Corp Govern - Liquidity

Comparative Economic Studies, 2010, 52, (82103)
r 2010 ACES. All rights reserved. 0888-7233/10
www.palgrave-journals.com/ces/
Corporate Governance and Liquidity

Constraints: A Dynamic Analysis
BERSANT HOBDARI1, DEREK C JONES2 & NIELS MYGIND1
1
International Economics and Management, Copenhagen Business School,

Porcelanshaven 24 A, Frederiksberg, 2000, Denmark.
2
Hamilton College, Clinton, NY 13323, USA.
Rich panel data for a large and representative sample of Estonian firms are used to
estimate the sensitivity of access to capital to differing ownership structures. This
is done through explicitly modelling firm investment behaviour in a dynamic setting
in the presence of adjustment costs, liquidity constraints and imperfect
competition. We estimate Euler equations derived in the presence of symmetric
and quadratic adjustment costs and both debt and equity constraints. Generalized
Method of Moments (GMM) estimates confirm the importance of access to capital in
determining investment rates and suggest that firms owned by insiders, especially
non-managerial employees, are more prone to be liquidity constrained than others.
Comparative Economic Studies (2010) 52, 82103. doi:10.1057/ces.2009.10;
published online 3 December 2009
Keywords: corporate investment, corporate governance, liquidity constraints,

GMM estimates
JEL Classifications: C33, D21, D92, E22, G32, J54, P34
INTRODUCTION
The importance of liquidity constraints in firms real investment decisions
has long been the focus of economic research (Stein, 2003). The literature
finds that access to capital is not unlimited and is determined by the degree of
informational asymmetries and agency costs. The large extant empirical work
has focused on identifying indicators at the firm level, such as dividend
payout ratios, bond rating, degree of bank affiliation, membership in financial
conglomerates, firm size, firm age and/or governance structure, that
approximate for the severity of capital market imperfections and explain
B Hobdari et al
Corporate Governance and Liquidity Constraints
83
1
the observed differences in investment behaviour across firms. In this paper,

by using a rich panel data for a large and representative sample of Estonian
firms, we investigate firms investment behaviour during the period 1993
through 2002 and make several contributions.
Fundamentally, we provide new evidence on a topic that has attracted
the attention of theorists but for which there is little empirical evidence the
impact on investment of alternative governance structures. The study
contributes to the literature in several ways. First, it accounts for the effect
of governance structures in investment decisions through their role in
mitigating or exacerbating informational asymmetries and agency costs.
Second, it assesses the long-run viability of certain ownership forms. This is
an important issue in light of the continuing debate in the literature about
the efficiency of various ownership forms resulting from the extensive
privatization process in almost all former centralized economies. Third, in a
more general context, it contributes to the debate in the corporate governance
literature on the effect of governance through ownership. Fourth, the results
of the analysis allow us to answer questions such as how pervasive across
firms and over time are liquidity constraints in Estonia and to what extent
are different governance structures likely to be financially constrained? The
answers to these questions, in turn, provide directions where public policy
should focus to promote successful restructuring on the part of firms. Further,
as the movement from state ownership led to the emergence of similar
ownership structures in almost all transition economies, our conclusions
would be applicable to other Central and East European and former Soviet
Union countries. Finally, by focusing on the small, open and dynamic
economy of Estonia we provide evidence of a country that has been
understudied in the governance literature.
The remainder of the paper is structured as follows. In the next section,
we outline the testable hypotheses and present the specifications to be
estimated in the empirical work. The next two following sections focus on
sample construction and data description, and the estimating strategy and
presentation of results. In the last section, we conclude with further
discussion and some policy recommendations.
This literature, which started with the seminal work of Fazzari et al. (1988), is large and
includes, for instance, Devereux and Schiantarelli (1990), Hoshi et al. (1991), Whited (1992), Oliner
and Rudebusch (1992), Schaller (1993), Galeotti et al. (1994), Petersen and Rajan (1994), Bond and
Meghir (1994), Vogt (1994), Hubbard et al. (1995), Kaplan and Zingales (1997), Hu and Schiantarelli
(1998), Hadlock (1998), Cleary (1999), Kaplan and Zingales (2000), Fazzari et al. (2000), Goergen
and Renneboog (2001), Alti (2003), Moyen (2004), Clementi and Hopenhayn (2006), Hanazaki and
Qun (2007) and Hennessy et al. (2007).
Comparative Economic Studies
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84
GOVERNANCE STRUCTURES, INVESTMENT AND LIQUIDITY CONSTRAINTS

The extensive literature on investment behaviour does not say much on the
role of different governance structures in investment decisions, because
most empirical studies are based on samples of large publicly traded firms
where ownership is widely dispersed and managers enjoy a high degree of
discretion. In the process of decentralizing their economies, in many
countries, the transition away from state ownership led to the emergence of
diverse forms of ownership. Thus, in many instances, insiders have majority
or dominant ownership or, even when they possess minority ownership,
enjoy a substantial degree of control. Accompanying the emergence of these
different forms of ownership and control, we also observe that a large
literature has emerged that highlights competing hypotheses concerning
the expected economic effects of these different regimes.
As far as the ability to raise capital is concerned, various arguments
suggest that firms that are insider-owned face a higher likelihood of being
more constrained than others. Thus, most of the literature on employee
ownership stresses a host of factors such as member wealth position, their
time horizon, risk attitudes, goal structure and the structure of property
rights2 in the firm that encourage employee-owners to take the residual in
the form of higher income rather than investing it in the firm (Dow, 2003).
This preference, along with employee owners potential aversion to accepting
new members, leads to a potential goal conflict between insiders and outside
providers of both equity and debt capital. In addition, the fact that most of
these firms are small and not listed on the stock markets exacerbates
information asymmetries and makes access to desired capital more difficult.
The net effect of the interaction of these factors could be that outside
investors may be reluctant to invest in employee-owned firms or, when they
do invest, the risk premium they charge will be substantially higher than the
market one. Overall, disincentives to invest internally and barriers to raise
capital externally might lead to employee-owned firms underinvesting.
The traditional analysis of employee ownership assumes that employee-owned firms are
characterized by collective ownership and non-transferable individual rights. An important
development in transition economies is that, in most of the cases, employee-owners are share
owners, that is, they own part of the firm on an individual basis and are able to trade shares in the
capital markets. However, these firms still retain a strong degree of collective ownership by imposing
limits on share trading. Evidence of this is provided by, for example, Kalmi (2002) for Estonia. In a
field survey of firms under insider ownership, the author reports that in only 6% of his sample were
there no restrictions on share trading. Furthermore, in 92% of the cases insiders are asked to offer
their shares first to current shareholders.
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85
At the same time, there are competing views of the role of employee-owners.
In particular, a large literature points to employee ownership having a
potentially powerful motivational effect, resulting in better mutual monitoring and heightened discretionary effort (Kruse and Blasi, 1997). It is clearly
possible that, if these effects dominate, then outside investors hesitation to
invest in employee-owned firms would be overcome.
Similarly, there are competing hypotheses concerning the role of
managerial ownership. In one camp are those who see increases in
managerial ownership as beneficial. One argument is that managerial
ownership better aligns the interests of managers and shareholders and,
consequently, lowers managerial discretion. Also, management buy-outs
serve as screening mechanisms that allow only highly qualified, growthoriented managers to become owners.3 Finally, it is noted that markets for
corporate control serve as disciplining devices for managers.
However, most researchers take a more pessimistic view concerning
the effects of managerial ownership (Morck et al., 1988). They argue that at
high levels, it4 is associated with entrenchment and divergence of interests
between managers and shareholders. In transition economies, managerial
shareholding in post-privatization ownership configurations, in the form of
majority, dominant or minority shareholders, is substantial. The possibility
of entrenchment and subsequent rent-seeking or asset-stripping behaviour
on the part of managers has been an argument against managerial ownership (Djankov, 1999). The likelihood of this happening depends to a large
extent on managers outside career opportunities and portfolio diversification, the way they obtain shares and the efficiency of the market for corporate
control. When outside career opportunities do not exist and managers
have invested most of their human and financial capital in the firm, they will
try to hold on to their equity share by following policies, including
investments, which will increase their job security. Furthermore, a managers
behaviour might be fundamentally different depending on whether she/he
acquires the firm through a managerial buy-out or gets it either free or in
the framework of a voucher-funded privatization. If ownership is gained
through one of the latter two methods, the manager might perceive it as a
Financing of an Managerial Buy-outs (MBO) often requires external financing, which only
qualified managers might be able to raise.
4
The models on which these conclusions are based start from zero managerial ownership and
then consider the dynamics once managerial ownership increases. However, the definition of low
and high managerial ownership should not be taken as meaning majority (dominant) versus
minority managerial ownership. High managerial ownership could be considered a stake around
10%.
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86
windfall gain and consume it faster than earned income (Djankov, 1999).
In addition, in an environment of high uncertainty and underdeveloped
capital markets, informational asymmetries might lead to adverse selection
problems in the market for corporate control (Earle and Estrin, 1996).
Overall, for most researchers on transition economies, these arguments imply
that ownership concentration in the hands of managers is likely to lead to
managers entrenchment, which is expected to exacerbate informational
asymmetries and lead to more expensive external finance and less
investment.
When managers control, but do not own, the firm, agency problems
arise. Under these circumstances the identity of outside owners is crucial to
their ability to curb managerial discretion. We distinguish three types of
outside owners: the state, foreign and domestic outside owners. The
efficiency of each in disciplining management results in differences in
managerial discretion across firms, which, in turn, results in differences in
access to capital and investment behaviour. High degrees of managerial
discretion mean that managers can engage in unprofitable investment
projects or even in projects with negative present value that are valuable
to them and lead to their entrenchment. Moreover, high managerial
discretion accentuates the degree of information asymmetry and makes
external finance more expensive. The outcome is a reliance on internal funds,
which results in investment being highly sensitive to the availability of
internal finance.
When a firm is under foreign ownership, managerial discretion is kept at
minimal levels because foreign owners are expected to possess enough
experience and resources to engage in effective monitoring. Moreover,
conventional wisdom is that foreign owners have access to their parent
companys resources and/or to international capital markets and thus the
investment behaviour of foreign-owned firms is not expected to be
constrained by the availability of either internal or external finance. On
the other hand, foreign ownership may not always enhance business
performance. Foreigners may understand local culture much less than
locals. They may also be less effective in coping with corruption and suffer
more from information failure of various kinds. When ownership is
concentrated in the hands of domestic outside investors the degree
of effective monitoring depends on the identity, number and size of
investors. Depending on the combination of these factors several scenarios
might arise. For instance, if ownership is concentrated in the hands of a
few big institutional investors with experience, resources and low coordination costs, then effective monitoring will be possible. Alternatively,
if ownership is dispersed in the hands of a large number of small investors,
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87
then managers are more likely to enjoy substantial discretion in pursuing

their objectives. Finally, when ownership is concentrated in the hands of the
state5 managers will often possess virtual control of the firm and enjoy high
degrees of discretion in pursuing their own interests.
In testing these competing propositions firms investment behaviour
is modelled in a dynamic setting in the presence of adjustment costs,
liquidity constraints and imperfect competition, similar to Whited (1992) and
Bond and Meghir (1994). The firm, at every point in time, is supposed
to maximize the discounted present value of future after-tax dividends
as follows6:
max Et
Kt ;Lt ;Bt
1
X
bts Dts
s1
where t represents a time index, Et denotes the expectation operator that

is based on all the information available at time t, bt+s 1/(1+ys) is
the discount factor at time s with ys being the nominal discount factor at
time s and bt 1 at time t, and Dt standing for after-tax dividends at time t.
The model is solved subject to a flow of funds constraint, capital
accumulation constraint, dividend non-negativity constraint and a credit
ceiling constraint.
Equation 1 models the firms as dividend (profit) maximizers. Yet, while
dividend maximization is a good approximation of firm behaviour for certain
groups of firms, it might not be appropriate for others (Ward, 1958; Dow,
2003). It is often argued that insider-owned firms maximize income per
worker rather than profit or dividends. The substantial insider power,
especially employee power, in transition economies would make dividends
per worker maximization seem the more appropriate objective function than
maximization of total dividends. Consequently, the model is solved for
alternative objective functions and in the empirical work tests are performed
As Shleifer and Vishny (1997) point out, state ownership can be viewed as relation between a
principal and two agents. The principal is the body of citizens, who are the ultimate owners of the
firm. Being dispersed they have no ability or resources to monitor the state, that is the politicians
and bureaucrats, who act as the first agent and who themselves have to monitor managers, the
second agent. Both agents usually have objectives quite different from those of the principal and can
easily collude to pursue their objectives at the expense of the principal.
6
Except for the time index, the firms maximization problem has to be written with a firm
identification index. Given that it plays no role in altering the solution to the problem not to
complicate notation the index is dropped.
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88
to determine which of them better approximates firm behaviour. The

equations to be estimated are the following:

I
S
L
I
ao a1
a2
a3
K t1
K t
K t
K t
2

I
DBt1 DBt
a4
z1

K t
Kt1
Kt
2

CFt1 CFt
DBt1 DBt 2
z2

z3
Kt1
Kt
Kt1
Kt

2
CFt1 CFt
z4

zt1
Kt1
Kt

I
K
S Kt1
ao
a1

L t1
L t1
L t Kt

Kt1
I
Kt1
a2 dt
a3

L t Kt
Kt
2
I
Kt1
Kt1
a4

a5
K t Lt
Lt

DBt1 DBt
CFt1 CFt
z1

z2
Lt1
Lt
Lt1
Lt

2

DBt1 DBt
CFt1 CFt 2
z3

z4

Lt1
Lt
Lt1
Lt
xt1
where I denotes investment, K capital, S sales, L labour, B debt as a measure
of external financing and CF cash flow as a measure of internal funds.7
Equation 2 is derived under the assumption that firms are dividend
maximizers, whereas equation 3 is derived under the assumption that firms
are dividend per worker maximizers.
7
Although our model is similar to the one of Bond and Meghir (1994) there is an important
difference with respect to the final estimating equations. Our estimating equations 2 and 3 differ
from the ones of Bond and Meghir (1994) in that our liquidity terms enter in first differences while
theirs in levels. This difference arises from the way financial constraints are specified in our model.
We have adopted an approach that allows for explicit solution of Lagrangean multiplier related to
dividend constraint in terms of financial variables. Our models solution is available from the
authors upon request.
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89
DATA AND SAMPLE DESCRIPTION

The data employed in this study cover a large and representative sample of
Estonian firms during the period 1993 through 2002. The data consists of
ownership configurations, obtained from surveys, and of financial information from firms balance sheets and income statements reported to the
Estonian Statistical Office. The firms included in the survey scheme are
selected as a stratified random sample based on size and industrial affiliation.
For the purposes of the analysis firms have to be classified into ownership
groups. Such a classification is not a trivial pursuit. Often firms are
misclassified among ownership groups because important information
contained in ownership variables is overlooked (Filer and Hanousek, 2002).
In this paper, ownership structure is defined by classifying firms into six
ownership categories: state, foreign, employee, former employee, manager
and domestic outsider, using the percentage of shares held by the largest or
dominant owner. This classification has frequently been used in the literature
(Jones and Mygind, 1999; Jones et al., 2005; Grosfeld and Hashi, 2007). After
correcting for data inconsistencies,8 the merging of ownership and financial
information creates an unbalanced panel of 4,218 observations to be used in
the analysis.
Table 1 provides information on the distribution at a given point in time
and evolution over time of the number of firms that fall into a given
ownership category. Focusing on the 1995 sample, it is apparent that, in more
than 22% of cases, insiders (employees and managers) or former insiders are
dominant owners. This provides evidence of the importance of insider
ownership during the early years of transition. Foreign-owned companies
comprise around 12% of the sample, while domestic outsider-owned firms
comprise around 18% of the sample. Finally, state-owned firms comprise
around 48% of the sample, with 232 firms being fully under state ownership
and 30 firms mostly in private hands with the state still holding the dominant
position.
The table also contains important information on ownership dynamics. It
is apparent that, over time, the number of state and employee-owned firms
steadily decreases, while the number of domestic outsider and managerowned firms increases. While the decrease in the number of state-owned
The following seven criteria were applied to the data: the firms capital at the beginning and
the end of the period should be positive, investment should be non-negative, investment should be
smaller than end of period capital stock, sales should be positive, the average employment per year
should be positive and equal to or greater than 10, labour cost in a given year should be positive and
ownership shares should add up to 100.
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90
Table 1: Ownership distribution over time according to dominant owner
Year ownership group 1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Total
Domestic outsiders
Employee
Former employees
Foreign
Managers
State
No answer
Total
94
54
0
60
53
181
56
498
97
47
11
63
65
262
110
41
14
68
76
204
1
514
95
27
19
67
81
172
19
480
90
26
15
59
71
123
18
402
119
29
16
72
84
6
31
357
118
24
13
79
87
19
4
344
104
19
3
72
77
15
104
19
3
72
77
15
290
290
1,012
334
94
654
716
1,225
183
4,218
81
48
0
42
45
228
54
498
545
Note: A firm is considered to be dominantly owned by the owner who holds the largest share.
firms over time is expected due to the continuation of the privatization

process, the decrease in the number of employee-owned firms seems to
underline the suspicion that in the long-run this ownership structure is not
viable and will be diluted in favour of others. The inability of employeeowned firms to secure enough external funding and, consequently, to carry
out the necessary investment in order to remain competitive may be among
the drivers of this dynamic.
As for the increase in the number of manager-owned firms, an argument
is often made that it results from the concentration of ownership in the hands
of managers in insider-owned firms, that is, by the shift of ownership rights
from employees to managers. Evidence on this claim is provided by transition
matrixes, which plot ownership structures at two different points in time
against each other. Exploring the transitions some important facts emerge.
First, state firms privatized after 1995 mostly end up in the hands of outsider
investors, that is, domestic outsiders and foreigners, with employees and
former employees being the least preferred option. Second, there is little
employee or former employee activity in taking over firms once they are in
private hands. Third, domestic outsiders, foreigners and managers are quite
active in the market for corporate control, with continuous acquisitions
across groups. Fourth, the concentration of ownership from employees to
managers, although it happens, is not the driving force behind the rise in
managerial ownership. Finally, former employees hang on to their dominating ownership position for some time after they have left the firm, but
ultimately relinquish it.
Table 2 presents the summary statistics for the whole sample of the most
relevant variables used in the analysis. The general facts that emerge when
inspecting these statistics over time are that investment levels are high
relative to capital stock, with investment/capital ratio ranging from 0.17 in
1993 to 0.34 in 1995, that average employment decreases while real wages
B Hobdari et al
91
Table 2: Means and standard deviations in parentheses of principal variables
Variablesa
Investment
Mean
St. dev.
3,715
(15,218)
4,207
Capital
Sales
Employmentb
Real wagec
Cash flow
Debt
15,168
(46,382)
28,428
(73,559)
154
(327)
24.72
(16.19)
2,364
(14,106)
2,158
(3,591)
4,218
4,218
4,218
4,218
4,218
4,218
All the variables except employment are expressed in thousands of Estonian kroons and in 1993 prices.
Average number of employees in a given year.
c
Real average wage per employee.
b
increase over time, that, on average, the cash flow is positive, that short-term
debt increases over time and that cash flow and short-term debt are
approximately the same in almost all years. Another important feature of
Estonian firms during this period is that, on average, they have become more
capital intensive, as demonstrated by the increase in capital and decrease in
employment.
RESULTS AND DISCUSSION

In Tables 3 and 4, we report the results of estimating investment equations by
ownership group for each objective function. The results are obtained using
Arellanos and Bonds (1991) GMM estimator. Inference on estimated
coefficients is based on one-step procedure results, while inference on model
specification is based on two-step procedure results. This method was chosen
because of the downward bias in standard errors for small samples when the
two-step procedure is applied. The standard errors of the underlying
parameters of the model, that is, the adjustment cost parameter, the optimal
investment/capital ratio and the market power parameter,9 are then
calculated using the delta method with analytical first derivatives (Oehlert,
1992).
The effect of ownership structures on a firms investment behaviour and
the degree of financial constraints is normally investigated by introducing
ownership dummies and estimating the specifications using the pooled
sample. In addition, all dummies are interacted with all other real and
financial variables in the regression allowing not only the intercepts but also
9
In terms of equations 2 and 3 coefficients a are functions of these structural parameters. These
functions can be solved to obtain the parameters of interest, which are then reported in the
respective tables. The exact solution for the parameters is available from the authors upon request.
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Table 3: GMM estimates of investment functions by ownership group for dividend maximization model
Ownership group parameters
Adjustment cost parameter, a
State
owned
2.131***
(4.75)
Optimal investment-capital ratio, b
0.206**
(2.143)
Market power parameter, Z
0.783
(0.882)
Internal funds parameter
0.027***
(4.178)
Internal funds squared parameter
0.001
(1.038)
External funds parameter
0.003
(0.837)
External funds squared parameter
0.002
(0.483)
Firm size
0.218
(0.974)
F-test 5% critical value
19.28
1.75
Sargans statistic degrees of Freedom 27.17
14
0.17
Second order autocorrelation test
0.83
0.57
No. of observations
342
0.216
Adjusted R2
Employee
owned
2.916***
(2.49)
0.089**
(2.033)
0.871
(0.804)
0.047***
(3.218)
0.004*
(1.683)
0.059**
(1.819)
0.014**
(2.092)
0.337*
(1.673)
17.37
1.75
33.92
14
0.18
0.93
0.33
239
0.227
Manager
owned
Foreign
owned
2.216**
1.457***
(1.27)
(7.12)
0.142*
0.193**
(1.679)
(2.236)
0.918
1.117**
(1.398)
(2.073)
0.022
0.010
(0.982)
(0.478)
0.002
0.000
(0.819)
(1.227)
0.026*** 0.000
(2.371)
(0.128)
0.011***
0.001
(5.328)
(1.192)
0.518**
0.278
(2.017)
(1.117)
13.17
21.63
1.75
1.75
29.81
19.03
14
14
0.38
0.14
1.15
0.58
0.26
0.48
307
284
0.231
0.208
Domestic
outsider
owned
2.117**
(1.71)
0.184***
(4.729)
1.067***
(5.028)
0.031**
(1.678)
0.000
(0.559)
0.022***
(3.827)
0.001
(1.017)
0.308**
(2.218)
27.12
1.75
22.48
14
0.15
0.51
0.62
296
0.199
Notes: Values in brackets denote respective t-statistics. Each model is estimated with time dummies,
whose estimates are not reported here. Internal funds are measured by the sum of cash flow, short-term
assets and revenue from sale of non-current assets, whereas external funds are measured by the amount
of outstanding debt. The t-statistics of adjustment cost, optimal investment/capital ratio and market
power parameters are calculated using delta method with analytical first derivatives. Instrument sets
include all real and financial variables lagged three periods or more. All regressions include the inverse of
Mills Ratio to account for sample selection bias.
***significant at 1% significance level; **significant at 5% significance level; *significant at 10%
significance level.
the slopes to differ across groups. A major problem in estimating such

specifications with ownership variables as the right-hand side variables is the
endogeneity of ownership, that is, in equilibrium different owners will
determine their optimal ownership share based on various firm characteristics, among which is the firms investment needs. This implies a
simultaneity problem in that the explanatory variable is co-determined with
the variable to be explained, namely investment rates. A potential solution to
the problem is the use of instrumental variables, that is, the endogenous
variables in the model, the ownership dummies in our case, are instrumented
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93
Table 4: GMM estimates of investment functions by ownership group for dividend per worker
maximization model
Ownership group parameters
Adjustment cost parameter, a
State
owned
2.047*
(1.648)
Optimal investment-capital ratio, b
0.217***
(4.226)
Market power parameter, Z
1.005
(0.221)
Internal funds parameter
0.017**
(2.019)
Internal funds squared parameter
0.001*
(1.648)
External funds parameter
0.001
(0.925)
External funds squared parameter
0.001
(0.682)
Firm size
0.178
(0.775)
F-test 5% critical value
31.26
1.67
Sargans statistic degrees of Freedom 15.25
14
0.27
Second order autocorrelation test
1.17
0.31
No. of observations
342
2
0.227
Adjusted R
Employee
owned
2.218**
(1.748)
0.193***
(6.681)
0.967
(1.026)
0.028**
(2.127)
0.001**
(2.186)
0.005**
(1.891)
0.002**
(2.018)
0.269
(1.053)
19.92
1.67
11.48
14
0.65
1.56
0.38
239
0.231
Manager
owned
Foreign
owned
Domestic
outsider
owned
1.883***
1.357***
1.448**
(5.328)
(2.918)
(1.782)
0.178**
0.373***
0.283**
(2.018)
(4.552)
(2.179)
1.117
1.218**
1.307***
(0.729)
(2.216)
(3.471)
0.001
0.001
0.021***
(1.003)
(0.836)
(4.128)
0.000
0.001
0.000
(0.983)
(0.483)
(0.348)
0.003
0.002
0.001
(0.482)
(1.184)
(0.218)
0.001
0.005
0.002
(0.581)
(0.318)
(0.735)
0.492**
0.117
0.478**
(2.241)
(0.952)
(1.927)
17.67
22.93
25.82
1.67
1.67
1.67
12.51
11.89
17.15
14
14
14
0.68
0.66
0.21
1.11
0.56
0.71
0.29
0.61
0.47
305
280
292
0.248
0.206
0.218
Notes: Values in brackets denote respective t-statistics. Each model is estimated with time dummies,
whose estimates are not reported here. Internal funds are measured by the sum of cash flow, short-term
assets and revenue from sale of non-current assets, whereas external funds are measured by the amount
of outstanding debt. The t-statistics of adjustment cost, optimal investment/capital ratio and market
power parameters are calculated using delta method with analytical first derivatives. Instrument sets
include all real and financial variables lagged three periods or more. All regressions include the inverse of
Mills Ratio to account for sample selection bias.
significance level.
with a set of variables that are correlated with them but not with the error
term.
However, this instrumental variable approach is not without problems.
Finding appropriate instruments for ownership dummies is difficult. The
literature on the determinants of ownership structures identifies firm size,
productivity, profitability, capital intensity, financing requirements and/or
firm quality as determinants of ownership shares. All these variables could
serve as instruments for the endogenous ownership dummies. The application of the instrumental variable approach requires all instruments to be
B Hobdari et al
94
uncorrelated with the unobserved variables. In structural investment

equations, however, all factors mentioned will be correlated with unobserved
firm specific shocks to investment and, as such, will still be correlated with
the error terms. A consequence of this is that the use of bad instruments will
still lead to biased parameter estimates (Angrist and Krueger, 2001).
An alternative approach is the division of the sample into several subsamples according to the ownership groups defined and the estimation of the
relevant specifications for every sub-sample separately. In addition to
avoiding the pitfalls of the instrumental variable approach, this approach
offers the possibility of testing the hypothesis of the existence of different
objective functions across groups of firms. This is the approach adopted here.
The sample is divided into five sub-samples as follows: state-owned,
domestic outsider-owned, foreign-owned, manager-owned and employeeowned firms.10 In the interpretation of results we then focus on the
differences in respective coefficients across ownership groups, which provide
unbiased estimates of the true differences.11
Focusing first on model performance we see that the overidentifying
restrictions, tested through Sargans test, are accepted at high probability
levels, while the second order autocorrelation test is always rejected. Also,
adjusted R2 are comparable across equations and range from around 20% to
around 25%. Finally, model adequacy is also confirmed by the rejection of
the null that all coefficients are jointly zero.
Turning to estimates of structural parameters we see that the adjustment
cost parameter and the optimal investment/capital ratio are generally positive
and significant across all equations, while the market power parameter is
significant only in the case of domestic outsider-owned and foreign-owned
firms. The estimates of adjustment cost parameters imply different relative
ratios of adjustment costs to investment expenditures across ownership
groups. Assuming that parameter b is zero and evaluating the size of
adjustment costs at the mean investment to capital ratio for each group, we
10
As the number of observations for former employee-owned firms does not allow independent
analysis of this group, these firms are included in the employee-owned firms group.
11
It must be noted that estimating specifications across different sub-samples does not lend
itself to direct testing of whether coefficients estimated on different sub-samples are statistically
different from each other. In checking this, as well as the robustness of our results, we pooled the
sample, introduced dummy variables for each ownership group, interacted these dummies with all
variables included as right hand side ones and estimated our specifications on the pooled sample.
The unreported estimated coefficients were essentially unaltered in terms of significance and sign.
Further, the test performed always resulted in rejecting the null of no statistical significance between
coefficients of financial variables for employee, manager and state-owned firms on the one hand and
those for foreign and domestic outsider-owned firms on the other. The coefficient estimates and test
results are available from the authors upon request.
B Hobdari et al
95
find that adjustment costs for foreign-owned firms vary between 15% and
19% of investment expenditures, for domestic outsider-owned firms between
19% and 24%, for manager-owned firms between 27% and 34%, for
employee-owned firms between 32% and 37% and for state-owned firms
between 27% and 33%. When optimal investment/capital ratios are
compared with their sample means across ownership groups we find that
state-owned firms have the lowest deviation of actual investment rate from
the optimal, while manager and employee-owned firms have the highest.
This suggests that, even accounting for the non-zero value of b in calculating
adjustment costs, manager and employee-owned firms will face large
adjustment costs relative to investment expenditures. Finally, the estimates
of the market power parameter are insignificant for state, manager and
employee-owned firms. In contrast, the values of this parameter for domestic
outsider and foreign-owned firms are positive, significant and well above
unity, indicating that these firms operate in the elastic portion of their
demand curve and enjoy some monopoly power.
Important differences in investment behaviour across ownership groups
emerge when inspecting the estimates of coefficients of financial variables.
Comparing the coefficients across groups several things are worth noting.
First, as expected, different types of firms display different sensitivity to
measures of financial constraints. As seen from the tables, estimates of all
coefficients of financial variables for foreign-owned firms are insignificant,
indicating that these firms are not constrained in any sense in their
investment behaviour. Given that foreign-owned firms in Estonia might be
either subsidiaries or joint ventures with foreign partners, it is highly
probable that profits earned in other countries could be invested in Estonia
and vice versa. Consequently, the measures of internal funds and debt as
defined here will not be relevant to these firms. Instead, measures of global
funds across different markets where these firms operate will be needed to
describe their behaviour.
Other types of firms, albeit to differing degrees, display sensitivity to the
availability of internal and/or external finance. Manager-owned firms are the
only ones not displaying significant sensitivity to the availability of internal
funds, whereas state, domestic outsider and employee-owned firms all
display positive and significant sensitivity to measures of internal funds,
implying different degrees of financing constraints. Among the latter three
groups, the sensitivity is highest for employee-owned firms, followed by
state-owned firms. For example, the estimate of the internal funds parameter
in Table 3 for employee-owned firms is 0.047. This estimate is 75% larger
than the one for state-owned firms and about 50% larger than the one for
domestic outsider-owned firms. The differences in estimates vary depending
B Hobdari et al
96
on the objective function assumed, but the pattern remains the same. The
estimate of internal funds squared parameter, included to capture potential
non-linearities, is significant only for employee-owned firms, indicating that
for these firms the availability of internal finance is crucial in investment
policies.
Our results are consistent with a body of studies that find cash flow an
important predictor of investment and interpret its coefficient as an indicator
of financial constraints (Fazzari et al., 2000; Aggarwal and Zong, 2006). One
argument against such an interpretation is that these coefficients also proxy
for future investment opportunities (Kaplan and Zingales, 2000). However, if
measures of cash flow are equally correlated with future opportunities across
all firm types, then the differences in these coefficients are unbiased
indicators of differences in financing constraints. This conjecture is tested
by estimating an equation with sales as the dependent variable and different
lags of cash flow, ownership dummies and their interaction with lagged
cash flow variables as independent variables. The results, not reported
here, show that cash flow predicts future sales across all firms and that the
effect is larger for foreign and domestic outsider-owned firms than for the
other types. This finding supports the conjecture that differences in the
internal funds parameter between, for example, employee-owned or stateowned firms and foreign-owned firms are a good predictor of financial
constraints.
Further evidence of financial constraints comes from the inspection of
coefficients of external finance variables. In this case, state-owned firms
display no sensitivity to the availability of external finance, as shown by the
insignificant coefficients of debt and its squared parameters. This could
serve as an indicator that state-owned firms are not as constrained as might
be conjectured in raising external finance, that is they might be operating in a
soft budget constraints regime. Alternatively, it could be conjectured that, due
to the high price they have to pay for external finance, they rely mostly on
internal funds to finance their investment, as expressed by the positive and
significant coefficient of the internal funds parameters, and, as such, have
not yet hit their credit limit. Finally, the significant coefficient of internal
finance and the insignificant coefficient of external finance could also be
interpreted as evidence of managerial discretion and their preferences against
outside control. In contrast, all other domestic-owned firms, whether
domestic outsider-owned, manager-owned or employee-owned, do seem to
have hit their debt limit in that, whenever significant, higher levels of debt
are associated with lower investment rates. The sensitivities are highest,
in absolute value, for employee-owned firms and then for domestic
outsider-owned firms across all specifications. Interestingly, the case of
B Hobdari et al
97
manager-owned firms is the opposite of that of state-owned firms, in that they

show significant sensitivity to the availability of external finance but
insignificant sensitivity to the availability of internal funds.
A general fact emerging from inspecting the tables is that financial
constraints operate both through debt and availability of internal funds,
although the coefficients of internal funds are significant more often than
those of external finance. A final observation is that the results are robust to
the alternative definitions of internal funds, that is, the use of cash flow or
value added, as well as to the assumptions relating to a firms objective
function. This means that, while their magnitude and significance changes
across different specifications, their sign remains the same.12
The last step of the analysis is testing whether firms under different
ownership structures have different objective functions. Given the non-nested
nature of the competing models, the tests are carried out using Davidson and
MacKinnons (1981) J-test for non-nested alternatives. The results of the test
are reported in Table 5. The table should be read as follows. The cells in
column Dividend Model show the t-test of the significance of the fitted
values from estimating equations assuming dividend per worker maximization added as an additional regressor in the equation derived from dividend
maximization. The cells in column Dividend per Worker Model show the ttest of the significance of the fitted values from estimating equations
assuming dividend maximization added as an additional regressor in the
equation derived from dividend per worker maximization. The test results
show that for state and manager-owned firms we are able to reject both
models. However, under alternative definitions of internal funds, we conclude
that foreign and domestic outsider-owned firms behave consistently with the
profit (dividends) maximization hypothesis, while employee-owned firms
behave consistently with dividends per worker maximization hypothesis.
These conclusions provide support for the notion that all firms should not be
treated as similar, nor should they be pooled in one sample.
CONCLUSIONS AND IMPLICATIONS

In this paper we have investigated whether investment spending of firms in
Estonia is affected by liquidity constraints, as well as whether the degree of
12
Another robustness check we performed is to carry out estimation with the fixed effects
estimator. The results we obtained, which we do not report here due to space constraints, are
essentially similar to those obtained with the GMM estimator with respect to the sign and
significance of coefficients. These results are available from the authors upon request.
B Hobdari et al
98
Table 5: Results of testing for the existence of different objective functions across ownership groups
using the Davidson and Mackinnon J-test for non-nested models
Model ownership group
With cash flow as

measures of internal funds
With value added as

measures of internal funds
Dividend
model
Dividend per
worker model
Dividend
model
Dividend per
worker model
State
t=6.94***
(0.000)
t=11.56***
(0.000)
t=5.37***
(0.000)
t=10.55***
(0.000)
Foreign
t=0.89
(0.578)
t=8.37***
(0.000)
t=1.04
(0.148)
t=11.21***
(0.000)
Domestic
t=1.58
(0.218)
t=6.53***
(0.000)
t=0.68
(0.237)
t=6.19***
(0.000)
Manager
t=8.12***
(0.000)
t=4.82***
(0.000)
t=8.45***
(0.000)
t=12.38***
(0.000)
Employee
t=12.75***
(0.000)
t=10.18***
(0.000)
t=0.38
(0.682)
t=1.27
(0.528)
Notes: The table reports the results of testing whether firm behaviour across ownership groups is better
characterized by maximization of the discounted present value of total dividends or by maximization of
the discounted present value of dividends per worker. The t-statistic corresponds to the fitted values of
the alternative model added as an additional variable in the basic model, which is the one identified in
the respective column. Numbers in brackets are the respective P-values. A significant coefficient of the
fitted values leads to the rejection of the respective basic model in favour of the alternative one.
significance level.
such constraints differs across firms under different governance structures.

Our findings underline several important points. First, structural parameters,
represented by the adjustment cost parameter, the optimal investment/capital
ratio and the market power parameter, are significant determinants of a firms
investment rates. Second, financial variables, used as a proxy for the extent of
liquidity constraints, play a significant role in a firms investment decisions.
Third, the degree of liquidity constraints varies with firm ownership
structure. We consistently find that, on average, all domestically owned firms
face some liquidity constraints either through positive and significant
coefficients of internal fund variables or through negative and significant
coefficients of external fund variables. The behaviour of foreign-owned firms,
however, is consistent with the Euler equation specification in the absence of
liquidity constraints. This suggests that foreign owners may have overcome
initial obstacles from entry into an unknown market, such as cultural barriers
or various information failures, compared with locals. Overall, the findings
provide support for the hierarchy of finance arguments and are consistent
B Hobdari et al
99
with the belief that successful restructuring in a transition economy is

dependent on the availability of finance. Focusing on coefficient differences
across groups, we find that the sensitivity of investment to the availability of
internal and external finance is stronger for employee-owned firms, implying
that motivational effects given by employee share ownership (Kruse and
Blasi, 1997) do not fully mitigate the informational asymmetries and agency
costs with providers of capital. For the other groups of firms, somewhat
surprisingly, only domestic outsider-owned firms display sensitivity to both
measures of the availability of finance, with manager-owned firms being
sensitive to the availability of external finance, and state-owned firms being
sensitive to the availability of internal finance. The results for firms owned by
domestic outsiders imply that these firms could suffer from high levels of
managerial discretion and control.
Finally, we provide evidence that firm behaviour in a transition economy
cannot be analysed by invoking the representative firm approach. The results
of Davidsons and MacKinnons (1981) J-tests for non-nested alternatives lead
to the rejection of the hypothesis that employee-owned firms can be modelled
as profit maximizers. Curiously, the tests do not provide such a clear
conclusion with respect to state and manager-owned firms, implying that
their behaviour is consistent with both profit maximization and profit per
worker maximization. The results imply that, because of firm heterogeneity,
pooling all the firms in one sample for the purpose of the analysis would
result in mis-specification bias.
A continuous and lively debate in the transition literature is the efficiency
and viability of various ownership structures. The arguments in the debate
could be well summarized in Hansmanns (1996) survivorship test, which
states that if a given organizational form does not survive, then it must have
been at a comparative disadvantage compared to other forms. One of the
organizational structures that, on various theoretical grounds, has been
pinpointed as inefficient, and, as such, subject to extinction, is employeeowned firms. The theoretical arguments have given rise to empirical work
that tries to assess the inefficiency of employee-owned firms. Estonia is one of
the countries where employee ownership has been in decline. Kalmi (2002)
makes a thorough analysis of the degeneration of these firms and finds that
structural bias towards extinction13 and insufficient motives of incumbent
insiders to extend ownership to new employees are the main reasons that
drive their decline. Our results emphasize the degree of liquidity constraints
as a further factor that potentially accentuates the decline of employee
13
This bias is caused by the property rights designation within the firm and the imperfection of
the market for shares.
B Hobdari et al
100
ownership. Indeed, Kalmis (2002) and our sets of conclusions are

complementary and provide the strongest evidence, yet, on the causes of
degeneration in employee ownership. In addition, a major contribution of this
paper is that it provides robust evidence for the argument that employeeowned firms face more stringent liquidity constraints than other types of
firms.
These results imply a role for public policy to increase the level of
investment by influencing the environment that firms operate in by providing
fiscal incentives, developing capital markets and financial systems and
improving of access to capital. Fiscal incentives in the form of lowering
corporate taxes and/or exemption of retained earnings used for investment
from taxes (and thus paying taxes only on profits after investments) would
stimulate investment through an increase in the availability of internal funds.
Indeed, since 2000 retained earnings have been exempt from taxation in
Estonia. It is expected that, in the long-run, this will result in higher capital
stock. For instance, Masso (2002), citing unpublished work conducted using a
model based on Tobins Q, states that the long-run effect of this policy is likely
to be an increase in capital stock of 6.1%. There is a possibility, however, that
such policies might produce undesirable effects. Under the conditions when
managers enjoy high degrees of discretion, an increase in the availability of
internal finance simply puts more resources at their disposal to pursue their
own interests at the expense of those of the other shareholders. Instead
of relaxing the constraints, the outcome of this policy might then be
overinvestment. These potential costs, as well as the fact that the provision
of fiscal incentives depends on government budget constraints, imply a
limited role for fiscal policies. Consequently, fiscal policies must be combined
with other policies designed not only to relax liquidity constraints but also to
mitigate agency conflicts within the firm by curbing managerial discretion.
One way to achieve both objectives is to follow policies to further develop
capital markets and the financial sector, that is banking and non-banking
institutions. Estonias capital market, although growing, is small, and, as
such, its future will lie in alliances with other stock exchanges. The first step
in this direction was the creation of the pan-Baltic stock exchange in early
2000, which was later integrated into the Nordic OMX and NASDAQ OMX
group that is now the worlds largest stock exchange company. Subsequent
membership of Estonia in the European Union in 2004 has opened European
capital markets to Estonian companies. However, those likely to benefit from
the stock market, at least in the short term, are large and listed firms. More
important for Estonian firms in general is the development of the banking
sector and other non-banking institutions, such as investment funds, venture
capital funds, mutual funds and credit unions. The banking system in Estonia
B Hobdari et al
101
is consolidated, well regulated and mostly foreign-owned. Over the period of

our analysis, as our results indicated, there was a general shortage of external
capital. Yet, in the following years banks were heavily involved into providing
finance to both companies and households. With hindsight, the credit
expansion was faster than desirable, and the outcome was unsustainable
current account deficits, a housing bubble and an overheated housing and
labour markets. At the start of 2008 inflows of capital, both in the form of
foreign direct investment and capital transfers from mainly Scandinavian
parent banks, slowed substantially and Estonias economy suffered accordingly. The outcome of the crisis is that by the beginning of 2009 Estonia is in a
credit crunch with bank financing being at a low level. This situation again
requires credit expansion in order to avoid strong liquidity constraints and
underinvestment. Similar steps need to be taken to increase the participation
of non-banking institutions in financing the private sector, which until now
has been marginal. A possible way would be to provide tax breaks to such
institutions that would be contingent to the amount of loans they extend to
private companies, especially to those encountering difficulties in raising
finance.
Finally, a faster way of injecting capital into firms is to promote the inflow
of foreign direct investment either in the form of fully owned, foreign
subsidiaries, established through Greenfield investment or acquisition of an
Estonian state or private-owned company, or partnerships with domestic
capital. The latter is of particular interests for Estonian private companies in
need of fresh funds for investment. Given that foreign owners have access to
global capital markets, this would enable Estonian companies to gain access
to sources of funds that will have otherwise been either inaccessible or too
costly. Surveys of privatization processes across formerly centrally planned
economies underscore the importance of foreign ownership in speedy and
effective restructuring (Estrin et al., 2009).
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Comparative Economic Studies, 2010, 52, (82103)

r 2010 ACES. All rights reserved. 0888-7233/10

Corporate Governance and Liquidity

International Economics and Management, Copenhagen Business School,

Keywords: corporate investment, corporate governance, liquidity constraints,

the observed differences in investment behaviour across firms. In this paper,

GOVERNANCE STRUCTURES, INVESTMENT AND LIQUIDITY CONSTRAINTS

then managers are more likely to enjoy substantial discretion in pursuing

where t represents a time index, Et denotes the expectation operator that

to determine which of them better approximates firm behaviour. The

DATA AND SAMPLE DESCRIPTION

firms over time is expected due to the continuation of the privatization

RESULTS AND DISCUSSION

Adjustment cost parameter, a

the slopes to differ across groups. A major problem in estimating such

Adjustment cost parameter, a

uncorrelated with the unobserved variables. In structural investment

Comparative Economic Studies

manager-owned firms is the opposite of that of state-owned firms, in that they

CONCLUSIONS AND IMPLICATIONS

Comparative Economic Studies

With cash flow as

With value added as

such constraints differs across firms under different governance structures.

with the belief that successful restructuring in a transition economy is

Comparative Economic Studies

ownership. Indeed, Kalmis (2002) and our sets of conclusions are

is consolidated, well regulated and mostly foreign-owned. Over the period of

Comparative Economic Studies

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