Family Ownership and Different Legal Environments

Introduction
The ever-changing current business environment and the need for novel, innovative solutions often
motivates businesses to expand their resources (Makri, Hitt, & Lane, 2010). This expansion of
resources is often achieved through mergers and acquisitions. Mergers and acquisitions represent a
unique form of entrepreneurial activity through which a company merges with or acquires another
business (Granata and Chirico, 2010). They represent a popular, although risky, way for firms to
expand and compliment their existing resources (Bae, kang & Kim, 2002). The primary reason for a
merger and acquisition is to create synergy by integrating two business units in a combination that will
increase competitive advantage (Porter, 1985). However, many mergers and acquisitions fail to
produce their desired results. Cartwright and Cooper (1993) found that barely half all mergers and
acquisitions meet their initial financial expectations, and that, irrespective of the measures used,
failure rates are typically in the 50-60 percent range. Beyond the potential financial ramifications,
mergers and acquisitions often create significant trauma for employees and managers, resulting in
attitudinal problems. Despite these issues and the relatively low success rate, the activity and volume
of mergers and acquisitions continues to grow (Weber, Tarbar & Bachar, 2011).

There is a substantial amount of evidence that family firms represent more than half public and
private firms around the world, with one study citing this figure as more than 75% of firms in most
economies (Miller, Le Breton-Miller, Lester & Cannella, 2003). However, there remains considerable
debate as to whether family firms are superior or inferior performers (Villalonga and Amit 2006; Miller
Steier, & Le Breton-Miller 2007). For family firms, who find growth to be one of the main challenges
facing their businesses, mergers and acquisitions often represent an attractive solution. Despite this,
and the prevalence of family firms, relatively few recent studies focus on family firm mergers and
acquisitions. This research aims to contribute to this dearth, by examining the family firm post-merger
and acquisition performance. Specifically, it will test the effect of the legal environment on the value
created during family firm mergers and acquisitions when compared to non family firm mergers and
acquisitions (with the family firm as the acquirer). The research question is as follows:

RQ: Is the effect of legal environment on post merger/acquisition performance different when
the acquiring firm is a family firm when compared to a non family firm?

Families represent a unique group of active, long-term owners, holding substantial equity positions in
their firms (Basu, Dimitrova & Paeglis, 2009). Basu et al. (2009) described three characteristics of
family firms. Firstly, the control of the firm is usually concentrated around one individual. Secondly,
the family is usually active in the management and governance of the firm. Finally, families are very
much invested in the long term as they often aim to transfer managerial control down through
generations. This results in growth often not being the primary goal of a family firm. These non-
financial aims influence the objectives of certain decisions and represent a key difference between
family and non-family firms. They also heavily influence the propensity of family firms to merge or
acquire. Another key difference between family and non-family firms are the different agency
relationships and resource mobilization, which influence adverse selection, opportunism, altruism,
and nepotism but also commitment and long-term investment horizons (James, 1999; Schulze,
Lubatkin, Dino, & Buchholtz, 2001; Westhead & Howorth, 2006). Altruism, which is regarded as
selfless behavior that benefits others, can manifest itself in two contrasting ways in family firms
(Schulze, Lubatkin & Dino, 2003a). It can result in decision makers putting the interests of the firm
above their own, however, more commonly, it can be exploited in family firms causing harm to the
business.

The literature examining the performance of family firms post merger and acquisition lacks a
consensus (Worek, 2017). Many studies find better abnormal returns and greater value creation for
shareholders for family firms following a mergers and acquisition deal (André, Magnan & St?Onge,
2014; Ben-Amar & André, 2006; Basu et al., 2009; Feito-Ruiz & Menéndez-Requejo, 2010;
Bouzgarrou & Navatte, 2013). This additional value is mainly attributed to the minimisation of agency
costs through governance mechanisms that monitor and incentivise the checking of opportunistic
behavior, shirking responsibility and free-riding. Unlike with non family firms, where individuals are
driven by personal financial gains, decision makers at family firms consistently put the long term
future of the firm above their own interests. In contrast, other studies find that family firms destroy
value when acquiring another firm, that they benefit less from acquisitions and that family control has
a negative effect on market value, in comparison with non-family firms(Bauguess & Stegemoller,
2008; Gleason et al., 2014; Leepsa & Mishra, 2013). They mainly attribute this loss in value to the
entrenchment effect which increases agency costs compared with non-family firms. The lack of
separation between ownership and control causes conflicts such as nepotism and results in a lack of
accountability for decisions. Furthermore, several studies found that family firms show no difference in
performance when compared with non-family firms (Miller, Breton-Miller & Lester, 2010; Caprio,
Croci, & Del Giudice, 2011). In these cases, the benefits and hindrances of the effects of family firms
balance each other out and no change is detected. This lack of consensus means that the question of
family firm performance post merger and acquisition remains unanswered.

In Worek (2017) summary of the family firm mergers and acquisitions literature she highlighted the
importance of considering the legal environment and national corporate governance system when
measuring post merger and acquisition performance. She described how many of the family firm
mergers and acquisition research on performance fails to do so. As shareholder valuation is used to
measure performance, and ownership structures differ across countries, it is important to consider the
legal environment and corporate governance system of the acquirer and target firms’ countries.
Targets in weaker legal environments are often willing to accept lower premiums to compensate for
asymmetric information and agency problems. In this environment, the likelihood of finding
undervalued target firms increases for bidders from countries with a stronger legal and institutional
environment. Many studies have found this to be true in non-family firms. However, Feito-Ruiz and
Menéndez-Requejo (2010) are the only people to focus on the effects of the legal environment on
merger and acquisition performance in family firms. Their findings are consistent with the findings of
the non family firm literature.

As family firm post merger and acquisition performance remains unanswered, it is a topic for future
research. Especially given the sheer quantity of family firms in operation around the world.
Determining with confidence, whether family firms over or under perform non family firms post merger
and acquisition would provide companies with significant value when deciding whether to commit to a
merger and acquisition with a family firm. Furthermore, if family firms were found to outperform non
family firms, further research could be carried out to find out why. This why would provide valuable
insights for non family firms. Similarly, examining the effect of the legal environment and corporate
governance system on the performance of family firms post merger and acquisition adds to the lone
study on this topic. If they do affect performance, family firms should take them into consideration
before committing to a merger and acquisition deal with a target firm in a different country.

This research will measure the effect of family ownership on shareholder value post merger and
acquisition. It will also test the effect of the legal environment on shareholder value post merger and
acquisition. It will finish by investigating the relationship between family ownership, legal environment
and the shareholder value post merger and acquisition.

Family Firms Versus Non Family Firms

Defining family firms is an important and difficult choice to make when examining the performance of
family firms. This is largely due to the absence of a commonly accepted definition of what constitutes
a family business- (Steiger, Tanja & Duller, 2015). Steiger et al. (2015) studied this issue in detail and
described the three dominant approaches used in the current literature. The components-of-
involvement approach is the most commonly used in literature and will be used for this research. With
this approach, firms are categorised based on the level of family involvement in the firm. Family
involvement is measured by the influence of the family on the business through ownership,
management and/or governance. Specifically, a firm is classified as a family firm if the majority
shareholder is a family or an individual, being non family other otherwise. This definition is consistent
with much of the literature on family firm merger and acquisitions (Feito-Ruiz & Menéndez-Requejo,
2010), and will allow for comparisons of the results to be made.

Many theoretical bases exist to explain the differences between family and non family firms. Agency
theory and the entrenchment/alignment effects will be used throughout this research to explain the
differences between family and non family firms which influence performance. Agency theory is a
principle that is used to explain and resolve issues in the relationship between business principals
and their agents (Kopp, 2020). Most commonly, that relationship is the one between shareholders, as
principals, and company executives, as agents. Family firms have different agency relationships,
information asymmetries and a different mobilization of resources when compared with non-family
firms (Granata and Chirico, 2010). These differences can produce entrenchment and alignment
effects. The value created for shareholders depends on which effect prevails. In theory, the
entrenchment effect results in less value created and the alignment effect results in greater value
created. As the current literature is mixed, and the entrenchment and alignment effects in theory
produce divergent results, two conflicting hypotheses are proposed below.

In merger and acquisition settings, managers may make decisions and undertake acquisitions to
increase their compensation and private benefits at the expense of the business (Shleifer and Vishny
1997). According to the interest alignment hypothesis (Jensen and Meckling 1976), family ownership
should reduce the costs associated with this problem and thus, increase value. Family ownerships
with large investments in the firm have significant incentives and resources to monitor the behaviour
of executives and managers within their firm. This monitoring by the family increases the
accountability of key decision makers and results in them making better acquisition decisions, than in
non family firms. Family ownership favors strong relationships between stakeholders, patient capital,
and parsimony in scarce environments and builds long-term reputation and decision-making horizons
(Tokarczyk, Hansen, Green, & Down, 2007). Furthermore, family ties within a firm can create a
culture of altruism and commitment which leads to a focus on long term investment horizons. This
altruism causes owners to put the interests of the company above their own personal interests, such
as their personal compensation and private benefits. Owners of family firms also often have different
objectives to non family firms. The desire to keep ownership of the firm in the family for future
generations is prevalent amongst family firms. This family monitoring, culture of loyalty and putting the
firm above personal gains, and commitment to the long term, improves the efficiency of investment in
the long term and creates value for shareholders.

The above arguments lead to the following hypothesis:

Family ownership of an acquiring firm positively influences shareholder value of a

merger/acquisition announcement.

The entrenchment perspective proposes that the different agency relationships, information
asymmetries and different mobilisation of resources of family firms has negative repercussions for the
business. The lack of separation between ownership and control results in conflicts such as nepotism
and asymmetric altruism, resulting in harmful decisions. Family firms are embedded in family
relationships, such as the parent–child relationship (Schulze, Lubatkin & Dino, 2003b). These
relationships are unique to family firms and can have negative repercussions for firm performance if
managed poorly. Parents can be overly generous with their children, and their children can exploit this
generosity by shirking or free riding (Dawson, 2011). These issues can be compounded by the family
firm leaders’ propensity to refrain from monitoring family members’ behavior (Schulze et al., 2001).
Furthermore, nepotism and asymmetric altruism can create adverse selection agency problems when
family firms hire family members over more skilled candidates for important positions. Family
ownerships may also seek to benefit the interests of the family at the expense of the minority
shareholders. They may prioritise maintaining their control of the business over increasing profits and
creating more value for shareholders. Family firm managers also tend to be more risk averse (Chen
and Hsu 2009; Chang et al. 2010; Miller et al. 2010), turning down potentially lucrative opportunities
to maintain their control of the business. These problems can manifest in behaviours in many ways.
Johnson et al. (2001) found the large shareholders such as families may transfer assets or profits to
other companies they own at the expense of minority shareholders.

The above arguments lead to the following hypothesis:

Family ownership of an acquiring firm negatively influences shareholder value of a merger

and acquisition announcement.

Legal Environment
The strength of a country’s shareholder protection systems is determined by its’ legal environment.
The level of protection varies greatly between countries. This variance can largely be explained by the
divergence between common and civil law systems. Common law countries are characterised by
strong legal systems which protect minority shareholders. Common law countries include the United
Kingdom, Australia, India and the United States of America. In contrast, civil law countries’, such as
France and Germany, have legal systems which offer less protection to stakeholders. While common
law countries’ legal systems are commonly referred to as “strong”, civil law countries are often
referred to as “weak”.

Two perspectives exist to explain and predict the influence that the legal environment has on the
performance of a firm post merger and acquisition. On one hand, a “weak” legal and institutional
environment in a country may be associated with: low investor (shareholder and creditor) protection,
which makes it significantly easier for majority shareholders to exploit minority shareholders (Bris &
Cabolis, 2008); reduced economic freedom, which hinders business activity and reduces foreign
investment; less capital market development, which increases the cost of external financing (Moeller
& Schlingemann, 2005; Pablo, 2009); and, less activity and competition among the corporate control
markets, which reduces the efficiency of corporate governance in firms (Rossi & Volpin, 2004). These
factors lead to an environment which increases the likelihood of firms in a “strong” legal environment
finding undervalued firms which is positive for acquiring shareholders. In addition, the acquired firm
(in the “weak” legal environment) will adopt the stronger corporate government practices of the
acquiring firm. It will also increase transparency and shareholder protection. These improvements will
further increase wealth for both firms involved in the merger and acquisition.

The above arguments lead to the following hypothesis:

Acquiring shareholder value after a merger/acquisition announcement will be greater when the
target firm is in a country with a “weaker” legal environment (when the difference between the
acquirer and target is positive).

On the other hand, acquisitions of targets in countries with “weaker” legal and institutional
environments may create problems which reduce the value created for shareholders. Reduced
economic freedom and less law enforcement in the target country may distort the economic and
financial environment and reduce the efficiency of governments and business when compared with
those in an acquiring country with a stronger legal environment. These characteristics increase the
risk of operating in these countries and hinder negotiations during the acquisition process.
Furthermore, target firms are more likely to have a more concentrated ownership structure in
countries with a weak legal and institutional environment, so they might require higher premiums to
sell their shares. This higher bargaining power increases the premium required to acquire the target
firm, reducing the value gained by the acquiring shareholders.

The above arguments lead to the following hypothesis:

Acquiring shareholder value after a merger/acquisition will be less when the target firm is in a
country with a “weaker” legal environment (when the difference between the acquirer and the
target is negative).
Maury (2006) found family control lowers the agency problem between owners and managers, but
gives rise to conflicts between the family and minority shareholders when shareholder protection is
low. Families therefore, may find it easier to exploit minority shareholders for private benefits when
the firm is located in a country with a weaker legal environment. This exploitation reduces the value of
the firm. Thus, family ownership may have a negative influence on shareholder valuation if the
acquirer firm belongs to a country with weak minority shareholder protection. In addition, as family
ownership reduces agency costs, family ownership will be more beneficial in legal environments
where minority shareholders’ are protected from exploitation by family shareholders (Maury, 2006).

The above arguments lead to the following hypothesis:

Acquiring shareholder value after a merger/acquisition by a family firm will be less when the
target firm is in a country with a “weaker” legal environment (compared with a non family
firm).

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