach allows us to determine the impact of political connections
on the cost of capital, an important channel of influence on firm value;
 Indeed, some political connections are a reflection of a firm’s agency
problems and corporate governance;
 Thus, our investigation reflects arguments that the costs of external
finance are driven by the extent of firms’ agency and information
problems and our use of the cost of equity as a test vehicle allows us to
uncover the extent of such problems in PCFs.
Objectives and Contributions
 Moreover, a potential advantage of using the cost of equity rather than
firm value, largely measured by Tobin’s Q, is that the former allows us to
deal with the fact that Tobin’s Q is also a measure of the firm’s growth
opportunities;
 Our study is related to two different streams of academic research,
namely the literature on political connections, and that on corporate
governance and the expropriation of minority shareholders;
Potential Benefits of Political Connections
 The literature suggests that “systematic exchanges of favors” between
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politicians and firms add value to PCFs (Chaney et al., 2008);
Government officials can influence the economic value of a corporation by
awarding lucrative government contracts, imposing tariffs on competitors, or
reducing regulatory requirements, to name a few (Goldman et al., 2006);
More generally, PCFs enjoy soft budget constraints and are not sensitive to
market pressures or prevailing competition;
Also, these firms generally pay less taxes (Faccio, 2007), hence they benefit
from lower operating costs;
Additional evidence on the soft budget constraints enjoyed by PCFs appears in
Khwaja and Mian (2005) who illustrate the role of ex-politicians in providing
government bank loans to politically connected Pakistani firms.
Potential Costs of Political Connections
 Leuz and Oberholzer-Gee (2006) suggest that politically connected
Indonesian firms choose not to cross list on U.S. markets, to avoid the
scrutiny and strict listing requirements imposed on foreign firms;
 Chaney et al. (2008) show that PCFs report earnings of lower quality
than their unconnected peers;
 Evidence from the privatization literature suggests that when firms are
politically connected, they underperform their unconnected newly
privatized counterparts (Boubakri et al., 2008a);
 Bertrand et al. (2007) find that profits in French firms managed by
politically connected CEOs tend to decline as the fraction of their
employment located in politically contested areas increases, due to
higher wage bills.
Hypothesis
 In light of this discussion on the potential benefits and costs of political
connections, we derive our main testable hypothesis: If the benefits (costs)
of political connections outweigh their costs (benefits), the cost of equity will be
negatively (positively) related to the cost of equity of PCFs.
Definition of political connection
 A company is defined as politically connected if at least one of its largest
shareholders or top officers is: (i) a member of parliament, (ii) a king,
president or minister, or (iii) closely related to politicians or a political
party as of 2001;
 We also consider close relationships to be indirect political connections,
as when heads of State or their relatives also serve as top officers of a
company or hold large blocks of its shares;
 Close relationships also include top officers who are known to be close
friends with a king, a president, a minister or a member of parliament, as
described in several journals (e.g., The Economist, Forbes and Fortune).
Cost of Equity Estimates
 We use the discount rate estimated following recent studies.
 We follow Hail and Leuz (2006), and use four models to estimate our
cost of equity capital.
 The four models are Easton (2004 ES), Ohlson and Juettner-Nauroth
(2005 OJ), Gebhardt, Lee and Swaminathan (2001 GLS), and Claus and
Thomas (2001 CT).
 Our final cost of equity estimate ‘K’ is the average of the cost of equity
estimates of these four models.
Distribution of Political Connections
Variables
Political Connections and the Cost of Capital
Robustness Tests
Robustness Tests
Conclusion
 Prior academic research has shown that PCFs are prevalent around the
world, regardless of a country’s level of economic development (Faccio,
2006);
 The literature also argues that shareholders in PCFs gain from the close
ties to politicians (e.g., Leuz and Oberholzer-Gee, 2006 for Indonesia;
Johnson and Mitton, 2003 for Malaysia);
 However, few studies have argued that government relationships could
potentially be detrimental to shareholder value;
 The objective of this study is to examine the net effects of political
connections by focusing on the cost of equity of PCFs;
Conclusion
 This approach allows us to determine the impact of political connections
on the cost of capital, an important channel of influence on firm value;
 Our results show that PCFs have a lower cost of equity capital than their
non-connected peers;
 These conclusions are robust to a battery of checks including alternative
proxies for the dependent variable, selection bias concerns, as well as
alternative control samples of non-connected comparable firms;
 Our main conclusion is that because of the soft budget constraints
generally enjoyed by these firms, and the assurance of corporate rescue
in the event of financial crisis/distress, the benefits from being politically
connected outweigh the costs leading investors to require a lower rate of
return for investing in PCFs.