The Value of Political Connections in Corporate Bailouts
To the tune of 450 million euros, the French government approves “rescue aid” to Groupe Bull SA, a technology company that has run into financial difficulty.
PHOTO: Mara Faccio, Associate Professor of Management (Finance)
In Canada not long after September 11, 2001, the federal cabinet approves $200 million in emergency financial aid to that country’s struggling airline industry.
In Thailand in 2002, the government provides troubled Bangchak Petroleum with a $140 million “capital injection.”
In Malaysia, the purchase of shipping assets belonging to a debt-laden firm, Konsortium Perkapalan, is viewed so suspiciously by the market that the country’s finance minister is moved to deny publicly that the transaction is a bailout. Fueling the doubts: Konsortium is controlled by the prime minister’s son.
All of these deals, spread across three continents over a six-year span, have one thing in common: They involved government aid bestowed on companies with powerful political connections.
The idea that companies with friends in high places would receive more aid than similarly situated businesses lacking such connections may not seem surprising to anyone familiar with stories of K Street lobbyists in Washington, D.C. But until Professors Mara Faccio and Ronald Masulis of Vanderbilt and John J. McConnell of Purdue set out to examine the dynamics of corporate bailouts in a more systematic way, researchers had not probed much beyond the anecdotal evidence that connections translate into opened checkbooks.
Faccio, Masulis and McConnell carefully studied which companies are — and are not — receiving public handouts when they encounter financial trouble. Do “connected” firms really reap the lion’s share, or is it more of a myth? They also asked a number of other questions. They wondered, for example, who ultimately benefits from bailouts by government. What effect does this largess have upon the performance of the recipient companies? What effect, if any, do global lenders such as the World Bank and International Monetary Fund, exert upon these transactions? The professors’ jointly authored research paper, “Political Connections and Corporate Bailouts,” sheds new light on all of these questions.
Faccio, Masulis and McConnell studied 458 politically connected firms, along with a set of matching peer firms, over a six-year period from 1997 through 2002. They examined 71 bailouts in 35 countries, from the United States and Canada to Western and Eastern Europe to “Asian Tigers” such as Thailand, Malaysia and Taiwan. Relying on media reports on bailouts, they looked into companies they defined as “politically connected” (one of its top officers was a head of state, government minister or — like Italian senator Giovanni Agnelli, chairman of the board of IFI, the holding company for Fiat — a member of the national parliament). They also scrutinized firms with “indirect connections” and “close relationships” that involve family or friendship ties between top officers and top government officials (in the case of the Malaysian shipping firm noted above, for example, board chairman Mokhzani Mahatir is the son of Malaysia’s prime minister). Fifty-one of the 71 bailouts involved connected companies; the other 20 involved companies without close connnections.
Through their research, Faccio, Masulis and McConnell found a notable correlation between such connections, both direct and indirect, and the likelihood that the connected firm would receive financial assistance. In fact, companies with connections were almost three times as likely to receive government assistance — in the form of direct cash payments, purchases of newly issued debt or equity, government-subsidized loans, loan guarantees, tax relief tied to the bailout and government purchases of company assets — than their unconnected peers. In addition, connected firms were bailed out more often than those without high-level connections; several of these companies received assistance more than once during the six-year period the researchers studied.
Connected firms also on average borrowed more money, more often, from private sources than their counterparts without good friends in high places. And after the bailouts occurred, the connected companies actually increased their leverage ratios, winding up with even larger debt over a two-year span. In contrast, non-connected firms that received assistance on averaged experienced declining leverage ratios after their bailouts.
These findings, in turn, raise another set of questions: Why would lenders be willing to extend credit to companies whose financial problems suggested they were poor credit risks? And why would they offer these loans — as the researchers found they frequently did — at terms no more unfavorable than they extended to healthy companies?
Though the research did not seek to resolve these questions, the findings were suggestive nonetheless. “If creditors expect that a risky or distressed company is likely to receive a bailout,” says Professor Faccio, “they may be more willing to extend credit on terms more favorable to that company. They anticipate that, even if the firm defaults, the government will repay the loan. So lending to these companies effectively becomes almost risk-free.”
The researchers, who limited their study to reports on corporate bailouts available in English-language media, found that government assistance encompassed a wide variety of industries, countries, governments and economies. They included highly developed nations, such as the U.S. and Germany, as well as less developed countries such as Indonesia. They include countries ranging in GDP per capita from Luxembourg ($33,450) to India ($1,939). They include countries with very different measured degrees of corruption, ranging from Denmark at the low end (as measured by the Kaufman Index) to Indonesia. And the connected firms in these countries come from a broad array of industries, including: consumer durable goods, construction, financial services, basic industry, transportation, utilities, textiles, and petroleum.
Ten of the 35 countries represented had at least 10 politically connected firms: the UK, Malaysia, Thailand, Japan, Indonesia, Italy, Singapore, France, the United States and Germany. However, neither the number of connected firms in a country nor the country’s level of corruption bore a consistent relationship to the likelihood of receiving a bailout. For example, several of the nations within the study that ranked highest on the corruption index — Russia (6.23), Indonesia (6.60), Thailand (5.33) and the Philippines (5.46) — also had among the highest percentages of connected companies that received bailouts. However, in other high-corruption countries such as India (5.61), Mexico (5.55) and Turkey (5.70), none of the connected companies in distress received assistance. In fact, in India and Germany, connected firms were actually less likely to receive bailouts than those with close ties to the government. Meanwhile, in relatively transparent Australia, both of the firms with political connections were bailout recipients. While Japan and Malaysia rank similarly in terms of corruption, 17 of the 81 connected firms in the latter received bailouts, compared to none of the 30 connected Japanese firms in the study.
In countries that received aid from the World Bank or IMF, government bailouts were much more likely to occur. In fact, both the connected and unconnected firms in these countries were roughly four times as likely to receive bailouts as were even the well connected companies in nations that did not receive any funds from the international lending institutions.
Perhaps, suggests Faccio, the strong correlation between government bailouts and IMF/World Bank aid is simply a reflection of the larger economic difficulties within those nations that led to foreign financial intervention in the first place. In these countries, after all, many companies are likely to be distressed — thereby representing a cause for foreign aid rather than an effect of it.
“However,” Faccio says, “what we found disturbing is that, when aid was given, most of that money went to connected firms rather than being more equally split among all of the country’s distressed companies. This finding bolsters a frequent criticism of the World Bank and IMF: that the aid is largely being used merely for the benefit of the family and friends of politicians within the recipient countries.”
Most significant of all, Faccio, Masulis and McConnell found that the well connected firms that were bailed out were less likely than their non-connected peers to use their financial infusions to good effect. Both before and after their bailouts, the companies with connections underperformed matching firms in similar circumstances. By the second year following the bailouts, the politically connected companies in the study recorded an industry-adjusted mean return on assets of –6.19% and a median of –3.84%. Meanwhile, their non-connected firms that received bailouts experienced mean and median industry-adjusted ROAs of +0.43% and +0.74%, respectively. The non-connected firms also enjoyed better debt positions — suggesting that their superior financial performance enabled them to repay portions of their loans sooner.
Does the poor performance of politically connected companies make bailouts irrational? Not necessarily, Faccio suggests. Though the researchers acknowledge that their study did not pinpoint the ultimate beneficiaries of the system of political connections and bailouts, Faccio notes that politicians, who may be able to extract all or most of the rents from borrowers and lenders, could be the biggest winners. But shareholders also win when their bailed-out companies are able to borrow on favorable terms that the market otherwise would not have bestowed. And private creditors who lend to risky companies can benefit if tacit understandings with governments mean that loans are essentially risk-free.
Especially with large companies — and the researchers found that connected companies that received bailouts were significantly larger than their unconnected counterparts — government assistance may reflect politicians’ desire to “buy votes.” Leaders may also regard bailouts of certain companies, as in the cases of Air Canada and U.S-based Lockheed-Martin, as important for the economy or key industries such as transportation and defense.
However rational the motivations of politicians, shareholders and lenders might be, however, this research makes at least one conclusion almost inescapable: From a market perspective, bailouts of politically connected companies are poor investments. “Assuming that capital markets channel funds to their highest value uses,” write Faccio, Masulis and McConnell, “and that firms receiving bailouts are firms to which other capital market participants are unwilling to provide capital, the implication is that bailouts of connected firms are even more wasteful than bailouts in general….[And] to the extent that bailouts of politically connected firms undermine the role of capital markets in allocating capital, they are likely to have an adverse impact on economic growth.”
This article was reprinted from Vanderbilt Business, Fall 2006.
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Published 2/15/07 in OWENintelligence
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