What Are Boards For? Evidence from Closely Held Firms in Colombia

• Author: María‐Andrea Trujillo,Neila Cáceres,Alexander Guzmán,Belén Villalonga
• Date: 01 June 2019
• DOI: http://doi.org/10.1111/fima.12224
• Published date: 01 June 2019

What Are Boards For? Evidence from

Closely Held Firms in Colombia

Bel´

en Villalonga, Mar´

ıa-Andrea Trujillo, Alexander Guzm´

an,

and Neila C´

aceres∗

Using a large survey database on the corporategovernance practices of privately held Colombian

firms, we investigate whyf irms have boards,and how that choice and the balance of power among

the board, controlling shareholders, and minority shareholders affect the trade-offs between

control, liquidity, and growth and, ultimately, firm performance. We find that the probability

of having a board increases with the number of shareholders and in family firms. When the

preferences of controllingand minority shareholders diverge, as with respect to capital structure

and dividend policy, boardssupport controlling shareholders’ decisions, thereby exacerbating the

agency conflict between the two groups of shareholders.

What role(s) do boards of directors play? Although the topic has received much attention from

academics and regulators (for reviews, see Hermalin and Weisbach, 2003; Adams, Hermalin, and

Weisbach, 2010), most of this research assumes a corporation model as described by Berle and

Means (1932)—one with a widely dispersed base of shareholders in which control is exercised

by management. Yet a growing volume of research showsthat such a model is more the exception

than the norm; instead, most public corporations around the world—and nearly all privately held

companies—have a controlling shareholder or group, for the most part individuals or families

(La Porta, L´

opez de Silanes, and Shleifer, 1999; Claessens, Djankov, and Lang, 2000; Faccioand

Lang, 2002). This is true even in countries where corporate ownership is relatively more widely

held, such as the United States (Holderness, 2009; Villalonga and Amit, 2009), and increasingly

so: the number of public corporations in the United States has almost halved over the last

20 years—from over 8,000 in 1996 to about 4,300 in 2016 (Doidge, Karolyi, and Stulz, 2017;

Grull´

on, Larkin, and Michaely, 2017), and a similar phenomenon has taken place in the United

Kingdom (Mayer, 2013).

The fact that most of what we know about boards is based on widely held US corporations is

of concern because the governance problems these companies face are fundamentally different

from the problems faced by closely held or controlled companies (for a review of controlled

companies, see Villalonga et al., 2015). Thus, the board’s role in these companies is also likely to

be different, in accordance with the problems it is—or should be—designed to solve. Moreover,

as Adams et al. (2010) note, because corporations are legally required to have a board, prior

We thank Saverio Bozzolan, Eduardo Gentil, Han Kim, Hannes Wagner, David Yermack, an anonymous referee, and

participants in seminars at Bocconi, LUISS Guido Carli, the University of Michigan, New York University, Tulane

University, Washington University at St. Louis, CESA School of Business, and at the annual meetings of the Northern

Finance Association 2015, Financial Management Association 2016, and Midwest Finance Association 2016 for their

comments and suggestions. All errors areour own.

∗Bel´

en Villalonga is a Professorof Management and a Professor of Finance (by courtesy) at New YorkUniversity Stern

School of Business in New York. Mar´

ıa-Andrea Trujillo is a Professor of Finance at the CESA School of Business in

Bogot ´

a, Colombia. Alexander Guzm´

an is a Professor of Finance at the CESA School of Business in Bogot´

a, Colombia.

Neila C´

aceres is a Researcher at the Superintendencia de Sociedades in Bogot´

a, Colombia.

Financial Management •Summer 2019 •pages 537 – 573

538 Financial Management rSummer 2019

research offers little insight into why companies may or may not want to have one board; they

simply have no choice.

To address these shortcomings of existing research, one needs to look at the role of boards in

a sample of companies for which establishing a board is voluntary—namely, noncorporations,

which by definition are privately held. Yet data on privatecompanies are notoriously hard to f ind,

and governance data on such companies are even more rare. In this article we take advantage

of one such rare data set to investigate the question of boards’ role(s). Specifically, our sample

comprises 55,313 firm-year observations from 21,417 closely held Colombian firms from 2007 to

2012, of which only 56% havea board. Using detailed data from a sur veyabout these companies’

governance practices, we examine why firms have boards and how the balance of power between

the board and different shareholders affects the trade-offs among control, liquidity, and growth

in these firms and, ultimately, their performance.

I. Role of the Board in Closely Held or Controlled Firms

The board of directors is the representative body that, on behalf of shareholders, advises

and monitors the top management team to ensure that it exercises the powers that have been

delegated to it by the firm’s owners in the best interests of those owners. For instance, as part

of its advisory role, the board reviews and approves major strategic and financing initiatives

such as the company’s strategic plan, mergers and acquisitions, significant investment projects,

and new equity issuances. As part of its monitoring role, the board reviews and approves the

annual operating budget or any substantive deviations from it, as well as the compensation for

top management, whom it is also responsible for hiring and firing.

Although both the need for strategic advice and the need for monitoring are likely to vary across

firms for multiple reasons, it is the need for monitoring that is most likely to differ systematically

between widely held corporations and closely held firms because of the differences between them

in the balance of power among the board, controlling shareholders, minority shareholders, and

managers.

In widely held corporations, well-structured and well-performing boards should mitigate the

conflict of interest between ownersand managers that results from the separation of ownership and

control denounced by Berle and Means (1932) and Jensen and Meckling (1976): whena f irm is not

managed directly byits owners but by managers hired to act as agents on their behalf, managers are

likely to pursue their own interests, which may differ from those of the principals. Furthermore,

ownership dispersion creates a problem of collective action where individual investors lack the

power, the incentives, and, often, the information to engage in direct monitoring. In such a

context, it is typically more efficient to concentrate information and authority in a representative

governance body such as the board (Bainbridge, 2003).

In contrast, in closely held or controlled companies, the agency problem between owners and

managers is inherently alleviated bythe concentration of ownership that characterizes these f irms,

either by ensuring better supervision of managers by owners who have both the power and the

incentives to do so, or by reuniting ownership and management within the same person or team,

as is often the case (La Porta et al., 1999; Villalonga and Amit, 2006, 2010).

However, these companies typically face a different agency problem: the conflicts of interest

between large, controlling shareholders and small(er), minority shareholders.1An example of

1Because, in our sample, noncontrolling shareholders are typically minority holders, in this article we use the term

“minority shareholders” to refer, indistinctively, to noncontrolling shareholders and/or minority shareholders.

Villalonga et al. rWhat Are Boards For? 539

such conflicts comes from the trade-offs between control, liquidity, and growth that closely held

firms often face. Controlling shareholders are typically keen on retaining their unique position in

their firms, as control is economically valuable. Moreover, when the controlling shareholder is

the firm’s founding family, the economic motives for retaining control are often compounded by

psychological motives such as the desire to perpetuate the founder’s legacy, the pride in having

a family member run the business, or the emotional attachment to the company that founding

families often exhibit. In fact, the empirical evidence about family firms shows that these firms

have significantly lower leverage than their non-family peers, which suggests that families are

reluctant to share control not only with other shareholders but also with creditors (Villalonga

and Amit, 2006; Gonz´

alez et al., 2013). This implies that family firms often restrict themselves

to retained earnings as their primary, or even only, source of financing. Thus, control typically

comes at the expense of reduced liquidity and/or firm growth.

Conversely, minority shareholders, having no control rights over the firm, derive all their

ownership benefits from their cash-flow rights, in the form of dividends and/or capital gains,

and would therefore rather not compromise their liquidity and/or growth objectives. Because

controlling owners have the upper hand, their objectives tend to prevail over those of minority

shareholders, as suggested by the evidence that family firms tend to be smaller and exhibit lower

growth, investment,and dividend payout ratios than their peers (Villalonga and Amit, 2006, 2010;

Gonz´

alez et al., 2014).

Large shareholders can thus act as a double-edged sword for minority shareholders in the same

firm, and boards, in turn, may either mitigate or exacerbate the power of large shareholders,

depending on whose interests they truly represent and how effective they are in the execution of

their functions.

A few empirical studies have examined the role of boards in publicly listed family-controlled

firms. Anderson and Reeb (2004) f ind that board composition in family firms in the S&P 500

plays a critical role in the relation between family ownership and performance. They find that

family firms outperform non-family f irms when independent directors balance family board

representation, but otherwise underperform. They conclude that founding families monitor the

firm, while independent directors monitor the family. Conversely, Klein, Shapiro, and Young

(2005) find board independence to be negatively associated with family firms’ performance in

a sample of Canadian firms. Barontini and Caprio (2006) f ind that descendant directors have a

positive impact on firm valuation and operating performance. Andres (2008) finds that family

firms perform better only when the founding family is still active on the board. Li and Srinivasan

(2011) find that companies in which the founder serves as a director with a nonfounder chief

executive officer (CEO) provide higher-powered incentives than the averageUS board. Gonz ´

alez

et al. (2012) find that both family directors and outside directors have a positive influence on firm

performance in Colombia. Gonz´

alez et al. (2015) find that boards dominated by families lead to

longer CEO tenures, but CEO turnover shows greater sensitivity to performance, which suggests

better supervision of management when family members serve on the board.

There is even less empirical evidence about the role of boards in privately held firms, despite

the fact that they constitute the majority of firms even in developed economies. The only study on

the subject of which we are awareis Bennedsen (2002), who uses a sample of Danish closely held

firms for which the establishment of a board is voluntary to investigate why firms have boards.

He finds that the likelihood of having a board increases with firm size (which he interprets as

evidence of a “governance” motive—monitoring management as a way to address the conflict

of interest between owners and managers) and with the number of shareholders and ownership

dispersion (which he interprets as evidence of a “distributive” motive—mitigating conflicts of

interest between controlling and noncontrolling shareholders). However, he does not test for either