1

Ownership concentration and firm financial

performance

Evidence from Saudi Arabia

By: Dr. Mohamed Moustafa Soliman

Arab Academy for Sciences & Tech.

Abstract

The effect of ownership concentration on a firm’s performance is an important

issue in the literature of finance theory. This study seeks to examine the effect of

ownership concentration on firm financial performance in Saudi Arabia, using

pooled cross-sectional observations from the listed Saudi firms for three years

between 2006 and 2008. I find that firm financial performance measured by the

accounting rate of return on assets and rate of return on equity generally improves

as ownership concentration increases. I also find that there exists a hump-shaped

relationship between ownership concentration and firm performance, in which

firm performance peaks at intermediate levels of ownership concentration. The

study provides some empirical support for the hypothesis that as ownership

concentration increases; the positive monitoring effect of concentrated ownership

first dominates but later is outweighed by the negative effects, such as the

expropriation of minority shareholders. The empirical findings shed light on the

role ownership concentration plays in corporate performance, and thus offer

insights to policy makers interested in improving corporate governance systems in

an emerging economy such as Saudi Arabia.

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Keywords: corporate governance, ownership concentration, financial performance,

and Saudi Arabia.

1. Introduction

The effect of ownership concentration on a firm‟s performance is an important

issue in the literature of finance theory. Ownership concentration may improve

performance by decreasing monitoring costs (Shleifer and Vishny, 1986).

However, it may also work in the opposite direction. There is a possibility that

large shareholders use their control rights to achieve private benefits. Ownership

concentration are considered as important factors that affect a firm‟s health (Zeitun

and Tian, 2007).

The idea that ownership concentration is one of the main corporate governance

mechanisms influencing the scope of a firm‟s agency costs is generally accepted

(Shleifer and Vishny, 1997). Also, it has been shown in various contexts that better

corporate governance is associated with higher financial performance. Different

countries have developed distinct patterns of corporate governance. In this respect,

different solutions to corporate governance problems may be appropriate

depending on the institutional setting of each country. Therefore, it might be

necessary to look into a country‟s unique corporate structures, rules, and

environments when analyzing the link between corporate governance and

performance in the country.

It is worth noting that most research on ownership concentration and firm

performance has been dominated by studies conducted in developed countries.

However, there is an increasing awareness that theories originating from developed

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countries such as the USA and the UK may have limited applicability to emerging

markets. Emerging markets have different characteristics such as different

political, economic and institutional conditions, which limit the application of

developed markets‟ empirical models (Zeitun and Tian, 2007). Recent studies of

corporate governance suggest that geographical position, industrial development

and cultural characteristics along with other factors affect ownership concentration

which in turn have impacts on a firm‟s performance (Pedersen and Thompson,

1997). There is a significant lack of applied studies dealing with financial distress

in Middle Eastern countries such as Saudi Arabia.

The main objective of this study is to examine the effect of ownership

concentration on firm financial performance of listed companies in Saudi Arabia.

After a decade of an extensive privatization program, a unique feature of the Saudi

stock exchange is that many listed companies have varying ownership structure

and concentration because many of them were formerly family-owned enterprises,

before being restructured and listed on the stock exchange. The results consistently

support the potential association between ownership concentration and firm

financial performance, though the relationship differs across different group of

owners.

The organization of the paper is as follows: Section 2 reviews the existing

literature on the effects of ownership concentration on firm performance. Section 3

presents for hypotheses development. Section 4 provides a discussion of the

variables tested, model development and sample. Section 5 presents a discussion

and summary of the results. Section 6 concludes the study.

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2. Literature review

The effects of ownership concentration on firm performance are theoretically

complex and empirically ambiguous. Concentrated ownership is widely

acknowledged to provide incentives to monitor management. Large shareholders

might have the greater incentive to improve firm performance than do dispersed

shareholders. Furthermore, concerted actions by large shareholders are easier than

by dispersed shareholders. In other words, large shareholders have both an interest

in getting their money back and the power to demand it. However, despite the

obvious benefits from concentrated ownership, attention has also been focused on

the adverse effects. For example, while dispersed ownership offers better risk

diversification for investors, concentrated ownership imposes increasing risk

premia because of risk aversion of large shareholders (Demsetz and Lehn, 1985),

causing potential under-investment problems. A more important issue in this

respect is that concentrated ownership could lead to another sort of agency

problem, that is, conflicts between large shareholders and small shareholders.

Large shareholders have incentives to use their controlling position to extract

private benefits at the expense of minority shareholders (Lee, 2008).

Since concentrated ownership has its own specific benefits and costs, it is

theoretically open which one dominates. Just as in the theoretical consideration,

while some empirical research supports the positive relationship, other empirical

research suggests that concentrated ownership does not necessarily lead to better

firm performance. Several papers (Short, 1994; Shleifer and Vishny, 1997; Gugler,

2001) provide comprehensive surveys and show that the overall empirical evidence

on the effects of ownership concentration on firm performance is mixed.

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There have been different studies examining the effects of ownership concentration

on performance. Hill and Snell (1988) show that ownership structure affects firm

performance as measured by profitability through strategic structure. Later, Hill

and Snell (1989) confirm this positive relation for US firms by taking productivity

as a measure of performance. On the contrary, McConnell and Servaes (1990) do

not find evidence supporting any direct effect of large shareholders on firm value.

Nevertheless, the empirical evidence in Agrawal and Mandelker (1990) supports

the hypothesis proposed by Shleifer and Vishny (1986) that the existence of large

owners or a high concentration ownership leads to better management and also

better performance, especially when ownership is concentrated in institutional

investors rather than individual investors. Therefore, institutional ownership could

increase a firm‟s performance.

Wu and Cui (2002) study the effect of ownership structure on a firm‟s health. They

found that there is a positive relation between ownership concentration and

accounting profits, indicated by return on assets (ROA) and return on equity

(ROE), but the relation is negative with respect to the market value measured by

the share price-earning ratio (P/E) and market price to book value ratio (M/B).

Also, the contribution of government (state) and institution ownership is

significantly positive to company profit, while negative to the market value. Xu

and Wang (1997) investigated whether ownership structure has significant effects

on the performance of publicly listed companies in China. They find that

ownership structures, both the mix and concentration of ownership have a

significant effect on the performance of stock companies. There is a significant and

positive relationship between ownership concentration and firm‟s profitability.

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Also the effect of ownership concentration is stronger for companies dominated by

shareholders than for those dominated by the state.

There is also some empirical evidence of a negative impact of large equity holders

on firm performance. Lehmann and Weigand (2000), focusing on German

corporations, find indeed a negative effect of ownership concentration on firm

performance. Leech and Leahy (1991) analyse the implications of the separation of

ownership from control for a UK firm value. They describe ownership structure

using several measures of concentration and control types. Therefore, ownership

structure is expected to affect a firm‟s performance through the effects of

ownership concentration. They found that there is a negative and significant

relationship between ownership concentration and firm value and profitability.

Another study of the British case, by Mudambi and Niclosia (1998), confirms this

negative relationship between ownership concentration and performance. Prowse

(1992) examines the structure of corporate ownership in a sample of Japanese

firms in the mid-1980s. His empirical work indicated that there is no relationship

between ownership concentration and profitability. Also, Chen and Cheung (2000)

found a negative relationship between concentrated ownership and firm value for a

sample of 412 publicly listed firms in the Hong Kong stock exchange through

1995-1998.

A nonlinear relationship between ownership concentration and firm performance is

another important issue in empirical analysis. Thomsen and Pedersen (2000) show

empirically that firm performance first improves as ownership is more

concentrated, but eventually declines in the largest European companies. It

indicates that, at high levels of ownership concentration, the benefit of

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concentrated ownership is outweighed by the negative effects. Among the negative

effects, the expropriation of small shareholders by large shareholders is

noteworthy. Porta et al. (1999) find that the main problem in large firms of 27

advanced countries may be the potential expropriation because controlling

shareholders have control rights significantly in excess of cash flow rights via

pyramid structure. Using data for public companies in East Asia, Claessens et al.

(2002) show that firm market value increases with the cash-flow ownership of

largest shareholders, but drops when the control rights of largest shareholders

exceed their cash-flow ownership. Similar results are often found in Korea (Joh,

2003; Baek et al., 2004). Interestingly, evidence shows that, in emerging

economies, control rights in excess of cash flow rights are related to lower firm

values, but not enough to offset the benefits of concentrated ownership (Lins,

2003). However, according to S´anchez-Ballesta and Garc´ıa-Meca (2007), the

relationship is moderated by institutional environment. The relationship is stronger

in continental countries than in Anglo-Saxon countries, which would support the

argument that ownership is more positively related to firm performance in

countries with lower levels of investor protection.

In spite of all these efforts to investigate the effect of ownership concentration on

firms‟ performance until now there are few studies of the effect of ownership

concentration on firms‟ health especially in the Middle East.

3. Hypotheses development

This study seeks to determine whether ownership structure affects firm financial

performance in Saudi Arabia listed companies. Ownership structure is analyzed in

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terms of ownership concentration and identity. According to agency theory,

ownership structure should affect the efficiency of monitoring mechanisms.

Traditionally, the theory holds that concentrated ownership should mitigate the

agency problem. Based on the traditional agency theory, the study predicts that

ownership concentration positively affects firm financial performance. The first

hypothesis to be tested is as follows:

H1: Ownership concentration is positively associated with firm financial

performance.

However, as discussed above, the negative effects of concentrated ownership are

shown to be considerable. The positive and negative effects could be combined to

develop the hypothesis that at low levels of ownership concentration, firm

performance improves as ownership concentration rises, but at high levels of

ownership concentration, an inverse relation between ownership and performance

is observed. Thus the second hypothesis is as follows:

H2: There is a hump-shaped relationship between ownership concentration and

firm financial performance.

4. Research method

4.1. Sample

The data used in this study included 64 publicly listed companies on the Saudi

Stock Exchange (SSE), over the period 2006-2008, forming approximately 67

percent of the total population of firms listed on the SSE, and fairly represents a

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wide cross-section of industries. The banking and insurance sectors are not

included in this study as the characteristics of these firms are different from the

firms in other industrial sectors in terms of financial statement profitability

measures and liquidity assessment (Zeitun and Tian 2007). All of the data were

collected from official Saudi Stock Exchange web site (tadawul).

4.2. Variables selection

Using pooled data for the listed companies in the SSE, three ownership structure

variables are used in the study. As a proxy for ownership concentration, the

percentage of shares held by a controlling shareholder (labeled as CR) is used. The

controlling shareholder refers to a group of shareholders who control the company,

such as shareholders owning substantial equity stake in a company, their family

members, and affiliated entities (Lee, 2008).

Two variables are selected as a proxy for firm financial performance: return on

assets ratio (ROA) and return on equity ratio (ROE). Several control variables are

introduced in the study: firm size, leverage, liquidity, and business cycle. Natural

logarithm of total assets (LNA) and natural logarithm of total sales (LNS) are

included to control for firm size. As for leverage, equity to assets ratio (EAR) is

employed to control for capital structure effect, and in order to control for long-

term financial distress, liabilities to equity ratio (LER) is utilized. With regard to

liquidity, current ratio (current assets to current liabilities ratio, CUR) is a well-

known liquidity ratio and is utilized as a proxy for a firm‟s financial capacity to

meet its short-term financial distress. A quick ratio (QKR) is also employed, which

is stricter than the current ratio, because it subtracts inventory from current assets.

Each firm‟s inventory to total assets ratio (IVA) is introduced to control for the

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effect of business cycle. The description of the variables and summary statistics for

the sample are presented in Table I.

Table I: Description of Variables and Summary Statistics

Variable Label Description Mean Median Min Max

Performance

Ownership

Concentration

Size

Leverage

Liquidity

Business Cycle

ROA

ROE

CR

LNA

LNS

EAR

LER

CUR

QKR

IVA

Net income/ total assets

Net income / total equity

The percentage of shares held by

large shareholders

Natural Logarithm of total assets

Natural Logarithm of total sales

Equity to total assets ratio

Liabilities to equity ratio

Current assets to liabilities ratio

Quick ratio

Inventory to total assets ratio

6.3873

8.5689

25.156

9.8755

7.0381

.4928

1.3856

2.5998

1.9455

.0558

1.9800

3.1500

15.000

9.8200

9.0600

.5200

.8100

2.4100

1.8800

.0300

-8.87

-13.14

5.00

8.06

.00

.02

.08

.50

.20

.00

43.45

54.29

70.00

11.43

11.18

.92

5.24

6.99

4.56

.45

4.3. Regression models

To provide empirical testing to the hypotheses addressed in the study, a linear-

multiple regression analysis was used to test the association between the dependent

variables of firm financial performance and the independent variable of ownership

concentration. The following two models are estimated:

ROA = α0 + ß1 CR+ ß2 LNA+ ß3 LNS+ ß4 EAR + ß5 LER + ß6 CUR

+ ß7 QKR + ß8 IVA + µ (1)

ROE = α0 + ß1 CR+ ß2 LNA+ ß3 LNS+ ß4 EAR + ß5 LER + ß6 CUR

+ ß7 QKR + ß8 IVA + µ (2)

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Where ROA, return on assets; ROE, return on equity; CR, percentage of shares

held by a controlling shareholder; LNA, natural logarithm of total assets; LNS,

natural logarithm of total sales; EAR, equity to assets ratio; LER, liabilities to

equity ratio; CUR, current ratio; QKR, quick ratio; and IVA, inventory to assets

ratio.

Table II represents a correlation matrix for the selected variables, The Pearson‟s

correlation matrix shows that the degree of correlation between the independent

variables is either low or moderate, which suggests the absence of multicollinearity

between independent variables. As suggested by Bryman and Cramer (1997), the

Pearson‟s R between each pair of independent variables should not exceed 0.80;

otherwise, independent variables with a coefficient in excess of 0.80 may be

suspected of exhibiting multicollinearity. Correlations coefficients in the sample

are within an acceptable range.

Table II. Correlation coefficients Matrix of the variables used in the study:

ROA ROE CR LNA LNS EAR LER CUR QUK IVA

ROA 1

ROE .322 1

CR .203 .306 1

LNA .020 .088 .588 1

LNS .332 .423 .220 .072 1

EAR .569 .530 -.017 -.399 .166 1

LER -.388 -.480 -,058 ,229 -.129 -.502 1

CUR .663 .648 .123 .040 .408 .610 -.419 1

QUK .530 .548 .137 .016 .290 .647 -.588 .647 1

VIA .047 .141 .062 -.108 .328 -.034 .057 -.017 -.131 1

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5. Results

The results of the regression analysis provides evidence that ownership

concentration has positive effects on firm financial performance. Table III presents

the regression analysis for the financial performance variables (ROA & ROE),

using binary logistic procedure. The explanatory power of the two models is 0.227

and 0.324 respectively . The results show that the return on assets ratio (ROA) is

positively associated with ownership concentration (sig. = 0.00). Firm financial

performance represented by return on equity (ROE) also a significant variable with

a positive sign (sig. = .001).

The significant impact of concentration ratios on ROE and ROA is in support of

the Shleifer and Vishny (1986) hypothesis that large shareholders may reduce the

problem of small investors, and hence increase the firm‟s performance. These

results are consistent with Abdel Shahid (2003); that ROA and ROE are the most

important factor used by investors rather than the market measure of performance.

This finding is also consistent with the results of Wu and Cui (2002); Zeitun et al.

(2007) and Lee (2008), that there is a positive relationship between ownership

concentration and accounting profits, indicated by ROA and ROE.

The effects of some control variables on firm financial performance are confirmed

to be significant in the regression. Among control variables, liquidity is noticeable.

The relation between the liquidity variables (CUR and QKR) and the dependent

variables is shown to be statistically significant: 0.00 (t=7.763), 0.00 (t=6.747) for

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ROA, and 0.00 (t=4.986) and 0.00 (t=4.101) for ROE. No significant association

was found between the remaining control variables and firm financial performance.

Table III. The regression results of the variables used in the study:

ROA ROE

B S E Coeffi. t Sig. B S E Coeffi. t Sig.

Constant

CR

LNA

LNS

EAR

LER

CUR

QUK

IVA

7.07

.237

-921

-.037

19.01

-.396

14.76

-17.17

-24.07

19.38

.055

1.84

.228

7.215

.964

1.901

2.545

10.75

.375

-.108

-.013

.385

-.050

2.108

-1.827

-.171

.365

4.306

-1.043

-.101

2.635

-.411

7.763

6.747

-2.240

.716

.000

.301

.872

.011

.683

.000

.000

.029

7.964

.326

-1.638

.438

7.451

-3.618

15.563

-17.14

-8.678

13.821

.090

3.023

.374

11.845

1.582

3.121

4.179

17.648

.365

-.065

.108

.107

-.321

1.572

-1.289

-.432

.250

3.616

-.542

1.171

.629

-2.287

4.986

4.101

.491

.803

.001

.590

.247

.532

.026

.000

.000

.625

Adjusted R Squire .735

F 23.176

Significance .000

Adjusted R Squire .643

F 15.408

Significance .000

Where ROA, return on assets; ROE, return on equity; CR, percentage of shares

held by a controlling shareholder; LNA, natural logarithm of total assets; LNS,

natural logarithm of total sales; EAR, equity to assets ratio; LER, liabilities to

equity ratio; CUR, current ratio; QKR, quick ratio; and IVA, inventory to assets

ratio.

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In relation to the second hypothesis that a hump-shaped relation exists between

ownership concentration and firm performance, Ramsey Regression Equation

Specification Error Test (RESET) is conducted. The RESET tests whether

nonlinear combinations of the independent variables help explain the dependent

variable (Ramsey, 1969). The test results (p < 4.17e − 08 for ROA; p < 2.8e − 16

for ROE) confirm the nonlinear relationship between ownership concentration and

firm performance. In order to test the hump-shaped pattern, piecewise OLS

regression and quadratic OLS regression are used.

The results of the piecewise regression and the quadratic regression can be

understood as supporting the idea of the hump-shaped relationship between

ownership concentration and firm financial performance. The effect of ownership

concentration on firm performance is positive at lower levels of ownership

concentration, but negative at higher levels of ownership concentration. The

piecewise regression results show that firm performance increases as ownership

concentration increases up to the point at which ownership concentration reaches

60%, but decreases slowly after the peak point. The slopes in each regression are

Sig. 0.11 (t=4.30), Sig. 0.09 (t=3.61) respectively, at low levels of ownership

concentration. At high levels of ownership concentration, teh slopes are -0.04, -

0.10,. The results reflects the hump-shaped relation between ownership

concentration and firm performance. Especially, the results provide strong

evidence of the rapid increase in ownership concentration at lower levels. The non-

linear hump-shaped relation of the present study is completely matched with

Belkaoui and Pavlik (1992), Xu and Wang (1999) on China. The results provide

some empirical support for the hypothesis that as ownership concentration

increases; the positive monitoring effect of concentrated ownership first dominates

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but later is outweighed by the negative effects, such as the expropriation of

minority shareholders.

6. Conclusion

The possible impact of ownership concentration on firm financial performance has

been a central question in research on corporate governance, but evidences on the

nature of this relationship has been decidedly mixed. While some theories and

empirical investigations suggest that ownership concentration affects firm financial

performance, some others suggest the irrelevance of the relationship between

ownership concentration and firm financial performance.

This study investigates the relationship between ownership concentration and firm

financial performance. Using panel data for 64 publicly listed companies on the

Saudi Stock Exchange (SSE), over the period 2006-2008, the study finds that firm

performance improves as ownership concentration increases. The empirical

findings in this study shed light on the role ownership structure plays in firm

financial performance, and thus offer insights to policy makers interested in

improving corporate governance systems in an emerging economy such as Saudi

Arabia. This finding is consistent with the prediction of agency theory revealing

that lower level ownership concentration has negative performance effect, while

higher level has positive effect. Explanatory power of other governance and

control variables of the models also produce expected results.

The data also provide strong evidence that there exists a hump-shaped relationship

between ownership concentration and firm financial performance, in which firm

performance peaks at intermediate levels of ownership concentration. The finding

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provides empirical support for the hypothesis that as ownership concentration

increases, the positive monitoring effect of concentrated ownership first dominates

but later is outweighed by the negative effects, such as the expropriation of

minority shareholders. Given substantial ownership concentration in Saudi firms,

the influence of controlling shareholders can lead to the expropriation of minority

shareholders. Although Saudi Arabia has made significant progress in legal and

regulatory reforms, the current legal framework is still deemed to be too weak to

prevent the expropriation of minority shareholders.

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