Country Governance and Foreign Investment in Business Groups

Abstract

We investigate how different dimensions of governance affect foreign investment in business groups around the world. Business groups help investors to reduce the risk of expropriation from the State and the financial risk of default, but expose them to higher risk of expropriation by majority shareholders/entrenched managers. These risks are affected by the quality of governance in the country. Using disaggregated data on portfolio investment of institutional investors in the biggest firms in the world over the period 2000-2009, we show that foreign institutional investors generally avoid investing in business group affiliates and when they do invest, they prefer to invest in firms at the top of the group hierarchies. Higher risk of expropriation from the State increases foreign ownership in business groups, while bad corporate governance increases the incentives to invest in the firm at the top of the business group. During the recent financial crisis foreign investors increased their ownership in business groups, particularly so in countries where state intervention is limited. Also, using unsponsored ADRs, we show that exogenous shocks to the disclosure of the firm reduce foreign investor demand for complex firms as they hamper the ability of such a structure to shield from government expropriation.