How do companies based in countries with weak government institutions earn the trust of minority investors and raise capital? Where the rule of law and government enforcement cannot control corruption, insiders seem free to expropriate their company’s resources, making it essential for them to somehow assure potential outside investors that they can be trusted. Establishing trust is especially important for growing firms that have profitable investment opportunities and are most in need of external capital.
One promising approach to building trust might be to pay a dividend – there is credibility in cash. However, paying a fixed dividend consistently, as is the norm in developed countries such as the U.S., is less feasible in the developing world, particularly for growth firms. Such a dividend would deprive a firm of resources precisely when they are needed and necessitate raising even more capital from outside investors to replace the dividend and to fund growth.
In a recent paper, we empirically examine the dividend policies of companies around the world. Our primary finding is that firms in countries with weak government institutions pay dividends very differently than do companies in developed countries. Specifically, they commit to pay a percentage of a current period’s earnings as dividends each year. These commitments are made much less frequently in more developed countries and are almost nonexistent in the U.S.[1] Returning a percentage of the cash being generated by the firm as dividends each year limits the resources that insiders control and can expropriate. Thus, firms can use the dividend to credibly signal that they have substantial income. In addition, firms tend to initiate dividends closer to the time of their IPO, which helps attract new investors when the firm is in a growth phase. Hiring a reputable auditor, so that investors have some assurance that the financial statements on which the dividend payments are based reflect economic income, further increases the credibility of the company and its dividend.
For example, Bao Viet Holdings in Vietnam states that it will use a “minimum of 50% of annual earnings to pay dividends.” Transneft Holdings in Russia, which is audited by KPMG, commits to dividends “not less than 15% of the normalized consolidated profit following the results of a reporting period and 25% of the Company’s net profit for a reporting year.” Transneft’s financial statements also contain formulae that determine the dividend payment within that 15 – 25 percent range as a function of investment spending and the ratio of debt to cash flow.
This practice of paying dividends as a percentage of earnings dates back to the first publicly-traded company and began in response to an activist campaign (Petram, 2011). Minority investors in the Dutch East India Company were concerned that insiders were expropriating resources and lobbied the Dutch government not to renew the company’s charter. Linking the dividend to earnings resolved these concerns and allowed the company to operate under the charter for another 200 years.
Our findings support the hypothesis that firms in weak-institution countries adjust the timing of dividend payments to reveal the level of agency conflicts to potential investors and facilitate the raising of external capital. To test this hypothesis, we use a global sample of approximately 33,000 firms from 85 countries and examine the relation between the timing of dividend payout and the quality and strength of government institutions. We measure the quality of institutions (i.e., Institutional Quality) in a firm’s home country using country-level World Bank data on Worldwide Governance Indicators. Our measure of dividend policy is the Speed of Adjustment (SOA), which captures the rate at which dividends revert back to the long-term target payout following a change in earnings (Leary and Michaely, 2011). In developed countries like the U.S., SOA is very low, but we show that it is significantly higher in countries with weak institutions, as Institutional Quality explains 48.2 percent of the average cross-country variation in the rate at which dividends revert back to the target payout following an earnings change.
In within-country analyses, we examine the role of variation in the availability of firm-level information and severity of agency problems. Specifically, we rank firms within-country on the basis of valuation (market capitalization), external monitoring (analyst following), financial statement attestation (audit fees), information uncertainty (return volatility), and equity raising (equity issuance), and show that these ranks are more strongly associated with SOA in weak-institution countries relative to strong-institution countries. These results suggest that firms in weak-institution countries with high-SOA tend to have higher market values, stronger monitoring by intermediaries, and more high-quality information available, perhaps indicating fewer information and agency problems. These in turn facilitate equity issuance, which we show is higher for firms with high SOA in countries with weak institutions. Because these equity issuances occur at a smaller discount to market value, these firms also face a lower cost of equity capital.
We also show that, because firms pay dividends differently in the developed world, they communicate different information to investors. First, we find that firms in weak-institution countries change dividends more frequently and, conditional on a decline in earnings, are also more likely to cut the dividend. Second, we find that firms in strong-institution countries are more likely to change the dividend in response to persistent changes in earnings (i.e., earnings changes that affect income in future years), but firms in weak-institution countries are less likely to do so. Taken together, these findings suggest that, while in strong-institution countries, dividends provide information about consistent earnings (i.e. earnings that recur year-after-year) available to fund dividends, in weak-institution countries, dividends are only informative about the cash generated by current earnings. Finally, we also show that firms in weak-institution countries with high-SOA dividend policies have stronger market reactions to earnings, which is consistent with dividends increasing the informativeness of earnings in these countries.
Overall, our paper provides new evidence of the different role that dividend policy plays in the developing world. Most studies on international payouts investigate which firms choose to distribute earnings and the average amount and conclude that “payout policies around the world have been subject to largely similar dynamics” (Farre-Mensa et al., 2014).[2] In contrast, by investigating the timing of dividends, we document significant differences between firms in countries with weak and strong institutions. Our findings also provide a potential explanation for firms’ simultaneously raising equity while paying dividends, a practice that Easterbrook (1984) describes as “downright inexplicable.” We show that the association between Institutional Quality and SOA becomes stronger when firms rely more on external equity capital, which is consistent with future investors being more willing to commit capital in weak-institution countries when the firm uses a high-SOA dividend policy to facilitate trust and attract outside capital.
ENDNOTES
[1] An exception is industries such as REITs, with strong tax incentives to return a minimum percentage of earnings to investors.
[2] For example, in motivating their valuation results, Pinkowitz et al. (2006) state: “As long as dividends are sticky, high current levels of dividends predict high future levels of dividends, and hence lower consumption of private benefits.” We show that in weak-institution countries firms have less sticky dividends.
REFERENCES
Easterbrook, F. “Two Agency-Cost Explanations of Dividends.” American Economic Review 74 (1984): 650–59.
Farre-Mensa, J., R. Michaely; and M. Schmalz. “Payout Policy.” Annual Review of Financial Economics 6 (2014): 75–134.
Leary, M., and R. Michaely. “Determinants of Dividend Smoothing: Empirical Evidence.” Review of Financial Studies 24 (2011): 3197–249.
Petram, L. The World’s First Stock Exchange: How the Amsterdam Market for Dutch East India Company Shares Became a Modern Securities Market, 1602–1700. New York, NY: Columbia University Press, 2011.
Pinkowitz, L., R. Stulz; and R. Williamson. “Does the Contribution of Corporate Cash Holdings and Dividends to Firm Value Depend on Governance? A Cross-Country Analysis.” Journal of Finance 61 (2006): 2725–51.
This post comes to us from professors Atif Ellahie at the University of Utah’s David Eccles School of Business and Zachary Kaplan at Washington University in St. Louis’ John M. Olin Business School. It is based on their recent article, “Show Me the Money! Dividend Policy in Countries with Weak Institutions,” available here.