Does Managerial Ability Matter in Private Firms? Evidence from Korea

• Author: Lee‐Seok Hwang,Seunghee Yang,Taejin Jung,Kyunghwa Yu
• Date: 01 April 2018
• Published date: 01 April 2018
• DOI: http://doi.org/10.1111/ajfs.12209

Does Managerial Ability Matter in Private

Firms? Evidence from Korea*

Lee-Seok Hwang

Business School, Seoul National University, Republic of Korea

Taejin Jung

Business School, Seoul National University, Republic of Korea

Seunghee Yang

Business School, Seoul National University, Republic of Korea

Kyunghwa Yu**

Business School, Seoul National University, Republic of Korea

Received 31 July 2017; Accepted 7 December 2017

Abstract

Using a large dataset of Korean private firms, we examine the value consequences of manage-

rial ability. We document that private firms with more able managers achieve better perfor-

mance, are less likely to over-invest, and are more likely to go public. However, we find that

these firms experience more severe underperformance following an IPO than firms with less

able managers. We provide evidence of more capable managers exhibiting lower earnings

quality before an IPO, which is a potential explanation for our findings. The results are

consistent with the notion that in the absence of effective monitoring mechanisms, owner-

managers in private firms can use their discretion in an opportunistic way.

Keywords Private firms; Managerial ability; Initial Public Offering (IPO); Post-IPO

performance; Earnings quality; Investment

JEL Classification: G30, G31, G32

1. Introduction

Estimating the value effect of top managers’ characteristics is a central research

topic that has attracted broad attention from academics and practitioners. In partic-

ular, prior research highlights the importance of managerial ability in various

*This work was supported by the Small and Medium Business Administration. We thank Iny

Hwang for sharing his data.

**Corresponding author: Business School, Seoul National University, 1 Gwanak-ro, Gwanak-

gu, Seoul, 08826, Korea. Tel: +82-2-880-5075, email: warm10@snu.ac.kr.

Asia-Pacific Journal of Financial Studies (2018) 47, 213–247 doi:10.1111/ajfs.12209

©2018 Korean Securities Association 213

contexts, including resource productivity (Holcomb et al., 2009), earnings quality

(Demerjian et al., 2013), voluntary disclosure (Baik et al., 2011), and firm value

(Chang et al., 2010; Li et al., 2014). Since these studies focus almost exclusively on

publicly traded firms due to data availability, relatively little is known about the

implications of managerial ability in privately held firms.

Consequently, a number of important questions remain unanswered: Does man-

agerial ability matter in private firms as it does in public firms? What are the conse-

quences of corporate entrepreneurship in private firms? Do the differences in

managerial ability translate into differences in corporate outcomes such as perfor-

mance, investment decisions, and the likelihood of going public? The purpose of

this paper is to answer these questions by examining the role of managerial ability

using a large dataset of private firms.

We focus on privat e firms in Korea for th e following reaso ns. First, priva te

firms are important components of the global economy. For example, Asker et al.

(2015) document that nearly 99.9% of US firms are private; in 2010 they accounted

for 52.8% of aggregate non-residential fixed investment, 68.7% of private sector

employment, and 48.9% of aggregate pre-tax profits. Thus, the empirical relation

between the managerial attributes and corporate outcomes of private firms is worth

investigating. Second, extant studies show that privately held companies are funda-

mentally different from publicly traded companies in many respects, including

ownership structure (Burgstahler et al., 2006), capital market pressure (Ball and

Shivakumar, 2005), and investment and financing behavior (Brav, 2009; Asker

et al., 2015). As such, whether prior studies’ conclusions based on public firms can

be generalized to private firms is an empirical question. Third, Korea provides an

excellent setting for studying our research questions. While scarce evidence for

private firms is largely due to the lack of data, private firms in Korea meeting

certain criteria are required to have their financial statements audited and disclosed

to the public.

1

Prior research shows that more able managers have a better understanding of

their business and industry trends, contributing to significant improvements in firm

performance (Demerjian et al., 2012). Relative to public firms, private firms have a

highly concentrated ownership structure in which managers hold a large portion of

equity (Burgstahler et al., 2006). As a result, private firms are subject to less conflict

of interest between managers and owners and less pressure from the capital market

(Burgstahler et al., 2006; Gao et al., 2013). Thus, managers in private firms often

enjoy greater discretion over the use of firms’ assets in the absence of close moni-

toring by external stakeholders (Lubatkin et al., 2005). Since managers with greater

discretion have stronger effects on a firm’s decisions and outcomes (Finkelstein and

1

According to the Act on External Audit of Stock Companies, Korean private firms with total

assets of more than KRW 12 billion or total assets and liabilities of more than KRW 7 bil-

lion, respectively, must be audited by external auditors and disclose their financial informa-

tion to the public.

L.-S. Hwang et al.

214 ©2018 Korean Securities Association

Hambrick, 1990; Finkelstein and Boyd, 1998), we conjecture that managerial ability

has a strong impact on the corporate behavior of private firms, even to a greater

extent than that observed for public firms.

Our measure of managerial ability based on Demerjian et al. (2012) has been

used in a number of studies (Demerjian et al., 2013; Krishnan and Wang, 2015;

Bonsall IV et al., 2017). This measure is intended to capture the efficiency of man-

agement in transforming corporate resources into revenues. Compared to other

commonly used proxies such as media citations and historical returns, it has the

advantage of providing a more structured and comprehensive measure for manage-

rial ability by isolating the effect of the management team from that of the firm.

Using a large sample of Korean private firms from 2002 to 2015, we examine

the value consequences of managerial ability. Our findings are summarized as fol-

lows. First, we find that higher managerial ability is associated with better contem-

poraneous and future firm performance and lower earnings volatility. Second, our

results show that firms with more capable managers are less (more) likely to over-

invest (under-invest). To ensure that our results are not an artifact of the construc-

tion of the managerial ability measure, we further test the association between man-

agerial ability and the level of investment but find no evidence of a mechanical

relationship. Third, our results indicate that firms with more talented managers are

more likely to go public. However, we find that private firms with more able man-

agers experience more severe underperformance after an initial public offering

(IPO) relative to firms with less able managers.

Although our findings, except those for post-IPO performance, appear to indi-

cate the positive value consequences of managerial ability in private firms, caution is

warranted in interpreting the results. Prior research generally provides evidence of

lower financial reporting quality for private firms (Ball and Shivakumar, 2005; Cop-

pens and Peek, 2005; Burgstahler et al., 2006; Hope et al., 2013). Thus, it is possible

that our results are confounded by the poor earnings quality of private firms.

To examine this issue, we further test the association between managerial ability

and earnings quality in private firms. Our results suggest that higher managerial

ability is associated with higher levels of total and discretionary accruals, lower

accruals quality, and lower earnings persistence. These results contrast with Demer-

jian et al. (2013 ) who find a positive association between managerial ability and

earnings quality, but are consistent with Malmendier and Tate (2009) and Francis

et al. (2008) who provide evidence of more reputable managers exhibiting lower

earnings quality. The negative relation observed between managerial ability and

post-IPO performance is also consistent with the interpretation in that more able

managers manipulate performance to go public but subsequently experience signifi-

cant underperformance due to accrual reversals (Rangan, 1998; Teoh et al., 1998).

Our measure of managerial ability is subject to potential measurement errors

which might cause spurious relationships with the variables of interest. In particu-

lar, Demerjian et al. (2012) raise the possibility that earnings management may

inflate the estimated efficiency of a firm, and as a result, the measure of managerial

Managerial Ability in Private Firms

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