Investor Protection and the Role of Firm‐Level Financial Transparency in Attracting Foreign Investment

• Author: Mihail K. Miletkov,M. Babajide Wintoki,Bowe Hansen
• DOI: http://doi.org/10.1111/fire.12072
• Published date: 01 August 2015
• Date: 01 August 2015

The Financial Review 50 (2015) 393–434

Investor Protection and the Role

of Firm-Level Financial Transparency

in Attracting Foreign Investment

Bowe Hansen

Pamplin Collegeof Business, Virginia Tech University

Mihail K. Miletkov∗

Paul Collegeof Business and Economics, University of New Hampshire

M. Babajide Wintoki

School of Business, University of Kansas

Abstract

We ask if companies can attract foreign equity capital by improving the transparency of

their financial statements. Using a large panel of firms across 51 countries outside the United

States, we show that the answer is yes, but only in countries with relatively high levels of in-

vestor protection. In countries with poor investor protection, unilaterally increasing firm-level

transparency has no effect on foreign ownership.Furthermore, our results indicate that in coun-

tries with higher levels of investor protection, the positive association between transparency

and foreign ownership is stronger following a country’sadoption of the International Financial

Reporting Standards.

∗Correspondingauthor: Paul College of Business and Economics, University of New Hampshire, Durham,

NH 03824; Phone: (603) 862-3331; E-mail: mihail.miletkov@unh.edu.

We are grateful for the research support of Virginia Tech University, the Universityof New Hampshire,

and the University of Kansas. We appreciate comments from Valaria Vendrzyk (the AAA discussant),

David Volkman(the Southern Finance Association discussant), Bryan Cloyd, Marc Lipson, Mitch Oler,

and workshop participants at Virginia Tech University, the 2012 AAA Annual Meeting, and the 2013

Virginia Accounting Research Colloquium, as well as from two anonymousreferees.

C2015 The Eastern Finance Association 393

394 B. Hansen et al./The Financial Review 50 (2015) 393–434

Keywords: foreign ownership, home bias, financial transparency, institutional development,

investor protection

JEL Classifications: G32, G34

1. Introduction

Access to foreign equity capital provides benefits for individual firms and for

entire countries. At the firm level, foreign investors expand the firm’s shareholder

base and reduce its cost of capital, and at the country level, foreign investment in-

creases aggregate investment and promotes economic growth.1Despite the fact that

over the past three decades many of the direct and indirect barriers to foreign port-

folio investment have been lifted, the observed levels of foreign investment are still

significantly below what is considered optimal under contemporary finance theory

(French and Poterba, 1991; Tesar and Werner, 1995; Ahearne, Griever and Warnock,

2004; Chan, Covrig and Ng, 2005). One of the main explanations for this “home

bias” in investors’ portfolio allocation decisions is the higher level of information

asymmetry that investors face when investingabroad. We examine whether firms can

attract foreign investors by implementing more transparent financial reporting prac-

tices, and the effect that the level of investor protection in the firm’s home country

has on the relationship between financial transparency and foreign ownership.

Prior literature suggests that a country’s overall level of investor protection,

mandatory adoption of International Financial Reporting Standards (IFRS), and firm-

level financial transparency are important determinants of aggregate and firm-level

foreign investment (Aggarwal,Klapper and Wysocki, 2005; Leuz, Lins and Warnock,

2009; Khurana and Michas, 2011; Florou and Pope, 2012).2However, our study is

the first to examine the interaction between country-level investor protection and

changes in firm-level financial transparency, and the effect this interaction has on

a firm’s ability to attract foreign investment. In other words, our study seeks to

answer the question of what happens to foreign ownership, within an individual firm,

when the firm’s levelof financial transparency changes, given the prevailing level of

overall investor protection in the firm’s home country. This is an important research

question because any differences in the association between firm-level transparency

and foreign ownership in countries with strong investor protection (as compared

1A partial list of studies examining the effects of foreign equity investment on firm- and country-level

outcomes includes: Bekaert and Harvey (2000), Blair Henry (2000a,b, 2003), Chari and Blair Henry

(2004), Bekaert, Harvey and Lundblad (2005, 2006), Moshirian (2008), and Huang and Shiu (2009),

among others.

2One potential limitation of these prior studies is that most of them are based exclusively on foreign

investments by U.S. institutional investors. In contrast, our study is based on different types of foreign

investors (institutional investors,governments, individuals, etc.) from multiple countries.

B. Hansen et al./The Financial Review 50 (2015) 393–434 395

to that in countries with poor investor protection) have direct implications for firm

management. Indeed, the biggest contribution of our paper is to demonstrate that the

ability of individual firms to use financial reporting transparency as a mechanism for

attracting foreign equity investment can be significantly constrained (or enhanced)

by the level of investor protection in the firm’s home country.

Using three different proxies for investor protection, we show that the positive

relationship between firm-leveltransparency and foreign ownership is driven by firms

located in countries with higher levels of investor protection. In countries where in-

vestor rights are poorly protected and the risk of minority shareholder expropriation

is greater, firm-level financialtransparency does not significantly affect the portfolio

allocation decisions of foreign investors. These results hold across different model

specifications and estimation methods, and are robust to the use of alternative mea-

sures of financial transparency. Firm-level transparency and country-level investor

protection turn out to be complements rather than substitutes. If a firm is located in

a strong investor protection country, it can increase foreign ownership by increasing

the transparency of its financial statements. If the firm is in a weak investorprotection

country, increasing transparency has no effect of foreign ownership.

There are several potential explanations for our findings. One possibility is that

in countries with weak investor protection, foreign investors question the credibility

of financial reporting of all firms regardless of their level of transparency. Another

possibility is that in countries with lower levels of investorprotection, financial trans-

parency may not necessarily reduce the risk of minority shareholder expropriation,

which may be the main deterrent to foreign equity investment. Johnson, La Porta,

Lopez-de-Silanes and Shleifer (2000) show that the various self-dealing transactions

that company insiders and controlling shareholders engage in (such as transfer pric-

ing, excessive compensation, loan guarantees, asset sales, and dilution) are not illegal

in many countries. Therefore, in these countries, even if foreign investors are better

able to identify potential cases of minority shareholder expropriation in firms with

more transparent financial reporting practices, they may still be reluctant to provide

capital to these firms due to the lack of legal recourse available to them.

Our findings indicate that in their quest for foreign capital, firms are captiveto the

investor protection environment in their home countries. In countries where investor

rights are better protected, increasing firm-level financial transparencyis an effective

mechanism for attracting foreign equity investors. On the other hand, in countries

where investor rights are not adequately protected, firms are unable to attract foreign

shareholders by unilaterally committing to higher levels of financial transparency.

Therefore, in order to attract foreign equity investment in their firms, countries

need to make more substantial investments in the legal and extra-legal institutions

protecting investor rights. Our results also support and extend the theoretical and

empirical arguments in Doidge, Karolyi and Stulz (2007). While their study does

not explicitly consider foreign ownership, they argue that below a threshold level

of investor protection and economic development, individual firm characteristics

explain very little of investor perception of a firm’s governance quality, and that only