In our paper How Does Law Affect Finance? An Examination of Equity Tunneling in Bulgaria, which was recently accepted for publication in the Journal of Financial Economics, we provide a simple model which unbundles different forms of “tunneling”, the extraction of firm value by a firm’s controlling shareholders or managers, and derive how each affects firm profitability and valuation. We develop the model partly to extend existing models of tunneling, but primarily to develop predictions which we can test using a natural experiment in Bulgaria, provided by 2002 anti-tunneling reforms.
Bulgaria went through mass privatization in 1998, which was followed by extensive equity tunneling. The 2002 legal changes limit both dilution and freezeouts, and allow us to examine how specific rules can affect specific forms of tunneling, firm valuation, and firm profitability. We model and study empirically two flavors of equity tunneling: dilutive equity offerings (issuance of shares to insiders at below market value); and freezeouts (forced sale of minority shares to the controller for below market value). We find that following the change, minority shareholders participate equally in secondary equity offers, where before they suffered severe dilution; and freezeout offer prices quadruple. At the same time, return on assets declines for high-equity-tunneling-risk firms, suggesting that controlling shareholders partly substitute for reduced equity tunneling by engaging in more cash-flow tunneling. The 2002 legal changes, and controllers’ responses to them, also affect market values. Tobin’s q levels rise sharply for high-equity-tunneling-risk firms relative to low-risk firms, despite the increased cash flow tunneling in high-risk firms. These results are economically large and robust to different ways of estimating tunneling risk, and different valuation measures (price/sales, price/earnings and market/book value of equity).
Our results have implications for asset pricing research in emerging markets. In high tunneling risk markets, investors must estimate not only expected cash flows (as in any market) but also tunneling risk. We find evidence that equity tunneling risk varies widely in cross-section, and that Bulgarian investors consider this risk and update their valuation estimates when legal rules change. Equity tunneling risk, as a factor in explaining equity prices and expected returns, can complement some commonly used factors, such as market risk and momentum, and interact with others, such as firm size and book/market ratio. Size may correlate with tunneling risk (as we confirm below for Bulgaria), and high book/market ratios could reflect high tunneling risk. Investor pricing of equity tunneling risk factors can also help explain home country bias, as local investors may be better equipped to evaluate equity tunneling risk at the firm-level.
The full paper is available for download here.