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1 C h i n a A c c o u n t i n g a n d F i n a n c e R e v i e w Volume 13, Number 3 September F23 F270 F272 * JJD shaofei_w@yahoo.com.cn

2 47 (Claessen et al., 2000 Faccio and Lang, 2002 La Porta et al., 1999) 2005 (Morck et al., 2005) (Anderson and Reeb, 2003 Holderness and Sheehan, 1988 Barth et al., 2005 Morck et al., 2000 Villalonga and Amit, 2006) (Bennedsen et al., 2007 Bertrand et al., 2008 Perez-Gonzales, 2006) (Bennedsen et al., 2007 Perez-Gonzales, 2006) (tunnelling) (Bertrand et al., 2008) Burkart et al.(2003) Bhattacharya and Ravikumar(2001) (Morck and Yeung, 2004) Bertrand and Schoar (2006)

3 48 Fan et al. (2007) ( (political connection) (Fisman, 2001; Faccio, 2006) (Dinc, 2005 Khwaja and Mian, 2005; Claessens et al., 2008) (Johnson and Mitton, 2003; Faccio, 2006) Fan, Rui and Zhao (2008)

4 49 Fan et al. (2007) Fan et al. (2007) 3 4 (Alchian and Demsetz, 1972) Bennedsen, Nielsen, and Wolfenzon 2007 sudden death Johnson, Magee, Nagarajan, and Newman 1985 Salas 2010 CEO Nguyen and Nielsen 2010

5

6 51 (self enforcement) (Fan et al., 2007) Klein et al. (1978) Williamson (1979) Hayek (1945) Fama and Jensen (1983a, b) Jensen and Meckling (1992)Christie et al. (2003) 10 11

7 52 (Decision Rights (Knowledge) (Jensen and Meckling, 1992) (Leuz and Oberholzer-Gee, 2006) Williamson(1979) Fan(2000) (Ball et al., 2000 Ball et al., 2003) Leuz and Oberholzer-Gee (2006) Chaney et al. (2010) Fan, Li, and Yang (2009) Jin and Myers (2006) 12 13

8 % QIN Wind

9 (1)

10 55 (2) % % 50% % 40% 60% Claessens et al.,

11 ,318 4,600 22% 15, ,877 7,300 27% 47, ,564 9,200 28% 56,565 44,000 78% ,808 10,050 29% 108,557 98,921 91% ,455 10,500 28% 117, ,713 90% ,148 9,000 24% 111,743 89,212 80% ,960 10,221 28% 84,086 49,799 59% , ,000 40% 78, , ,890 49% 159, , ,191 47% 257, ,134 78% , ,899 70% 300, ,429 74% ,119, ,798 68% 366, ,413 68% ,200, ,330 66% 323, ,923 60%

12

13 , , % , % ,800* 243, % % , , % % , , % % , , % % , , % % ,000 1,023, % % * Wind Qin % Qin % 55.41% 48.08% 42.82% 54.89%50% Qin

14 Panel A 71, ,000 5,046,720 5,718,303 6,684,508 8,292,385 11,280,630 11,887,880 7,016 11,000 41, , , ,510 77,264 2,295, , ,800 5,762,224 6,606,328 7,440,793 7,794,527 10,215,792 12,005,850 (%) (%) Panel B , , , , , , , , ,766 16,759 22,799 28,699 54,388 69,288 23,642 23,175 37,487 5, , , , , , ,271 1,280,239 1,628,102 2,206,138 (%) (%) Panel C (%) (%) Panel D (Wind Wind (%) (%) STQin 2 Qin % Fan et al.(2007) 60% Wind % 11% 10% 5% 10% Qin % 2007Qin

15 (No.3)

16 Alchain, A. A. and Demsetz, H. (1972), Production, Information Costs, and Economic Organization, American Economics Review 62 (5): Anderson, R. and Reeb, D. (2003), Founding-Family Ownership and Firm Performance: Evidence from the S&P 500, Journal of Finance 58 (3): Ball, R., Kothari, S. P., and Robin, A. (2000), The Effect of International Factors on Properties of Accounting Earnings, Journal of Accounting and Economics 29 (1): Ball, R., Robin, A., and Wu, J. (2003), Incentives versus Standards: Properties of Accounting Income in Four East Asian Countries, Journal of Accounting and Economics 36 (1-3): Barth, E., Gulbrandsen, T., and Schonea, P. (2005), Family ownership and productivity: the role of owner-management, Journal of Corporate Finance 11 (1-2): Bennedsen, M., Nielsen, K., Pérez-González, F., and Wolfenzon, D. (2007), Inside the Family Firm: The Role of Families in Succession Decisions and Performance, Quarterly Journal of Economics 122 (2): Bertrand, M. and Schoar, A. (2006), The Role of Family in Family Firms, Journal of Economic Perspectives 20 (2): Bertrand, M., Johnson, S., Samphantharak, K., and Schoar, A. (2008), Mixing Family with Business: A Study of Thai Business Groups and the Families Behind Them, Journal of Financial Economics 88 (3): Bhattacharya, U. and Ravikumar B. (2001), Capital Markets and the Evolution of Family Businesses, Journal of Business 74 (2): Burkart, M., Panunzi, F., and Shleifer, A. (2003), Family Firms, Journal of Finance 58 (2): Chaney, P. K., Faccio, M., and Parsley, D. (2010), The quality of accounting information in politically connected firms, Working Paper. Christie, P. M. J., Kwon, I. G., Stoeberl, P. A., and Baumhart, R. (2003), A Cross-Cultural Comparison of Ethical Attitudes of Business Managers: India, Korea and the United States, Journal of Business Ethics 46 (3): Claessens, S., Djankov, S., and Lang, L. H. P. (2000), The Separation of Ownership and Control in East Asian Corporations, Journal of Financial Economics 58 (1-2): Claessens, S., Feijen, E., and Luc, L. (2008), Political Connections and Preferential Access to Finance: The Role of Campaign Contributions, Working Paper. Dinc, S. (2005), Politicians and Banks: Political Influences on Government-Owned Banks in Emerging Markets, Journal of Financial Economics 77 (2): Faccio, M. (2006), Politically Connected Firms, American Economic Review 96 (1):

17 62 Faccio, M. and Lang, L. H. P. (2002), The Ultimate Ownership of Western European Corporation, Journal of Financial Economics 65 (3): Fama, E. F. and Jensen, M. C. (1983a), Separation of Ownership and Control, Journal of Law and Economics 26 (3): Fama, E. F. and Jensen, M. C. (1983b), Agency Problems and Residual Claims, Journal of Law and Economics 26 (2): Fan, J. P. H., Jian, M., and Yeh, Y. H. (2007), Succession: The Roles of Specialized Assets and Transfer Costs, Working Paper. Fan, J. P. H., Li, Z., and Yang, Y. G. (2009), Relationship Networks and Earnings Informativeness: Evidence from Corruption Cases, Working Paper. Fan, J. P. H., Rui, O. M., and Zhao, M. (2008), Public Governance and Corporate Finance: Evidence from Corruption Cases, Journal of Comparative Economics 36 (3): Fan, J. P.H. (2000), Price Uncertainty and Vertical Integration: An Examination of Petrochemical Firms, Journal of Corporate Finance 6 (4): Fisman, R. (2001), Estimating the Value of Political Connections, American Economic Review 91 (4): Hayek, F. A. (1945), The Use of Knowledge in Society, American Economic Review 35 (4): Holderness, C. G. and Sheehan, D. P. (1988), The Role of Majority Shareholders in Publicly Held Corporations: An Exploratory Analysis, Journal of Financial Economics 20 (1-2): Jensen, M. C. and Meckling, W. H. (1992), Specific and General Knowledge, and Organizational Structure, in Werin, L. and Wijkander, H. (eds.), Contract Economics, Oxford: Blackwell, pp Jin, L. and Myers, S. C. (2006), R2 Around the World: New Theory and New Tests, Journal of Financial Economics 79 (2): Johnson, B. W., Magee, R., Nagarajan, N., and Newman, H. (1985), An analysis of the stock price reaction to sudden executive deaths: Implications for the management labor market, Journal of Accounting and Economics 7 (1-3): Johnson, S. and Mitton, T. (2003), Cronyism and Capital Controls: Evidence from Malaysia, Journal of Financial Economics 67 (2): Khwaja, A. I. and Mian, A. (2005), Do Lenders Favor Politically Connected Firms? Rent Provision in an Emerging Financial Market, Quarterly Journal of Economics 120 (4): Klein, B., Crawford, R. A., and Alchain, A. A. (1978), Vertical Integration, Appropriable Rents, and the Competitive Contracting Process, Journal of Law and Economics 21 (2): La Porta, R., Lopez-de-Silanes, F., and Shleifer, A. (1999), Corporate Ownership around the World, Journal of Finance 54 (2):

18 63 Leuz, C. and Oberholzer-Gee, F. (2006), Political relationships, global financing, and corporate transparency: Evidence from Indonesia, Journal of Financial Economics 81 (2): Morck, R. and Yeung, B. (2004), Family Control and the Rent-Seeking Society, Entrepreneurship: Theory and Practice 28 (4): Morck, R., Nakamura, M., and Shivdasani, A. (2000), Banks, Ownership Structure, and Firm Value in Japan, Journal of Business 73 (4): Morck, R., Wolfenzon, D., and Yeung, B. (2005), Corporate Governance, Economic Entrenchment and Growth, Journal of Economic Literature 43 (3): Nguyen, B. D. and Nielsen, K. M. (2010), The value of independent directors: Evidence from sudden deaths, Journal of Financial Economics 98 (3): Perez-Gonzalez, F. (2006), Inherited Control and Firm Performance, American Economic Review 96 (5): Salas, J. M. (2010), Entrenchment, governance, and the stock price reaction to sudden executive deaths, Journal of Banking and Finance 34 (3): Villalonga, B. and Amit, R. (2006), How Do Family Ownership, Control and Management Affect Firm Value?, Journal of Financial Economics 80 (2): Williamson, O. E. (1979), Transaction Cost Economies: The Governance of Contractual Relations, Journal of Law and Economics 22 (2): % ( zfxx.haining.gov.cn

19 Fan et al. (2007) % (Fan et al., 2007) 30% 1 1. CAR1 A CAR2 A CAR3 2. Fan et al. (2007)

20 C h i n a A c c o u n t i n g a n d F i n a n c e R e v i e w Volume 13, Number 3 September 2011 Political Connections, Family Succession, and Firm Performance: A Case Study of Shanxi Haixin Steel Group* Shaofei Wang, Zengquan Li, and Qifen Zhu 1 Abstract Drawing on the theory of specific assets, this paper examines the determinants and economic consequences of the emergence of Chinese family firms. We argue that in a transit economy such as China s, where resource allocation is highly controlled by the government, political connections are a key production factor within a firm, especially for private firms. But because of high defining and enforcement costs, this intangible asset is difficult to transfer to professional managers when the founder retires, and so it remains attached to the owner of the firm. To preserve such a valuable asset within the firm, family succession will be preferred among other choices, and the negative effect of the founder s retirement on firm value will thus be attenuated by this arrangement. This case study of Shanxi Haixin Steel Group provides anecdotal evidence consistent with the above predictions. Keywords: Political Connections, Specific Assets, Family Succession CLC codes: F23, F270, F272 * This paper was supported by the National Natural Science Foundation of China (Project: ), and the Major Program of the Key Science Foundation of the Ministry of Education of China (Project: 07JJD630007), 1 Shaofei Wang, Case Center of the College of Business, Shanghai University of Finance and Economics, 20008; Zengquan Li, Institute of Accounting and Finance, Shanghai University of Finance and Economics, ; Qifen Zhu, the 8th Institute of Shanghai Academy of Spaceflight Technology, Corresponding author: Shaofei Wang, shaofei_w@yahoo.com.cn.

21 Political Connections, Family Succession, and Firm Performance 66 I. Introduction Around the world, family firms, which are characterised by family control or family management, account for a significant proportion of private companies and even of public companies (Claessen et al., 2000; Faccio and Lang, 2002; La Porta et al., 1999). In China, the development of private firms has contributed to the high growth of the economy. According to a survey by China s National Federation Committee, most private companies in China are run by family members (Huang, 2005). This family-controlled pattern transforms not only the nature of the agency conflict between managers and shareholders at the micro level, but also the mode of economic development at the macro level. Prior research, however, suggests that when a country s wealth is controlled mainly by a few wealthy families, the efficiency of resource allocation can be reduced by a lack of management skills within these families. Economic growth can also be slowed by the families objection to innovations and reforms in the existing system (Morck et al., 2005). But although family firms have attracted great attention from researchers in social and management science, we are still far from fully understanding the causes and the economic consequences of these firms. To shed light on these matters, this paper uses a case study of a Chinese private firm to analyse how the institution environment affects the formation of family firms. The importance of family succession derives from the systematic difference in firm value between family and non-family firms. Although prior empirical evidence is mixed over whether the performance of family firms is significantly lower than that of non-family firms (Anderson and Reeb, 2003; Holderness and Sheehan, 1988; Barth et al., 2005; Morck et al., 2000; Villalonga and Amit, 2006), those studies are consistent with the prediction that the performance of family firms run by family successors is significantly lower than that of non-family firms or family firms operated by the founders (Bennedsen et al., 2007; Bertrand et al., 2008; Perez-Gonzales, 2006). This lower performance is usually attributed to the poorer management skills of the family successors (Bennedsen et al., 2007; Perez-Gonzales, 2006), or else to tunnelling by family members who are involved in daily operations (Bertrand et al., 2008). Thus, it is puzzling why the founders would decide to pass their businesses on to descendants with poor management skills rather than to professional managers, or else just sell the company. Three major perspectives can be used to explain family succession, namely the institutional, cultural, and specific assets perspectives. From the institutional perspective, family firms are viewed as an alternative mechanism to the inefficient market system. For example, Burkart et al. (2003) find that when the law or judicial system do not protect the interests of shareholders very well, family succession, as an alternative mechanism to the legal system, can significantly mitigate the agency conflict between management

22 67 Wang, Li, and Zhu and shareholders; this is so even when family successors are short of management skills compared with professional managers. Using an analytical model, Bhattacharya and Ravikumar (2001) show that in an imperfect capital market, family succession becomes a reasonable choice when the founder needs to quit the company, since professional managers are usually unable to obtain sufficient funds to buy, and family members worry that firm value could be impaired by the managers self-interested behaviour. Prior studies also find that rent-seeking is important for a firm s growth and survival in an imperfect market. Blood-ties among family members thus have the advantage of reducing the high costs resulting from information leakage or interest conflicts in the distribution of rents (Morck and Yeung, 2004). Bertrand and Schoar (2006) test the institutional-perspective argument in a crosscountry study, but instead of finding evidence supporting this perspective, their evidence is consistent with the cultural perspective. From this latter perspective, founders choose descendents instead of professional managers as successors to maximise not the firm s value but the family s utility. For example, in a culture characterised by family nepotism, founders must recruit other family members to the firm, even though this may result in high operating costs. Particularly in a culture in which the family business is regarded as the legacy of the whole family, inheriting the father s undertakings becomes a social norm. Usually a father s property (i.e. the enterprise) should be inherited by the eldest son, or else be equally distributed among all children. Inheriting the father s undertakings thus well explains the reasons for family succession. Fan et al. (2007), on the other hand, propose the specific-assets perspective. They examine the family successions of 217 listed companies in Hong Kong, Taiwan, and Singapore, and find that on average the market value of the sample firms decreases by 60 per cent within five years of a succession. They argue that the decrease in value results from the low transferability of specific assets, such as the founder s reputation, or of a good relationship with the government, employees, bankers, customers, and suppliers. Because it is difficult to accurately price assets, they are not easily transferred in the market; although they can be partly transferred to the founder s descendants through blood-tie connections, most of them remain untransferable. This paper provides empirical evidence consistent with the specific-assets perspective. Specifically, we find that the likelihood of family succession increases with the extent of asset specificity. Since the vast majority of private firms in China were founded during the early period of the opening-up reform, large-scale successions will begin to occur in five to 10 years from now. According to survey data, family succession with ownership and management transfers is a common practice among private firms in China (Chen and Xu, 2003). Prior literature has provided some explanations for faamily succession in China from the institutional and cultural perspectives (see relevant literature compiled by Li et al. (2005)). Of interest is that in many cases of family succession in China, we do not

23 Political Connections, Family Succession, and Firm Performance 68 observe a significant decrease in firm value, unlike the findings from Western research. 2 Moreover, none of the existing theories can explain this finding. We argue here that it is related to China s unique institutional environment, which is characterised by close relationships between firms in the private sector and the government. In emerging markets, political connections are an important intangible asset that affects a firm s performance and development (Fisman, 2001; Faccio, 2006). For instance, firms with political connections are more likely to have access to bank loans or to loans at lower interest rates (Dinc, 2005; Khwaja and Mian, 2005; Claessens et al., 2008), and to receive government grants when they are in financial difficulty (Johnson and Mitton, 2003; Faccio, 2006). But these political connections are essentially a kind of personal connection or private relationship between firm operators (such as executives or natural person shareholders) and government officials; furthermore, they are always based on bribery, political contributions, or blood relationships and are maintained by the establishment of trust during long-term operations. Consequently, if anyone should quit, the relationship will end. For example, by examining corrupt government officials in China, Fan et al. (2008) find that when officials are arrested on corruption charges, those private firms that have established personal political connections will lose their advantage. But compared with hiring professional managers, family succession is more likely to maintain that trust, even though the very personal nature of the trust means it cannot be completely transferred to the successor. This partial transfer of political connections during a family succession thus in part explains the decrease in firm value observed in such cases. Unlike Fan et al. (2007), we focus on the effect of impersonal political connections in family successions rather than personal ones. In China, connections between many private firms, especially large private firms, and the government are built not on personal relationships with government officials, but for impersonal reasons, such as the private firm s importance to local economic and social development, which in turn benefits the political careers of government officials. As the reform of state-owned enterprises (SOEs) gains impetus, private firms are playing an increasingly important role in China. In many counties or municipal regions, some large private firms have become a pillar of the local economy, bearing social responsibilities of employment, taxation, and other 2 For example, Junyao Wang, the founder of Junyao Group, was replaced by his younger brother Junjin Wang, when he died in As a non-listed company, the firm s financial information was not available, but the prominent changes in its operating performance were still evident in the Forbes China Rich List. According to a provisional purchasing announcement of Wuxi Commercial Mansion Ltd (code on the Shanghai Stock Exchange), Junyao Group s total and net assets were 845 million and 324 million renminbi on 22 September 2004, respectively, but the group was not listed in Forbes China. In 2006, two years after Junyao Wang s death, the group was listed in Forbes China for the first time and was ranked 204th with a value of 1.6 billion renminbi, which thereafter increased to 3.1 billion renminbi in It can be roughly concluded that, similar to the case of SHSG, Junyao Group s performance was not negatively affected by the family succession.

24 69 Wang, Li, and Zhu economic and social development tasks in the region. 3 At the same time, private firms also depend on the local government s monopolistic power to obtain access to resources such as land, water, electricity, and financial support. The connections between the local government and private firms are thus impersonal, and their value derives from the government s monopoly over resource allocation and the imperfect incentive arrangement for government officials. Therefore, the instability of institutions and policies in an emerging market makes it difficult to accurately price impersonal political connections, resulting in high ownership transfer costs as well as monitoring costs if professional managers are hired. 4 Family succession will thus become the optimal choice in this situation. Meanwhile, it is the impersonal characteristics of this political connection that will limit the downward change in firm value after the family succession. Because of the short history of Chinese family firms, 5 we are unable to construct tests with a large sample. Therefore, we use a case study to develop implications for future studies. We choose Shanxi Haixin Steel Group (SHSG) in this study for two main reasons. First, as the largest private enterprise in Shanxi Province, SHSG has received wide attention from the public. In particular, the media reported many stories on the sudden death of its founder, Haicang Li, and the following quick succession by his young son. All these reports provide us rich material to conduct the study. Second, the sudden death of the founder and the following family succession addresses the concern over endogeneity issues when examining the association between family succession and firm performance after a succession. 6 Our analysis shows that SHSG built a reciprocal relationship with the local government. The local government provided SHSG with many forms of policy support, including matters of land and taxation. In return, SHSG helped the local government meet economic and social development objectives, such as dealing with employment problems, fulfilling the public budget, and making infrastructure investments. This invaluable relationship was so immeasurable and so closely attached to the ownership that the founder s son, Zhaohui Li, who had no business experience at all, was quickly chosen successor after his father s sudden death. 7 And because the firm 3 For instance, SHSG s annual pre-tax profit and employment accounted for about 50 per cent of Wenxi County s fiscal revenues and 20 per cent of the county s total employment. 4 The ever-changing characteristics of China s institutions are manifested primarily at two levels: the central government (e.g. the extent of decentralisation continuously changes), and the local government (e.g. the local government s focuses and targets also frequently change over time). 5 Our sample consists of family firms in mainland China. Since the retirement age in China is normally 60, the entrepreneurs in our sample will retire in 10 to 20 years on average. 6 Bennedsen, Nielsen, and Wolfenzon (2007) have a review paper addressing the issue of using timeseries and cross-sectional data. In particular, they raise a concern about the credibility of such studies because of the endogeneity problem. Many studies have thus popularly adopted sudden death to solve this problem, such as research on the value of CEOs and founders (Johnson, Magee, Nagarajan, and Newman, 1985; Salas, 2010) and independent directors (Nguyen and Nielsen, 2010). 7 Family succession in this paper means the choice of management rather than the legal distribution of the founder s legacy. Facing the sudden death of the founder, the successor has three choices: (1) sell his/her shares in full and receive cash, (2) hire professional managers to run his/her company and obtain dividends, or (3) serve as the general manager by herself/himself. Using a real case, this paper aims to examine how the successor will make such a choice when the firm has strong political connections.

25 Political Connections, Family Succession, and Firm Performance 70 continuously received support from the local government, its performance remained the same after the succession. This paper not only enriches the literature on corporate governance in family firms, but also has implications for facilitating the development of private firms in China. Our analysis shows that family succession is a rational response to government intervention in the private sector. The choice of family succession, however, ignores the role of management skills in business operations. Furthermore, considering the long history of the population-control policy in China, usually only one child is available to inherit the business when the founder retires; thus the chances that the successor will have high management skills become even slimmer. We predict that the effect of political connections on firm value will be weakened as the government s power over resource allocation continues to shrink and the role of the market in the economy expands. Management skills may then eventually become a major consideration in determining the business succession. The rest of the paper is organised as follows. Section II provides a theoretical analysis of the relations among political connections, family succession, and firm performance. Section III briefly describes the background of SHSG, including its current performance and the family succession. Section IV presents the case study of SHSG, and the last section concludes. II. Theoretical Analysis 2.1 Political Connections, Specific Assets, and Family Succession With the continuous progress of the market-oriented reforms, the business environment for private firms in China has improved significantly in recent years. But compared with SOEs, private firms have more disadvantages in many areas, including access to basic resources such as water, electricity, coal, land, and capital, and taxation treatment (Huang, 2005). 8 Because of the government s monopoly on resource allocation in China, private entrepreneurs are willing to build close relationships with the government to offset the above disadvantages. This relationship can be built either on private relations between the entrepreneur and government officials, or on the organisational relations between the firm and the government. In reality, the former is built on the rent-seeking ability of officials, which is usually illegal, and so the relationship can be maintained only through personal trust. In contrast, the latter is formed based on the government s control over resource allocation, which is legal, 9 so that the personal identities of the involved parties do not matter in maintaining the relationship. 8 The disadvantages of private firms in resource allocation are further reinforced by the market s response to government intervention. For example, Sun et al. (2005, 2007) find that the preferential treatment enjoyed by SOEs in obtaining bank loans arises from the government s soft budget constraints instead of its direct intervention in issuing bank loans. 9

26 71 Wang, Li, and Zhu Because prior studies have already examined personal political connections and their effect on family succession (Fan et al., 2007), this paper focuses on the other type of political connection, namely the impersonal. When entrepreneurs establish close relationships with the government, they usually expect to receive the government s support in obtaining economic resources such as land and capital. In return, the government expects the firms to contribute to the local economy. But neither the support nor the contributions are made instantly; instead, they are continuously honoured throughout the long-term relationship. Once the government devotes resources to a private firm, it is possible that the firm will default on its implicit commitment; for example, it may refuse to hire redundant staff for considerations of efficiency, or it may hide profits to avoid taxes. 10 If this occurs, it becomes very hard for the government to transfer its investments to other firms. Similarly, once a private entrepreneur provides employment and taxes for the local government, it is unlikely to withdraw its input when the government dishonours its own commitments. 11 The literature indicates that implicit contracts cannot be enforced by law or formal mechanisms, and the more specific assets that are involved in the transactions, the more likely the parties will be integrated to share the assets (Klein et al., 1978; Williamson, 1979). In particular, when an SOE is involved in the transaction, the government acts as both parties, and so ownership is automatically integrated. But for private firms, although the government cannot become owner of the firm by law, it can share some of the firm s property rights in other ways, such as through the business registration system and participation in the decision-making process. According to China s current regulations on business registration, the government is supposed to collect taxes from firms that are registered in the same district. As a result, the government and the entrepreneurs jointly share the firm s earnings, thereby creating impersonal connections. Although the government s direct involvement in a firm s operation is quite costly, it is still an optimal choice to protect its interest in the firm when asset specificity increases in the relationship. The above analysis shows that when impersonal political connections exist in private firms, the founder s retirement will not affect the value of political connections. Hence, family succession will not necessarily lead to a decrease in firm value. 2.2 Political Connections, Specific Assets, and the Family Business Although the importance to private firms of impersonal political connections is emphasised above, this does not mean that we can ignore the crucial role played by management skills in a firm s operation. Facing the founder s retirement and a lack of 10 The government can withdraw the resources it has granted to enterprises. For example, it could terminate preferential tax policies or franchise licensing. But the realised economic benefits cannot be taken back. 11 Companies can also suspend their contributions to the local government, such as dismissing redundant employees, but cannot recover the incurred costs.

27 Political Connections, Family Succession, and Firm Performance 72 experience and management skills in family members, is it appropriate for the firm to hire professional managers? The rest of this section explores this question using the theory of decentralisation (Hayek, 1945; Fama and Jensen, 1983a, 1983b; Jensen and Meckling, 1992; Christie et al., 2003). According to this theory, decision rights should be transferred to persons with specific knowledge so that the maximal value of resources can be finally achieved. 12 In reality, either non-specific knowledge should be transferred to decision makers (centralisation), or decision rights should be shifted to persons with specific knowledge (decentralisation). The former produces knowledge-transfer costs, while the latter may induce agency costs. The extent of decentralisation, then, is the outcome of minimisation of the sum of the two costs. When a political connection has a great impact on a firm s operation, the decisionmakers must possess related specific knowledge. Since the specific knowledge lies in the hands of both shareholders and the government, professional managers must obtain this knowledge from them. As the complexity of the political relationship increases, 13 the related knowledge will be more specific to the shareholder and the government, resulting in higher knowledge-transfer (Jensen and Meckling, 1992) and monitoring costs. Consequently, it will be more difficult to isolate the managers contribution to firm value from that of the political relationship. The shareholder s direct involvement in operations could then save the above two costs considerably. The next question is whether it is possible for professional managers to take over the firm s operation by purchasing shares when the founder is ready to retire. This depends on the measurability of political connections. When a firm relies heavily on political connections, it will have more uncertainties in its business environment (Leuz and Oberholzer-Gee, 2006). These uncertainties may be caused by the changeability of politicians (in the case of personal political connections) or by the instability of the local government s policies (in the case of impersonal political connections). Williamson (1979) points out that when uncertainty increases, transactions will be governed by internal authority instead of the external market mechanism. Fan (2000) supports this argument with empirical evidence from the oil industry. In addition, firms with political connections always provide information of lower quality, which invariably leads to difficulties in accurate valuation. The existing literature suggests that firms with political relationships normally lack motivation to provide high-quality financial information, since private channels rely more heavily upon communications among stakeholders (Ball et al., 2000; Ball et al., 2003; Leuz and Oberholzer-Gee, 2006; Fan, Li, and Yang, 2009; Chaney et al., 2010). From the perspective of stock-price synchronicity, Jin and Myers (2006) prove that the costs of accurate pricing will increase with the decrease 12 Knowledge in this paper includes skills and information. 13 The complexity of impersonal political connections, which can be shown in various ways, makes the value of the relationship uncertain. The greater the authority granted to officials in resource allocation, or the more frequently policies are changed, the greater the uncertainty in the relationship between a political connection and its value to the firm.

28 73 Wang, Li, and Zhu in information transparency. All these considerations suggest that it is difficult to price the shares of the firms with political connections accurately and transfer them in the market. In other words, in the above situation, the possibility of selling a firm s shares to professional managers will decrease. In the following section, we analyse the case of SHSG to test our hypothesis that impersonal political connections are associated with family succession and with more stable firm performance after succession. III. The Background of SHSG As a large private firm with business in the energy, finance, and primary education industries, SHSG is located in Dong Town, Wenxi County, Shanxi Province. SHSG was co-founded by seven legal corporations, namely Shanxi Wenxi Santie Consolidated Coking and Chemical Corporation, the Beijing Branch of China s Railway Service Company, Luoyang Railway Express Group, Henan Metallurgical and Constructional Materials Supply Corporation, Hunan Ruijin Metallurgical Ltd, Shanghai Metallurgical Furnace Charge Corporation, and Shanxi Nantie Tengfei Industry and Trade Corporation. At present, 14 the company possesses total assets of 12 billion renminbi, and an annual productivity of 1 million tons of coke, 5.6 million tons of iron, 6 million tons of steel, 2.6 million tons of materials, and 2.6 million tons of slabs. The group is ranked among the world s top 160 metallurgical companies, and among the top 500 industrial corporations, top 30 private enterprises, and top 50 iron and steel and metallurgy companies in China. It is also the largest private company and the second largest iron and steel enterprise in Shanxi Province. Wenxi Santie Consolidated Coking and Chemical Corporation, SHSG s predecessor, was founded in May 1987 by Haicang Li, Cunhai Xin, Lanyun Hou, and a local stateowned enterprise, White Cement Plant. The company realised a pre-tax profit of 100,000 renminbi in the first year. In 1989, with an initial investment of 600,000 renminbi, Haicang Li and Sanmenxia jointly founded a factory that achieved a production capacity of 100,000 tons and a pre-tax profit of 13 million renminbi in the first year. In 1990, the factory was merged with Santie Coking and Chemical Corporation to form Wenxi Santie Consolidated Coking and Chemical Corporation, which achieved a productivity of 260,000 tons in early In September 1992, Haicang Li founded Shanxi Haixin Iron and Steel Ltd jointly with several metallurgical bureaus and railway units. In August 2002, SHSG was established upon the approval of the Trade and Industry Bureau of Shanxi Province with a registered capital of billion renminbi, in which the investment of Shanxi Haixin Steel Ltd accounted for per cent. By the end of 2002, SHSG had grown into a large company with total assets of billion renminbi, net assets of 2.43 billion renminbi, annual sales of billion renminbi, net profits of The data are taken from the SHSG website (

29 Political Connections, Family Succession, and Firm Performance 74 million renminbi, and pre-tax profits of 454 million renminbi, and had hired more than 7,500 regular employees. 15 In January 2003, Haicang Li was killed by a villager, Yinliang Feng, in his office at the age of 48. Thus, SHSG s prominent impersonal political connections and its founder s sudden death qualify the case as a good experiment to examine how political connections affect family succession in private firms. According to the theoretical analysis, we expect that SHSG s owner would become the company s operating manager and the group s performance would remain almost the same after the succession. Data used in the paper are taken from the following sources: financial data from the QIN Database, CCER Database, and Wind Database; local government financial data mainly from The Shanxi Statistical Yearbook and China InfoBank The Statistical Database; and the remaining data mainly from China InfoBank China Business Report Database, China InfoBank China Economic News Library, the CNKI Database, and other major types of newspapers and periodicals. IV. Case Study 4.1 SHSG s Political Connections In China s unique institutional environment, the numerous honorary titles of its founder and of SHSG itself can be regarded as initial evidence of strong political connections. For example, Haicang Li, the founder and chairman of SHSG, served as a vice president of the Chinese Industrial and Commercial Association, a committee member of the Ninth Chinese People s Political Consultative Conference (CPPCC), vice president of the Industrial and Commercial Association in Shanxi Province, vice chairman of the Standing Committee of the National People s Congress (NPC) in Yuncheng City, president of the Industry and Commerce Federation of Yuncheng City, vice president of the Association of Township Enterprises, and vice president of the Society for Promotion of the Guangcai Program both in Shanxi Province and Yuncheng City. Moreover, he was selected National Model Worker twice, awarded the National Labour Medal, and acclaimed Meritorious Entrepreneur of Shanxi for three consecutive years. In 2007, the brand name Haixin was awarded the title Chinese Renowned Trademark, and SHSG was awarded the following titles: National Advanced Export Enterprise, National Environmental Protection Advanced Unit, National Top Ten Quality Inspection- Free Company, National Preferred and Quality-Assured Enterprise in the building materials industry, National Advanced Unit in township enterprise management, National Township Enterprise Science Park, Major Protected Enterprise in Shanxi Province, The Outstanding Private Enterprise in Shanxi Province, and Exemplary Taxpayer in Shanxi. 15 The data are taken from the article Uncovering the Mysterious Veil of Haicang Li s Wealth: An Investigation into SHSG, which was originally published in China Business Times, reprinted on Xinhua Net on 26 February 2003, and recorded in the CNKI database.

30 75 Wang, Li, and Zhu To answer the question of whether political connections lie behind these honorary titles, we conduct the following analysis from two perspectives: the local government s support of SHSG, and SHSG s contributions to the local government Local Government Support for SHSG Taxation and Other Fundamental Resources In 1987, as a new township enterprise, SHSG was given considerable support by the local government, such as exemptions from product taxes and fixed-asset investment taxes, in the first year of its founding. Subsequently during the years of its development, SHSG enjoyed preferential policies to the full. 16 For example, Haixin Steel Rolling Company, one of three major subsidiaries of SHSG, earned a total profit of 239 million renminbi, while it was exempted from income tax of 79 million renminbi and from fixedasset investment tax of 87 million renminbi, during the three years before the death of Haicang Li. SHSG also received many other forms of support from the local government, such as land use rights, electricity, and water supply. In 2002, the government assigned experts to help the group expand its water supply area, 17 but many severe difficulties were encountered in implementing the project. For instance, the ditch was designed to go across several counties, agricultural land, earth graves, and even houses in Shanxi Province. Yet, the government finally enforced the project. 18 As Dong Pengxiang (the party committee secretary of Wenxi County) said in a media interview in 2003, 19 the deputy county governor was assigned to be in charge of electricity supply and land problems for SHSG, because if SHSG tried to plant the ground poles in farmers land by itself, the villagers would try to extort the company. We even made the greatest efforts to grant SHSG acres of land, which almost reached the ceiling of our provincial authority, which was 300 acres. Moreover, according to relevant reports, 20 since 1996 Wenxi County had allocated 5 million renminbi to SHSG per year from its fiscal revenue as a reward to encourage the company s growth. In addition, the local government granted financial aid to the 30 external technicians employed by SHSG and the 160 internal skilled workers trained by SHSG. 16 The data are taken from the article Behind the Murder Case of Haicang Li, published in Life Magazine, and reprinted by Sohu Net on 10 April The data source is the same as in Note 16. We assume that the types of support come from a municipal or provincial government, although the data do not clearly indicate the level of government support. 18 The data source is the same as in Note 16. According to the reports, in 1996, during its second growth period, SHSG was granted 296 acres of land (almost the annual quota of Shanxi province, 300 acres) by Wensheng Sun, the governor of Shanxi Province. In 1997, the group started its fiveyear development plan, which was fiercely opposed by local citizens over conflicts concerning land compensation issues. Finally, the dispute was settled jointly by local government entities, including the County Party Committee, the County NPC, the County Government, and the County CPPCC, together with Shuicheng Wang, the secretary of the County Party Committee. 19 The data are taken from Family Succession in China-Style, written by Jianqiang Liu and Jie Bian, and published by CITIC Publishing House in May The data source is the same as in Note 16.

31 Political Connections, Family Succession, and Firm Performance Support of Bank Loans SHSG s prominent political connections are also reflected in its support from local banks. 21 During the period 1987 to 1997, the Agricultural Bank of China issued loans of 117 million renminbi to SHSG; 22 by the end of 2002, 23 total credits and mortgage loans received by SHSG amounted to billion renminbi, accounting for 40 per cent of its total assets that year. These loans were issued by the Haixin Wenxi Branch of Industrial and Commercial Bank of China, the Wenxi Branch of the Agricultural Bank of China, the Yuncheng Branch of the Industrial and Commercial Bank of China, and other financial institutions in Yuncheng City. The above analyses thus clearly describe the indispensible role played by the local government in SHSG s development. Telling the story of SHSG in an interview in Family Succession in China-Style after Haicang Li s death, Chunyuan Li, his father, said, Without support from the government, you will accomplish nothing, even if you have infinite talent and energy SHSG s Contributions to the Local Economy and Social Development A prior study (Xia et al., 2005) shows that since the implementation of economic decentralisation reform in China, local governments at all levels have transformed themselves from executive bodies of the central government to independent economic entities. This transformation has given them strong incentives to achieve economic goals through various measures, including building close and interdependent relationships with local enterprises. According to reports from the Xinhua Net, during the period of the Eighth Five- Year Plan, Wenxi County, where SHSG is located, was well known as a national-level poverty-stricken county. But because of the rapid rise of SHSG, which promoted the development of local interrelated township businesses in the early 1990s, its poverty and backwardness label was later removed, and since 2003 it has consistently ranked first on the list of the top 100 private enterprise tax-payers in China. 24 Dong Town was first to gain huge wealth and prosperity among all the towns in Wenxi County, while Chuankou Village, adjacent to Dong Town, was acclaimed the Best Village in the Eastern River. Table 1 compares key statistical data of Wenxi County for recent years with those of SHSG. 21 It is easier for companies with political connections to gain access to bank loans in an emerging market, which may be the result either of the government s direct involvement in resource allocation, or of the market s rational response to government intervention. (Sun et al., 2005; Sun et al., 2007; Claessens et al., 2008). 22 The data are taken from the Financial Times, 13 June The data are taken from the article Revealing the Truth of SHSG: 3 Billion in Debt to the Banks, published in 21st Century Business Reports, 23 February The data are taken from the People s Daily (14 September 2004) and other media reports.