Do Family Owners Use Firm Hedging Policy to Hedge Personal Undiversified Wealth Risk?

• Published date: 01 June 2014
• DOI: http://doi.org/10.1111/fima.12021
• Author: Christos Pantzalis,Jung Chul Park,Chansog Kim
• Date: 01 June 2014

Do Family Owners Use Firm Hedging

Policy to Hedge Personal Undiversified

Wealth Risk?

Chansog Kim, Christos Pantzalis, and Jung Chul Park∗

We examine whether family ownership affects the value impact of the operational and financial

dimensions of firms’ hedging policies. Weshow that family firms’ market valuations are higher than

those of non-family firms, consistent with the view that family firms benefit from family owners’

long-term perspectives and ability to monitor managers. In addition, while both operationaland

financial hedging policies per se are valuable in non-family firms, they do not create anyvalue in

family firms. These results support the notion that the founding families’ need to hedge the risk of

their undiversified personal wealth portfolio leads to suboptimal risk management decisions.

Family ownership is quite common and significant in US fir ms across a broad range of

industries. Firms with founding families’ presence constitute about one-third of the S&P 500 and

Fortune 500 industrial firms, and founding families represent the most common types of large,

undiversified shareholders (Shleifer and Vishny, 1986; Villalonga and Amit, 2006). As reported

in Anderson and Reeb (2004), excluding 97 banks and public utilities, founding families are

present in 141 of 403 S&P 500 firms and hold, on average, about 17.9% of equity stakes and

20% of the board seats in these firms.

Prior literature has provided mixed evidence on the benefits firms derive from substantial

ownership by founder families (hereafter “family firms”).1Based on Fama and Jensen (1983),

concentrated shareholdings allow for an exchange of profits for private rents. Hence, it is possible

that combining ownership and control in family firms may result in a suboptimal ownership

structure. Agency problems (Demsetz, 1983; Shleifer and Vishny, 1997) between controlling and

noncontrolling shareholders are more likely to arise within family-owned firms (Anderson and

Reeb, 2004; Anderson, Duru, and Reeb, 2009).

However, family ownership maybe benef icial to outside shareholders. Forinstance, a founding

family presence facilitates more efficient monitoring of firm managers (Demsetz and Lehn, 1985).

In addition, family owners’ long-term horizons and their preference for long-term investments

may mitigate managerial incentives for myopic investment decisions, thereby leading to greater

investment efficiency (James, 1999). Anderson and Reeb (2003a,b) show that US family firms

exhibit better accounting and market measures of performance than non-family firms.

We are especially grateful to Raghavendra Rau (Editor) and an anonymous reviewer for their many insightful and

constructive suggestions.

∗Chansog (Francis) Kim is an Associate Professor of Accounting at Wayne State University in Detroit, MI. Christos

Pantzalis is a Professorof Finance and the Bank of America Professor at the University of South Florida in Tampa, FL.

Jung Chul Parkis an Associate Professor of Finance and the McLain Family Professorat Auburn University in Auburn,

AL.

1Firms that are managed or controlled by their founders or by the founders’ families and heirs are, hereafter, referred to

as family firms.

Financial Management •Summer 2014 •pages 415 - 444

416 Financial Management rSummer 2014

Our study contributes to the literature by providing evidence on the role of family owners

in a specific type of corporate decision, the risk management policy of the f irm.2We examine

the managerial hedging decisions of family firms and their impact on f irm value to assess

whether family ownership is associated with less severe agency costs than non-family firms.

In particular, we compare family-owned and non-family-owned S&P 500 firms in terms of the

value impact of industry diversification and derivatives use. These may be thought of as proxies

for the operational and financial dimensions of f irms’ hedging (or risk management) policy,

respectively. Risk management decisions have been found to either exacerbate (e.g., in the case of

speculative use risk management policies, see G´

eczy, Minton, and Schrand, 2007; Aabo, Hansen,

and Pantzalis, 2012, among others) or mitigate (DaDalt, Gay, and Nam, 2002; Lin, Pantzalis, and

Park, 2007) agency problems. Hence, analyzing them may yield insights into family ownership

valuation effects.

Weposit that there should be differences between family and non-family-owned firms in terms

of the impact of hedging policies on firm valuation. Family ownership, usually in the form of

large, undiversified blockholdings, may increase the propensity to use hedging policies to reduce

personal wealth portfolio risk at the expense of firm value. Specifically, if family owners seek to

reduce firm-specif ic risk in order to hedge their undiversified wealth portfolio, they may try to

do so by influencing firm hedging policy through the use of derivatives in the short run and the

adjustment of operating policies in the long run. Alternatively, since hedging policycan improve

firms’ information environments by reducing information asymmetry between managers and the

financial markets, family firms that are often regarded as more opaque (Anderson et al., 2009)

may use hedging policies to reduce information asymmetries.

Our empirical investigationis performed in three stages. We start by examining howf amilyown-

ership affects the value ofoperational hedging. Next, weinvestigate the effect of financial hedging

and finally examine both dimensions of hedging policy in combination. Our univariate results

on operational hedging show that family firms exhibit higher values and larger diversification

discounts than non-family firms. Multivariate tests also show a negative effect of diversification

on valuation (as in Berger and Ofek, 1995, among others) and a larger diversification discount

for family firms than for non-family fir ms. Interestingly, after controlling for the endogenous

relationship between diversification and firm value, we find that the average firm experiences a

value premium through diversification. This result holds for alternative valuation measures, as

well as alternative estimation methods. Moreover, the diversification premium disappears in the

case of family firms. Therefore, our results are consistent with diversification strategies being

used by undiversified family owners of family firms to diversify their personal wealth portfolios.

In the second stage of our empirical examination, we show that financial hedging policy is

also positively associated with firm value. This effect is stronger for firms with policies relying

on a greater number of different financial derivatives contracts. It indicates that comprehensive

and sophisticated financial risk management policies tend to have significantly positive value

impacts (Lin, Pantzalis, and Park, 2009). However, we also find that the value impact of financial

hedging policy is not significant for family firms, implying that as in the case of operational

hedging policies, family owners may use financial hedging policies to reduce the risk of their

own undiversified wealth portfolio, thereby reducing their effectiveness.

2Many theoretical studies (Stulz, 1984; Shapiro and Titman, 1985; Smith and Stulz, 1985; Froot, Scharfstein, and Stein,

1993; DeMarzo and Duffie, 1995) have demonstrated that in the presence of market imperfections, such as taxes,f inancial

distress costs, and agency conflicts, corporate hedging policy becomes relevant(i.e., hedging decisions may have a positive

impact on firm valuation).