CORPORATE GOVERNANCE AND POLITICAL PERFORMANCE: THE ROLE OF INTERNAL PROCEDURES IN THE EXTRACTION OF ECONOMIC RENTS FROM
POLITICAL MARKETS
Alberto Bosco (11956224)
Supervisor: dr. Ilir Haxhi
Second Reader: dr. Francesca Ciulli Master’s Thesis in International Management
June 22th, 2018
Statement of Originality
I hereby declare that the text and work presented in this document are original and that no sources other than those mentioned in the text and its references have been used in creating it. The faculty of Economics and Business is solely responsible for the supervision of the work, not for its contents.
Abstract
Prior literature on non-market strategies such as corporate political activity (CPA) has often provided conflicting and incomplete empirical evidence for firms’ ability to extract economic rents from political markets. Moreover, by aggregating the CPA strategies into a single construct, it has on the one hand overlooked potential differences between the type of political resource exchanged in different strategies and on the other, it has paid limited attention to corporate governance (CG) mechanisms, i.e. board independence and stock compensation, which are linked to managerial motives and likely to influence corporate financial performance (CFP). This study argues that the type of political resource exchanged is likely to affect CFP in distinct ways, and that internal procedures that aim at minimising agency, i.e. CG, will affect the political performance of CPA strategies. We address these gaps by testing the direct effect of CPA on CFP as well as the moderating role of CG mechanisms for a panel dataset comprising 635 US listed firms for the period 2010-2017. Our results show three main findings, which are robust to firm, time and industry fixed effects. First, when excluding CG mechanisms associated with minimized agency costs, information CPA strategies are negatively associated with CFP. The opposite is true for financial incentive CPA strategies. Second, monitoring and bonding CG mechanisms mitigate both effects. Therefore, firms with stronger CG, and potentially greater principal-agent alignment, experience different degrees of political performance when engaging in financial incentive versus information CPA strategies. These findings shed light on the nexus linking CPA and CG to CFP, yielding several research directions and emphasizing the value of microeconomic and behavioural arguments in this growing field of management research.
Keywords: non-market strategies, corporate political activity, corporate governance, corporate financial performance, agency theory, stakeholder theory
Table of Contents
1. Introduction 5
2. Literature Review 10
2.1. CPA and Political Rent-Seeking 10
2.2 Implications for Firm Performance 13
2.3 Corporate Governance and the Role of Agency 17
2.4 CPA and Corporate Governance 20
3. Theoretical Framework 22
3.1 Corporate Political Activity and Financial Performance 22
3.2 Corporate Governance and Political Performance 24
4. Hypothesis Development 26
5. Methods 30
5.1 Data and Sample 31
5.2 Models 32
5.3 Independent Variable 34
5.4 Dependent Variables 34
5.5 Moderating Variables 35
5.6 Controls 35
5.7 Data Analysis and Preliminary Estimations 36
6. Results 39
7. Discussions 43
7.1 Findings 43
7.2 Theoretical Contributions 43
7.3 Managerial Implications 46
7.3 Limitations and Future Research Directions 47
8. Conclusion 50
9. References 53
1. Introduction
In recent years, the rising degree of socio-economic complexity and embeddedness of financial markets have propelled the rate of change in private enterprise, fostering the demand for public policy (Ghemawat, 2001; Scherer, Palazzo and Baumann, 2006; De Bakker et al., 2013). For this reason, a growing number of firms have attempted at favourably shaping their non-market environment by engaging in non-market strategies such as CPA, defined as the interaction between firms and government aimed at nurturing institutional approval through the acquisition of political resources (Hillman, 1999; Oliver and Holzinger, 2008; Hond et al., 2014). Yet, from a shareholder perspective, the interaction with the public policy process has been shown to yield conflicting results in terms of firms’ ability to extract economic rents from political markets (Hillman et al., 2004; Hadani, 2012; Dahan, Hadani and Schuler, 2013). As a result, several scholars have paid increasing attention at the nexus linking corporate political activity (CPA) to corporate financial performance (CFP).
Assuming that some firms are able to appropriate economic rents from the political environment, engagement therewith may be led by two motives, generally regarded in literature as the conflict-resolution1 and CEO overinvestment hypotheses. According to the first, managers pursuing their fiduciary duty to shareholders may act upon efficiency and legitimacy considerations to align political investment with firm strategy and potentially improve performance both in the short and long-term (Hond et al., 2014). By engaging in CPA strategies, the firm may seek to gain or retain the support of key stakeholders, thereby strengthening its institutional legitimacy (Ravasi and Zattoni, 2006; Jo and Harjoto, 2012, Okhmatovskiy and David, 2012), or to internalise non-market resources by securing political access in pursuit of minimising non-market risk and building a competitive advantage (Hillman, Withers & Collins, 2009). Hence, some studies suggest CPA has a positive effect on CFP, in support of the conflict-resolution hypothesis posited by stakeholder theory (Lawton, McGuire & Rajwani, 2013). On the other hand, agency theory offers several argumentations in
1 This study borrows the “conflict-resolution” hypothesis’ definition from stakeholder theory and focuses on its
microeconomic dimension to illustrate the dual agency between (1) managers and shareholders (2) managers and policymakers in determining political performance.
support of the CEO overinvestment hypothesis, holding how CEOs’ engagement in CPA may be symptomatic of managerial entrenchment and agency problems when aimed at advancing personal objectives at the detriment of shareholder value (Waddock and Graves, 1997; Domadenik, Prasnikar and Svejnar, 2016).
Several studies have thus investigated the relationship between CPA and CFP by building on stakeholder theory (ST), agency theory (AT), resource-dependency theory (RDT) and resource-based views (RBV, Hadani 2012; Dahan, Hadani and Schuler, 2013); however, the lack of theoretical consensus with respect to the expected effect of CPA on CFP suggests how this research stream is still in its infancy. Among the underexplored aspects of political markets, the literature has generally disregarded the differences between CPA strategies, which lie in the political resource that is exchanged (Hillman et al., 2004). Notwithstanding how Hillman and Hitt (1999) differentiate between information and financial incentive CPA strategies, empirical research has generally considered the two CPA strategies aggregately, neglecting the individual effect of either for the profitability of firms with different organisational characteristics. Specifically, whereas an
information strategy aims at providing policymakers with the firm’s preferences for policy and
includes tactics such as lobbying, whether in-house or external, a financial incentive strategy targets political decision-makers by providing financial inducements such as investment in Political Action Committees (PACs), which are vehicles that pool donations to campaign for candidates, initiatives and legislation. In either case, the firm aims at influencing policymaking in its favour to positively affect its profitability, e.g. hedging risks or gaining preferential access. We thus posit how information versus financial CPA strategies will affect CFP differently depending on the managerial motives underlying their CPA engagement, indicating whether CPA can be considered a calculated investment or the result of agency problems (Aggarwal, Meschke and Wang, 2012). Therefore, we address our first research question:
Managers engage in CPA strategies for several motives that are shaped by firm, industry-level and country-level antecedents (Hillman, 1999; Bonardi, Holburn and Van den Bergh, 2006). Yet the conflicting evidence with respect to the association between CPA and CFP suggests an incomplete understanding of the antecedents of CPA and determinants of political performance. For this reason, interpreting the motives that underlie CPA engagement by firm’s managers stands as a precondition to explain the effect of political rent-seeking on financial performance. Accordingly, we study the underexplored microeconomic foundations of CPA by analysing the role of monitoring and bonding corporate governance (CG) mechanisms. The latter shape the alignment between managers and shareholders through supervision and incentive structures. Consequently, managerial incentives are likely to influence the motives underlying the engagement in CPA strategies, providing indication of whether CPA is aimed at extracting personal reputation gains or economic rents that reflect the firm’s strategy (Lux, Crook and Woehr, 2011; Lu, Shailer and Wilson, 2016). Therefore, different managerial motives, proxied by the strength of firms’ CG mechanisms, are expected to result in different degrees of political performance, which we define as the economic value of the rents extracted from the public policy process (i.e. the coefficient of association between CPA and CFP).
We thus hypothesise how political performance is contingent upon institutionally embedded CG mechanisms that govern the behaviour of corporate actors (i.e. shareholders and managers) by mitigating agency problems (Aguilera & Jackson, 2003; Hadani, 2012). Hillman et al. (2004) distinguish between two CG mechanisms, i.e. monitoring and bonding. The former measure the monitoring faculties of the board (i.e. size, independence and CEO duality) and the characteristics of shareholders (i.e. the degree of institutional ownership and portfolio concentration); whilst the latter encompass the share of managerial ownership as well as the executive management’s stock compensation, bonding the interests of principal and agent. Both mechanisms result in greater alignment between the interests of managers and shareholders by minimising information asymmetries and are generally found to have a positive effect on CFP (Yermack, 1996; Core et al., 1999; Bebchuk et al., 2007; Bhagat & Bolton, 2008).
Besides a few studies (Hillman and Hitt, 1999; Hillman et al., 2004), the relationship between CG mechanisms and CPA strategies has remained underexplored, suggesting the need for a microeconomic approach to empirically examine the effect of effective agency on political performance. Lower agency costs minimise the likelihood of managerial entrenchment, thereby reducing the risk that CPA is driven by self-interested motives that go beyond the interests of shareholders, i.e. reputational gains and political access. This effect suggests that stronger CG mechanisms may abet firms’ political performance (Joseph et al., 2004). For this reason, we investigate the moderating effect of CG mechanisms on political performance to explore the role of agency in shaping the motives that underlie CPA engagement, and whether these affect the firm’s political performance in different ways. This leads us to the second question addressed in this study.
RQ2: How do firms’ monitoring and bonding CG mechanisms affect political performance?
The study empirically addresses these questions by testing the direct effect of CPA on CFP as well as the moderating role of CG mechanisms for a panel dataset comprising 635 US listed firms for the period 2010-2017. We operationalise information and financial incentive strategies as lobbying expenditures and PAC contributions, correspondingly. Whilst with respect to CG, we measure monitoring and bonding mechanisms by observing the firms’ degree of board independence and CEO’s stock compensation.
By controlling for time, firm and industry fixed effects to account for the unobserved heterogeneities across entities, our results lead to three main findings. First, information CPA strategies are negatively associated with CFP, whereas the opposite is true for financial incentive CPA strategies when excluding controls for CG mechanisms. Second, monitoring and bonding CG mechanisms partially overturn both effects. Hence, firms with stronger CG, and thus potentially lower agency costs, experience different degrees of political performance when engaging in financial incentive versus information CPA strategies. These results add value to the existing literature by exposing (1) how the value of the economic rents that a firm is able to extract from political markets
also depends on the type of political resource that is exchanged and (2) that internal procedures affect political performance by playing a role in shaping the managerial motives that underlie political engagement by firms. From a managerial standpoint, firms with managers that are more likely to act out of self-interest gain greater financial return from CPA strategies associated with larger reputational gains (Hond et al., 2014; Lu, Shailer and Wilson, 2016). On the contrary, lower agency costs are associated with greater financial return from information CPA strategies, suggesting how information is a more valuable resource to firms that align market and non-market strategy.
The following section provides the theoretical foundations upon which our research questions have been built. Thereafter, the theoretical framework and hypothesis development outline the theoretical argumentations for the effects that are investigated empirically in the study’s results, following a description of the methods and dataset that were used. Ultimately, the study discusses the theoretical and managerial implications of these results, culminating in several future research directions for non-market strategy research and addressing the limitations endemic to this study’s methodological approach.
2. Literature Review
Corporate political activity (CPA) and Corporate Governance (CG) belong to distinct bodies in literature yet are linked in several ways. The study hereby provides an overview of the developments brought forward by these two research streams in recent decades, investigating their association with corporate financial performance (CFP) to emphasise their complementarities and shed light on this relatively underexplored antecedent to firms’ political involvement.
2.1. Political Rent-Seeking and the Non-Market Environment
In 1980, Weidenbaum compared the expansion in the powers of government over economic markets to a managerial revolution, second in influence only to the separation of ownership and control (Weidenbaum, 1980; Berle and Means, 1932). Since Weidenbaum (1980), the impact of government actions over the competitive structure and size of markets through the use of policy instruments, regulation and fiscal measures has become increasingly pervasive (Lenway and Rehbein, 1991; Mitchell, Hansen and Jepsen, 1997). For this reason, as explained by Hillman (1999: 826), “in many industries, the success of business in the public policy arena is no less important than success in the marketplace”. Accordingly, firms have dedicated progressively larger amounts of resources to the development of CPA strategies (Cooper, Gulen and Ovtchinnikov, 2010; Lawton, McGuire and Rajwani, 2013). The latter have been portrayed by Hillman et al. (2004) as the “corporate attempts to shape government policy in ways favourable to the firm”, in light of several firm-specific reasons for engaging in these political efforts. Yet before exploring the different approaches adopted by firms to influence public policy, the levels of participation and the types of CPA strategies, it is first useful to understand the how these political efforts relate to the management of the non-market environment. CPA is the part of a broader universe of non-market actions by which firms seek to manage their non-market environment, which only concerns their engagement with policymakers (Mellahi et al., 2016). These strategies encompass all of the firm’s political interactions that aim at influencing public policy by “[…] receiving information and preferential treatment from government officials”
(Hillman et al., 2004, in Mellahi et al., 2016). Therefore, Baron (1995) questions whether these efforts may really be considered external to the firm’s environment, and whether the exchanged resources, despite falling outside the traditional definition of goods and services, rather constitute “markets” of their own (Hillman, 1999). Hillman et al. (2004) elaborate by describing how political markets are shaped by the demand and supply for public policy, which in turn affect the outcome of CPA (Hillman and Keim, 1995). Mellahi et al. (2016) further highlight the diversity of strategies by grouping non-market practices into bridging and buffering activities. The first involve activities that relate to compliance with socio-political stakeholder expectations, whilst the latter relate to defensive and proactive mechanisms (Mellahi et al., 2016; Keig, Brouthers & Marshall, 2015). Within those defensive (or reactive) and proactive strategies, a further distinction is made by Widenbaum (1980), who outlines three corporate responses to public policy: (1) passive reaction, (2) positive anticipation and (3) public policy shaping. The first two fall within Mellahi et al.’s (2016) definition of reactive buffering strategies, as these do not involve direct interaction with policymakers (Hillman et al., 2004). Accordingly, passive reaction relates to reacting post hoc to new policy and positive anticipation regards the measures that firms adopt within their processes and activities to account for changes in regulation (Hillman, 1999). Nevertheless, the research has been primarily concerned with the third form of corporate response – public policy shaping – that is proactive in nature and constitutes what is generally regarded as CPA.
To illustrate how the CPA engagement of firms interacts with policymakers, Ryan, Swanson and Buchholz (1987) identify the three stages in the public policy issue life cycle: public opinion formation, public policy formulation and public policy implementation. In the last stage, implementation regards the bureaucratisation of legislation, restricting firms to political action of reactive nature (Hillman, 1999). For this reason, firms have limited power in influencing policy implementation, yet may attempt at shaping the public policy formulation process described in the first two stages through proactive CPA strategies (Hillman et al., 2004). Within the domains of the public policy process, exchange theory suggests that firms may use three generic political strategies
to compete in political markets: information, financial incentive and constituency-building CPA strategies (Bonardi, Hillman and Keim, 2005). These strategies may be approached by managers in two ways: a transactional approach, by which the formulation of the firm’s CPA is issue-specific and only occurs in function of public policy that is anticipated to significantly affect business activities, or a relational approach with which the firm nurtures an on-going and potentially long-term relationship with policymakers (Hillman, 1999). According to Hillman and Keim (1995), relational approaches hinge on reciprocal trust and mutual exchange of resources, which decrease the marginal transaction costs of participation over time.
Turning the attention to the types of CPA strategy, Hillman (1999) forwards a taxonomy of the three forms of proactive political behaviour by distinguishing between three types of CPA: information, financial incentive and constituency-building strategies. Each relate to the type of political resource that the strategy involves. Firstly, in information strategies, the firm provides policymakers with its policy preferences and any specific information that may substantiate its policy position; this includes tactics such as lobbying, commissioned research, technical reports, or even testifying as expert witnesses, and may be done in-house or by hiring external professional firms (Hillman, 1999). It follows how the definition of lobbying used in this study strictly regards the provision of information to government officials by firm representatives, whereas its European connotation is more general and may encompass any proactive political engagement (Hillman and Keim, 1995). Secondly, financial incentive CPA strategies also target policymakers directly by providing financial inducements. Aplin and Hagarty (1980) first described this relationship in terms of agency, whereby the firm’s financial “incentives” aim at aligning the interests of politicians and their “principals” – managers. This strategy typically involves (but is not limited to) financial contributions to Political Action Committees (PACs), which are special political investment vehicles that pool financial resources in support of specific candidates, parties or policies. Financial incentive strategies also encompass paid expenses and personal services, i.e. hiring managers and consultants with political experience or having former directors in government positions (Hillman and Keim,
1999). Lastly, firms employing constituency-building strategies seek to affect the outcome of public policy by mobilising individual voters and interest groups to express their preferences to policymakers. Consequently, these may thus be considered a “bottom-up” strategies that are proactive, yet indirect in nature (Hillman, 1999). Due to the elusive nature of constituency-building CPA strategies and the problems associated with its quantification (Lenway and Rehbein, 1991; Lord, 2000), the study focuses on lobbying and PAC expenditures as CPA measures relating to exchanges of information and financial resources, respectively.
Schuler, Rehbein and Cramer (2002) model how firms that have access to the public policy process may appreciate a competitive advantage by bundling information and financial incentive CPA. Their research finds that the likelihood of combing the two strategies increases under the following conditions: greater industry concentration, political activism, unionisation, firm size, slack resources, government dependency and if the firm’s industry has a congressional caucus. Particularly, all measures suggest that industrial organisation matters. Accordingly, firms which invest in both strategies are likely to be large corporations with “deep pockets” that potentially compete in heavily regulated industries and thus are in greater need to hedge their non-market environment (Schuler, 1996; Schuler, Rehbein and Cramer, 2002). Nevertheless, Lenway and Rehbein (1991) further confirm that organisational slack and industry regulation foster CPA engagement, yet also show how the presence of politically inactive firms foes not deter other competitors from becoming politically active. Lastly, Okhmatovksiy (2010) empirically exposes evidence of a positive association between dependency on SOEs (State-Owned Enterprises) and CFP but provide no evidence of a link between government dependency and performance. The reason for this divergence in outcome may be due to the transaction costs associated with government collaboration, which outweigh the benefits. Conversely, benefitting indirectly from state resources through SOEs is linked with higher CFP.
All in all, firms that participate in political markets seek to influence the public policy process in ways that potentially lead to the accrual of economic rents (Shaffer, Quasney and Grimm, 2000). For example, Cho, Patten and Roberts (2006), find how firms with lower environmental credentials
invest more in CPA and have greater degree of environmental disclosure. Another instance is provided by Holburn and van den Bergh (2014), who show how electric utility firms, which compete in highly regulated markets, substantially increase their political spending in the twelve months prior to the regulatory review of a proposed merger and do so especially if based in states with greater political competition. As a result, this suggests that competitive pressures (i.e. concentration) in both market and non-market environments shape firms’ engagement in political markets by fostering political spending. Yet CPA has been found to have an elusive effect on performance. Some studies have even suggested that CPA is potentially symptomatic of underlying operational weaknesses (Cho, Patten and Roberts, 2010). One example shows how politically connected firms are disproportionately more likely to be bailed out, despite continuing to make losses (Faccio, Masulis and McConnel, 2006). For this reason, we now shift our attention on CPA strategies’ effect on several measures of firm performance.
2.2 Implications for Firm Performance
The extant literature in non-market strategy has provided inconclusive evidence for the ability of firms to extract rents from political markets, emphasising our limited understanding of the conditions by which buffering rent-seeking activities interact with firm performance (Schuler, 2012; Hadani and Schuler, 2013; Mellahi et al., 2016).
The majority of studies seem to emphasise a positive association between CPA investment and firm value; the claim is supported by Lux et al.’s (2011) and Mellahi et al.’s (2016) meta-analyses indicating how CPA strategies generally lead to higher firm performance and value. Schuler (1996) and Shaffer, Quasney and Grimm (2000) are among the earliest empirical studies to find a positive association between CPA and firm performance, whether measured in terms of profits, market share, stock returns or capacity utilisation. Nevertheless, in light of the limited availability of longitudinal data, Schuler (1996) tests the associations with cross-sectional models, indicating how the elusive nature of CPA may require investigation over longer periods of time (Shaffer, Quasney and Grimm,
2002). To address this concern, Hillman, Zardkoohi and Bierman (1999) employ a Scholes-Williams event study to analyse whether firms appreciate abnormal returns upon the announcement of managers’ election to public office. In an attempt to isolate the effect of political strategies on CFP, their results show how firm value is positively affected from having a firm representative in a political capacity (Hillman, Zardkoohi and Bierman, 1999). This is due to how firms that are able to gain access to the public policy process can benefit from a reduction in uncertainty and financial risk (Lazonick and O’Sullivan, 2000), thus underlining how CPA engagement is not without justification. Furthermore, according to the RBV and RDT views of the firm, proactive non-market activities such as CPA strategies enable economic actors to extract rents from political markets by creating a more favourable non-market environment and ensuring the internalisation of key political resources to the firm (Hillman, Withers & Collins, 2009).
Some other studies also provide empirical evidence of a positive association between CPA and CFP. Citing a lack of attention to the antecedents of non-market performance, Bonardi, Holburn and van den Bergh (2006) examine the highly regulated US utilities’ industry through the lens of exchange theory and political markets theory, finding that non-market performance is influenced by the characteristics of firms on two levels of analysis. On one hand, by the regulatory and political environment (i.e. rivalry among interest groups and politicians), and competition therein; on the other, by how their internal capabilities enable the firm to mitigate political transaction costs, thereby extracting rents from the public policy process and internalising them to foster a strategic advantage in markets. Cooper, Gulen and Ovtchinnikov (2010) substantiate this claim by exposing a strong correlation between the number of candidates supported by a firm and its future abnormal returns. The relationship appears strongest for candidates that hold office in the same state as the firm’s headquarters, underlining the value of explicit relationships that derives from political connectedness. Conclusively, the relationship between CPA and CFP appears suggestively positive and being driven by efficiency and legitimacy considerations in support of the conflict-resolution hypothesis posited by stakeholder theory, thereby substantiating the claim that firms are able to potentially accrue
benefits from the political environment. Mellahi et al. (2016) describes the conflict resolution hypothesis as the effective management of stakeholder interests, exposing how the definition may be abstracted at the agency level between policymakers and managers, as well as between shareholders and managers.
Nevertheless, another stream of research brings into question the profit-maximising assumptions underlying the abovementioned studies by suggesting that CPA is not associated with financial performance and may rather be the symptom of agency problems and fundamental weaknesses (Schuler, 2012; Hadani and Schuler, 2013). This limited number of studies provide support for the CEO overinvestment hypothesis forwarded by agency theory (Mellahi et al., 2016). The latter relates to the managerial motives underpinning the firm’s CPA, describing how political efforts may be led by CEOs’ self-interest pursuit of reputational gains or political access, or as a hedging measure to compensate for operational weaknesses, ultimately leading to a degradation of market capabilities and a decrease in firm performance (Core et al., 1999; Aggarwal, Meschke and Wang, 2012; Lu, Shailer and Wilson, 2016). CPA as a rent-seeking activity “may well imply a weakening in the development of some other productive capabilities and thus weaken firms’ ability to earn other forms of rents such as efficiency and innovation rents” (Ahuja & Yayavaram, 2011: 1648). Hence, CPA may also signal the underdevelopment of market-related skills. Liquidity and specifically free cash flow is typically associated with firms’ higher CPA engagement, whilst denoting less investment in R&D (Aggarwal, Meschke & Wang, 2012). Hadani and Schuler (2013) substantiate the claims holding that CPA is detrimental to firm performance by investigating the relationship between CPA and financial returns on a set of 943 S&P 1500 firms between 1998 and 2008. Results are negative when CPA is measured as direct political strategies, i.e. PAC contributions and lobbying, and board service by public officials, finding that these political endowments are negatively associated with market performance, and cumulative investments over time decrease firm performance. In regulated industries, however, the effect appears reversed, exposing how firms whose market capabilities strongly depend on regulation may potentially accrue rents from political markets.
As a result, it appears unclear how CPA is related to CFP. Agency theory suggests that besides industry-level antecedents such as regulation, firm-level antecedents may play a role in demystifying the managerial motives that shape firms’ political behaviours. For this reason, we turn our attention to an underexplored firm-level antecedent, corporate governance, to investigate the role of internal procedures in influencing the political performance of firms’ CPA.
2.3 Corporate Governance and the Role of Agency
Among procedures that internally regulate firm behaviour, CG mechanisms have often been cited by literature as the “design of institutions that induce or force management to internalise the welfare of stakeholders”. Several studies have provided different, yet complementary definitions, which describe how internal and external forces shape CG and how CG affects the democratic functioning of a firm. In the words of Shleifer and Vishny (1997), “corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment”. Although this definition does not describe the role of CG mechanisms to their entirety, it highlights their crucial link to the agency relationship between shareholder and managers at the heart of the firm’s decision-making process. For this reason, Zingales (1997) clarifies how CG involve a “complex set of constraints that shape the ex-post bargaining over the quasi-rents generated in the course of the [agency] relationship”. Consequently, we discern how firms’ configurations of internal procedures shape corporate behaviour with respect to all shareholders and include characteristics of corporate ownership, board structure and the incentive structures that drive managerial alignment (Core et al., 1999). When viewing the firm as a nexus of contracts, in accordance with the legal and economic scholarship, research in CG has primarily been focused on understanding the optimal contracts between the two (Jensen and Meckling, 1976; Fama and Jansen, 1983).
These mechanisms have primarily been researched from the perspective of agency theory and stakeholder theory with respect to performance, yet in accordance with Agrawal and Knoeber
(1996), the resulting decrease in agency costs (e.g. corporate malfeasance and managerial self-interest) affects all aspects of the company, from strategy to organisational design. As a result, CG mechanisms have been generally found to be positively associated with CFP (Core et al., 1999), in line with the notion that firms are more likely to adopt effective mechanisms when these are found to have led to favourable outcomes (Nelson and Winter, 1982). As aforementioned, Hillman et al. (2004) distinguish between monitoring and bonding CG mechanisms. The first encompass all internal procedures that relate to the supervising faculties of the board of directors (BOD) such as board independence, board size and the separation of duties between CEO and Chairman of the BOD. Due to how these mechanisms are aimed at monitoring the democratic and transparent functioning of the board, which is in turn closely involved in the firm’s decision-making (and political involvement), this study regards monitoring mechanisms in relation to their board functions. Nevertheless, monitoring mechanisms also include characteristics relating to the nature shareholders such as the degree of ownership concentration and the presence of institutional investors (Hillman et al., 2004). Conversely, bonding mechanisms “bond” the interests of shareholders and managers by affecting the incentive structures of CEOs and top management. These CG mechanisms include the degree of managerial ownership and any performance-related compensation scheme such as stock options (Agrawal and Knoeber, 1996).
With respect to CG mechanisms’ influence on firm performance, Yermack (1996) suggests an inverse relationship between board size and CFP, underscoring how smaller boards are generally associated with better incentives structures for CEOs, both in terms of compensation and threat of dismissal. According to Core et al. (1999), variations in compensation may also be explained by ownership structures, finding how weaker CG often stems into higher CEO compensation and thus validating the CEO overinvestment hypothesis. Cho et al. (2006) further underline how minimised agency costs, operationalised by BOD independent directors have a positive impact on CFP, and that high performers rarely feature relatively higher agency costs. Moreover, Hadani (2012) turns the attention towards the firm’s ownership structure, finding how institutional ownership is negatively
correlated with CFP, whilst investors’ portfolio concentration is found to have a positive association with CFP. These findings provide further substantiation for the claim that higher degrees of shareholder activism and participation in monitoring and decision-making is linked to minimised agency costs and subsequently constitutes one of the elements of a strong CG configuration. In addition, Bhagat and Bolton (2008) further elucidate the relationship between ownership and variations in CFP, finding a positive association between two monitoring practices – BOD stock ownership and CEO-Chair separation of duties – and CFP. We now briefly focus on the CG mechanisms that characterise the shareholder model, in light of this study’s investigation of US firms’ political engagement.
Several US corporate scandals at the turn of the century have highlighted the perils of weak governance, prompting firms to bridge deficits in regulation by adopting stronger CG practices and gain legitimacy with investors (Lu, Shailer and Wilson, 2016). Subsequently, the adoption of CG mechanisms beyond the requirements mandated by corporate law has undergone an evolutionary trajectory driven by legitimacy and efficiency considerations, fostering convergence towards the shareholder model by foreign MNEs (Aguilera and Jackson, 2003; Haxhi, 2015). CG practices may thus be considered as de facto regulating mechanisms adopted to minimise the moral hazard in agent’s behaviour, consequently diminishing agency costs by encouraging transparent, democratic and active participation in the firm’s decision-making processes, whilst governing firms’ behaviour in the market for corporate control (Shleifer and Vishny, 1997; Lazonick and O’Sullivan, 2000). The US have been historically characterised by the transposition of CG mechanisms into hard law, especially in light of the 2002 Sarbanes-Oxley Act, which mandated stricter codes of good governance in response to the wave of corporate malfeasance at the beginning of the 2000.
Conclusively, firms’ idiosyncratic configurations of CG mechanisms show a clear association between greater principal-agent alignment and firm performance (Core et al., 1999). For this reason, the minimisation of agency costs is thereby anticipated to play a key role in shaping the managerial
motives that underlie the decision to invest in political markets. Accordingly, we now bring together these two streams of research in seeking to understand the conditions which lead CPA to favourably affect firms’ performance.
2.4 CPA and Corporate Governance
Several studies have cited CG mechanisms as a key antecedent to CPA engagement, underlining the need for empirical substantiation and examination of performance outcomes (Hillman and Hitt, 1999; Hillman et al., 2004). Nevertheless, only few papers investigate the interrelation between CG and CPA (Aggarwal, Meschke and Wang, 2012; Lee, Lee and Nagarajan, 2014; Lu, Shailer and Wilson, 2016; Sun, Hu and Hillman, 2016). The reason underpinning their theoretical interdependency may be described in terms of agency (Keim and Basinger, 1983), and relates to the alignment between the interests of shareholders and managers. As CG structures shape managerial incentives, by association these also impact the motives for dedicating firm resources to political markets. As a result, CG mechanisms may be operationalised to provide indication of why a specific firm would invest in CPA strategies, given that the reasons shaping the choice of political engagement are likely to also impact the outcome of those strategies in terms of political performance (Lux, Crook and Woehr, 2011).
Aggarwal, Meschke and Wang (2012) are among the first to research the performance implications of agency to determine whether CPA may be considered an investment or the result of managerial self-interest at the detriment of shareholder value. This study provides the foundations upon which our research is built, by highlighting how dedicating resources to political markets may, in some cases, signal underlying weaknesses instead of a strategic attempt at minimising non-market risk (Lux, Crook and Woehr, 2011; Aggarwal, Meschke and Wang, 2012; Dahan, Hadani and Schuler, 2013). Their research finds how a $10,000 increase in political donations in associated with a reduction in annual excess returns of 7.4 basis points, and how worse CG is associated with larger donations, exposing how CPA may rather be considered symptomatic of agency problems. The study however does not establish a direct link between internal procedures and political performance, but
rather provides insight into the organisational forces that influence political spending, whether PAC contributions, soft money expenditures or donations to 527 groups. In addition, Hadani (2012) underlines the unclear nature of the relationship between the interests of agents and principals with regards to CPA engagement. Building on stakeholder and institutional theory, he shows how higher levels of institutional ownership and portfolio concentration, suggestive of greater shareholder activism and thus of the stronger monitoring faculties of shareholders, are both negatively associated with firms’ level of CPA. The overall negative relationship between CG and CPA is further reiterated by Dahan, Hadani and Schuler (2013), who stress the rent-seeking nature of political engagement and its failure to create value for consumers, but also potentially for the firm (Dahan, Hadani and Schuler 2013). Also, Domadenik, Prasnikar and Svejnar (2016) underline consumer welfare considerations, finding how, especially in countries with underdeveloped democratic institutions, political connectedness and weak CG may result in lower productivity and an erosion of market capabilities. To conclude, CG mechanisms constitute a “barometer” for the democratic functioning of a firm’s decision-making bodies, shaping both market and non-market strategies by limiting the risk of agency that may arise from managerial self-interest. For this reason, these internal procedures are anticipated to a play a pivotal role in firms’ political engagement, influencing the motives that lead managers to invest in political markets. Subsequently, the strength of firms’ monitoring and bonding CG mechanisms may signal why managers of different firms dedicate resources in attempting to influence the public policy process, and disclose how these reasons impact the political performance of firms’ CPA. In this way, CG mechanisms may provide indication of the conditions under which CPA can be considered an investment and when a value-destroying activity, ultimately contributing to clarify its elusive nature.
3. Theoretical Framework
The non-market strategy literature has given CPA increasing attention, as firms seek to manage their external environment by providing policymakers with issue-specific preferences and by aligning their interests with those of political representatives through financial inducements (Hillman, 1999). Therefore, similarly to the relationship between shareholders and managers, the public policy process may thus be described in terms of agency, where the policymaker is the agent and firms take the role of principals (Aplin and Hagarty, 1980; Hillman, 1999; Oliver and Holzinger, 2008), highlighting the notion of mutual interdependence and exchange (Benson, 1975).
3.1 Corporate Political Activity and Financial Performance
Several studies have explored the firm and industry-level antecedents to CPA investments (Hillman, 1999; Hillman et al., 2004) and the ways in which firms may attempt at influencing legislators (Keim and Zeithalm, 1986; Lord, 2000; Bonardi, Hillman and Keim, 2005; Oliver and Holzinger, 2008). Nevertheless, a limited body of literature has been dedicated to the direct relationship between CPA and CFP and to the determinants of political performance (Shaffer, Quasney and Grimm, 2000; Dahan, Hadani and Schuler, 2013; Holburn and Van den Bergh, 2014). Since the first empirical investigation into the effectiveness of CPA strategies by Hillman, Zardkoohi and Bierman (1999), the elusive nature of political investment has led to conflicting empirical results. Some studies indicate that firms are able to extract economic rents from political markets, in support of the conflict-resolution hypothesis (Bonardi, Hillman and Keim, 2005; Bonardi, Holburn and Van den Bergh, 2006; Cooper, Gulen and Ovtchinnikov, 2010; Lux, Crook and Woehr, 2011). In contrast, others suggest the detrimental impact of CPA on CFP in line with the CEO overinvestment hypothesis, citing managerial entrenchment and other symptoms of agency among the reasons for the negative association (Schuler, 2012; Dahan, Hadani and Schuler, 2013). The variety of estimation methods for CPA has further confounded the relationship between business and politics (Hillman et al., 2004). Besides Schuler, Rehbein and Cramer (2012), who model the conditions under which firms are more
likely to combine CPA strategies, no study to date has examined the distinct effect of information and financial incentive strategies, thus overlooking potential differences between the financial benefits that firms may gain from different CPA strategies.
From a theoretical standpoint, gaining access to the political process may reduce a firm’s uncertainty, transaction costs and lead to the utilisation of non-market ties in ways that may increase its chances of survival in the market environment (Lux, Crook and Woehr, 2011). Accordingly, the association between CPA and CFP appears positive despite the conflicting empirical evidence, indicating how our understanding of CPA determinants is still incomplete. Agency theory and exchange theory suggest that managerial motives, a widely disregarded antecedent to CPA engagement, may play a role in determining the effectiveness of CPA strategies with respect to financial performance. Also, research by Sheng, Zhou and Li (2011) highlights that political ties are positively associated with CFP when legal enforcement is inefficient and government support is weak, exposing how CPA engagement may be symptomatic of agency problems (Aggarwal, Meschke and Wang, 2012). For this reason, this study forwards a novel proxy for the inference of managerial motives as a way of indicating whether CPA is an investment activity in support of market strategy or is rather driven by entrenchment effects or the reputational pursuits of CEOs and hence, the symptom of agency (Hond et al., 2014; Lu, Shailer and Wilson, 2016). This proxy consists in CG mechanisms, or the internal procedures that shape the incentive structures of managers and, syllogistically, affect the reasons for dedicating firm resources to CPA (and potentially their outcome). Internal procedures have been empirically examined with respect to CPA and CFP only by a limited number of studies (Aggarwal, Meschke and Wang, 2012; Dahan, Hadani and Schuler, 2013). Accordingly, CG mechanisms have remained underexplored, despite how several scholars have underlined their relevance for CPA research (Hillman et al., 2004; Lux, Crook & Woehr, 2011).
3.2 Corporate Governance and Political Performance
In accordance with the conflict-resolution and CEO overinvestment hypotheses forwarded by stakeholder theory and agency theory, CPA may be driven by two reasons. On one hand, CPA is underpinned by strategic considerations that are likely to be aligned with the interests of shareholders, as an attempt to favourably shape the firm’s non-market environment, or by managerial entrenchment. On the other, CEOs employ firm resources in CPA to gain reputational capital among the public spheres, to invest slack resources that would have been dedicated to R&D and other core activities, or may do so to mitigate underlying operational weaknesses, symptomatic of a degradation in the firm’s market capabilities (Aggarwal, Meschke and Wang, 2012; Okhmatovskiy and David, 2012; Lu, Shailer and Wilson, 2016). CG mechanisms have been widely disregarded by non-market literature yet are hypothesised to provide insight into whether CPA is driven by efficiency or managerial entrenchment.
Monitoring and bonding CG mechanisms shape the incentive structures of the firm’s principal-agent relationship by curbing the cognitive biases and moral hazards that may result in information asymmetry and thus constraining agency costs associated with weaker financial performance (Core et al., 1999). Hillman et al. (2004) describes how monitoring mechanisms such as independent boards reduce asymmetries by minimising conflicts of interests and safeguarding democratic decision-making, whereas bonding mechanisms such as stock compensation foster alignment between the interests of shareholders and managers by linking CEOs’ incentives to their fiduciary duty through performance-related compensation structures. In the past decade, several studies have underlined the positive association between CG mechanisms and CFP (Agrawal and Knoeber, 1996; Yermack, 1996; Bhagat and Bolton, 2008), suggesting how minimising agency costs may be considered synonymous with profit-maximisation from a shareholder perspective. For this reason, CG mechanisms are anticipated to provide insight into how managerial motives shape CPA engagement, and whether agency costs affect a firm’s ability to extract economic rents from the political environment. Due to the expectedly positive direct effect on CFP, strong monitoring and
bonding CG mechanisms may provide indication of the managerial motives for investing in political markets (Bonardi, Hillman and Keim, 2005).
Hence, this study aims at providing an empirical understanding of the nexus linking CG and CPA to CFP for two reasons. First, to determine whether information and financial incentive CPA strategies have different effects on financial performance, as prior studies have often conflated the strategies or treated them aggregately, thus disregarding their individual characteristics. Second, to comprehend how managerial motives affect the link between CPA and CFP, using internal procedures as proxy for the alignment of principal and agent.
4. Hypothesis Development
The extant non-market literature exposes the weak consensus on the likely effect of CPA strategies on CFP. The conflict-resolution hypothesis anticipates engagement in political markets to have a positive effect on the relationship, by allowing the firm to favourably shape its non-market environment and secure political access (Mellahi et al., 2016). Alternatively, the CEO overinvestment hypothesis posits that CPA strategies may rather be aimed at forwarding CEOs’ personal agendas, signalling agency and leading to an erosion of market capabilities, thus negatively affecting CFP. In seeking to measure the elusive relationship between CPA and CFP, prior research has lacked a unified approach to the analysis of CPA strategies, overlooking the individual effects of different firm approaches to political markets (Lenway & Rehbein, 1991; Schuler, Rehbein and Cramer, 2002; Bonardi, Hillman and Keim, 2005; Oliver and Holzinger, 2008). For this reason, this study addresses these concerns by investigating the distinct effect of information and financial incentive CPA strategies on CFP.
Both information and financial incentive CPA may be driven by efficiency and legitimacy considerations (Lenway and Rehbein, 1991). However, the two strategies differ starkly in terms of the political good that is exchanged, raising questions as to whether they yield comparable outcomes in terms of CFP. On one hand, firms engage in information CPA strategies to provide policymakers with their preferences for public policy (Hillman, 1999; Hillman et al., 2004). The strategy may be described as covert in nature, given how any exchange of tacit knowledge must be first internalised by the firm, transferred to the market environment and exploited strategically in order to yield positive returns in terms of financial performance. On the other hand, financial incentive CPA strategies involve the provision of financial inducements by firms to PACs, which in turn support specific policy issues, candidates or parties (Hillman, 1999). It may be argued how with respect to the latter, the firm stands to gain greater legitimacy and reputational capital by aligning the financial incentives of the firm and policymakers (Lu, Shailer and Wilson, 2016).
Despite the elusive effect of CPA strategies on CFP, the majority of papers that empirically examine the relationship find a generally weak, yet positive association with CFP (Mellahi et al., 2016). Hillman and Hitt (1999) regard both information and financial incentive CPA strategies as direct approaches to the public policy process. Yet, the strategies present several differences. As provided by the name, the two strategies relate to the exchange of different kinds of political resource. On one hand, financial inducements are tangible and covert. On the other, information can be intangible, covert, yet not fungible.
The minor, yet significant differences between the two CPA strategies highlight how these may yield different outcomes in terms of political performance. Specifically, PAC contributions are anticipated to deliver greater, more overt reputational gains, legitimising the practices of the firm and aligning the interests of policy-maker and manager (Aggarwal, Meschke and Wang, 2012; Lu, Shailer and Wilson, 2016. Alternatively, acquiring political resources through lobbying is expected to be driven by efficiency and strategic alignment considerations (Hillman et al., 2004). The argument leads us to the first hypothesis addressed in this study.
H1a: The firm’s information CPA strategy is expected to positively influence CFP. H1b: The firm’s financial incentive CPA strategy is expected to positively influence CFP.
Furthermore, the conflicting evidence with respect to the association between CPA and CFP suggests an incomplete understanding of the antecedents of CPA and determinants of political performance. Among the drivers of political performance, the managerial motives underlying the engagement in CPA strategies are anticipated to play a central role in the extraction of economic rents from political markets. As abovementioned, prior research has regarded the conflict-resolution and CEO overinvestment hypotheses as dichotomous, entailing that CPA engagement is either driven by profit-maximising reasons and positively associated with performance, or the result of agency and negatively associated with CFP. Hence, the study forwards the notion that differences in the
managerial motives underlying firm’s engagement in CPA may lead to different outcomes in terms of CFP, and that these motives may be inferred by the firm-specific configurations of CG mechanisms, which will in turn strengthen or mitigate firm’s political performance.
For this reason, the study focuses on CG mechanisms as a key, yet underexplored organisational antecedent to provide insight into managerial motives by acting as proxy for agency. In accordance with agency theory, both CG monitoring and bonding mechanisms are expected to minimise agency problems, by fostering alignment between the incentives of owners and managers, whilst mitigating information asymmetries (Keim and Basinger, 1988; Yermack, 1996; Bhagat and Bolton, 2008). Core et al. (1999) substantiate this claim, exploring how weaker CG mechanisms are conducive to higher agency problems, resulting in a negative effect on CFP. For this reason, monitoring and bonding CG mechanisms are anticipated to provide indication for the managerial incentives driving firm’s engagement in political markets, thereby strengthening the effect of CPA strategies on CFP (Aggarwal, Meschke and Wang, 2012; Dahan, Hadani and Schuler, 2013). Specifically, monitoring and bonding CG mechanisms shape the degree of managerial discretion and the alignment between principal and agent (Agrawal and Knoeber, 1996; Bhagat and Bolton, 2008).
With respect to monitoring CG mechanisms, which are operationalised as board independence, some studies have found mixed results for their effect on CFP (Bhagat and Black, 2001; Bhagat and Bolton, 2008). Nevertheless, Bhagat and Bolton (2008) conclude that a greater share of independent directors may reduce transaction costs between principal and agent, leading to a decrease in information asymmetries that is anticipated to positively affect the political performance of CPA strategies. Analogously, drawing from agency theory and transaction cost economics, Agrawal and Knoeber (1996) empirically establish the link between the stock compensation of executives, our measure for bonding CG practices, and CFP. The effect of performance-related compensation structures is hypothesised to abet the alignment between principal and agent (Core et al., 1996), which will in turn lead to political engagement for strategic purposes, as opposed to
self-interest, ultimately fostering the political performance of CPA strategies and leading us to our second hypotheses.
H2a: Monitoring CG practices conducive to minimised agency costs are expected to strengthen the political performance of information CPA strategies.
H2b: Monitoring CG practices conducive to greater principal-agent alignment are expected to strengthen the political performance of information CPA strategies.
Theory suggests that the effect of monitoring and bonding CG mechanisms is likely to be comparable with respect to the political performance of both information and financial incentive CPA strategies (Schuler, Rehbein and Cramer, 2002). In this way, the study addresses our limited understanding of how different CPA strategies interact with the firm’s internal procedures, to ultimately observe their moderating impact on financial performance. Therefore, building on agency theory and stakeholder theory, the study thus investigates the parallel role of monitoring and bonding mechanisms in moderating the political performance of different CPA strategies, or the coefficient of association between CPA and CFP. Figure 1 provides an overview of the hypothesised relationships. As little is known about the effect of different CPA strategies, we investigate their independent effect. The two strategies expose several differences, yet theory has generally regarded them as positively associated with CFP (Hillman, Zardkoohi and Bierman, 1999). This study seeks to determine whether this is, in actuality, the case. This leads us to our third hypothesis.
H3a: Monitoring CG practices conducive to minimised agency costs are expected to strengthen the political performance of financial incentive CPA strategies.
H3b: Bonding CG practices conducive to greater principal-agent alignment are expected to strengthen the political performance of financial incentive CPA strategies.
5. Methods
5.1 Data and Sample
The study employs a panel dataset comprising the 635 largest Fortune 1000 US companies by revenues for the years 2010-2017, yielding a total of 5,080 firm-year observations. The dataset compiles information from the following publically available sources.2
First, our measures for the explained variable (i.e. Tobin’s Q) and controls (i.e. employees, assets, revenues, value of government contracts) have been derived from the Compustat financial database (Compustat, 2018). Secondly, data for the study’s independent variables, lobbying and PAC expenditures, is taken from the Centre for Responsive Politics (CRP), which reports all the political engagements of US firms with policymakers (CRP, 2018). Lastly, the ESG database was used to source the moderating variables measuring CG monitoring and bonding practices (ESG, 2018), as previously done in research (Bhagat and Bolton, 2008).
After excluding missing observations casewise, the models in the study are tested on a final sample of 1,683 firm-year observations. Furthermore, as positive outliers are not found to impact the robustness of the estimations and constitute valid firm observations, only negative ones have been removed due to their implausibility. Across the years, 81 percent of firms were politically active, investing in either lobbying or PAC contributions. Investigating the relationship between CPA and CFP among the largest firms by revenues enables the study to isolate strategically proactive firms which are most likely to engage in CPA strategies aimed at strengthening their competitive advantage. This approach mitigates issues concerning the free-rider problem common among smaller firms active in the political markets (Oliver & Holzinger, 2008; Lux et al., 2012).
Model Specifications
Financial Performance (Tobin’s Q)+
Model 1 Model 2 Model 3 Model 4
Lobbying Expenditures x x x x PAC Contributions x x x x BOD Independence x x x x Stock Compensation x x x x Controls x x x x Time-trend (Year) x
Time Fixed Effects x x x
Firm Fixed Effects x x x
Industry Fixed Effects x x
Lagged Tobin’s Q x
+ The estimations on future performance (t+1) show consistent results (Appendix, Item 2)
Table 1
5.2 Models
Several model specifications underscore the robustness and predictive power of the estimations with respect to the effect of CPA and CG on CFP. These are shown in Table 1. The first model constitutes an Ordinary Least Squares (OLS) panel regression inclusive of a time-trend to partially control for changes in firms’ CPA engagement through time. In light of the effect of firms’ individual characteristics on the relationship between lobbying and PAC expenditures on financial performance, the balanced panel dataset allows us to control for entity fixed effects in models 2, 3 and 4 (Sun, Hu and Hillman, 2016; Lu, Shailer and Wilson, 2016). The models thereby partially alleviate the endemic problem of endogeneity (due to the closely-knit set of variables) by controlling for the individual heterogeneity across firms, years and industries to remove time-invariant characteristics that may bias CPA strategies’ net effect on the financial performance. The following constitutes the assumed true model inclusive of CG moderators that will be empirically tested.
𝑐𝑓𝑝𝑖𝑗𝑡 = 𝛼𝑖 + 𝛽1𝑖𝑛𝑓𝑖𝑡+ 𝛽2𝑓𝑖𝑛𝑖𝑡+ 𝛽3𝑏𝑜𝑛𝑖𝑡+ 𝛽4𝑚𝑜𝑛𝑖𝑡+ 𝛽5𝑖𝑛𝑓𝑖𝑡· 𝑏𝑜𝑛𝑖𝑡+ 𝛽6𝑖𝑛𝑓𝑖𝑡· 𝑚𝑜𝑛𝑖𝑡 + 𝛽7𝑓𝑖𝑛𝑖𝑡 · 𝑏𝑜𝑛𝑖𝑡+ 𝛽8𝑓𝑖𝑛𝑖𝑡 · 𝑚𝑜𝑛𝑖𝑡+ 𝜔𝑖𝑡+ 𝜆𝑗+ 𝜀𝑖𝑡
Where,
cfp Financial performance (Tobin’s Q) of firm i at time t (t=2010, …, 2017)
𝛼 Unobserved time-invariant idiosyncratic effect
inf CPA information strategy (Lobbying expenditures)
fin CPA financial incentive strategy (PAC contributions)
mon CG monitoring practices (Share of independent board directors)
bon CG bonding practices (CEO’s total stock compensation)
Industry classification dummies (SIC code) Vector of controls
𝜀 Error term
The Durbin-Wu-Hausman test exposes how the entities’ error terms are correlated with the predictors but not across entities, indicating that the individual effects are idiosyncratic and constant, and thus confirming the model’s efficiency under fixed effects. Additionally, testing for Granger reverse causality provides further indication of the effects. The study adopts several approaches to fixed effects panel regressions. Model 2 is an OLS regression that uses dummy variables to control for firm and time fixed effects, whilst models 3 and 4 employ a within estimation method to additionally control for industry fixed effects. The reason for this is that CPA strategies of firms in heavily regulated industries are likely to be affected in similar ways by policymaking (Hadani, 1996; Dahan, Hadani and Schuler, 2013). Following the example of Okhmatovskiy (2010), the last model includes the lagged measure of CFP to control for the effect of past CFP on current CFP. In this way, the models account for the observed and unobserved heterogeneities of entities – firms in different industries – across subsequent time-periods.
5.3 Independent Variable
Analogously to prior non-market strategy research (Bhagat and Bolton, 2008; Lee, Lee and Nagarajan, 2014; Ridge, Ingram & Hill, 2017), the dependent variable measuring financial performance is operationalised as Tobin’s Q, as computed in Chung & Pruitt, 1986. The measure represents the ratio between a firm’s physical assets’ market value and their replacement value. If a firm’s Tobin’s Q is greater than 1, or exceeds parity, the market value of the assets is larger than the reported value (or book value), suggesting how markets may currently be overvaluing the firm due to optimism about future returns. As the study seeks to demystify the role of CG mechanisms that internally regulate firms’ principal-agent relationship in moderating political performance from a shareholder perspective, this future-oriented measure allows the proposed model to capture the effect of CPA engagement on the markets’ perception of the firm’s anticipated financial performance. In validation of the findings, Return-on-Equity (ROE) was also used to validate the effects, confirming the direction and magnitude of the estimated coefficients.
5.4 Dependent Variables
Second, the study investigates the discrete (direct) effect of information and financial incentive CPA strategies on CFP, as prior research has often conflated various forms of political engagement in aggregate measures, thereby disregarding differences in the individual effects of different political investments. Information and financial incentive CPA strategies are operationalised as lobbying and PAC contributions, respectively (Hillman et al., 2004; Hillman, 2005). These measures represent the US$ investment by a firm for a single year. PAC expenditures can only occur every two years in accordance with political cycles, thus values were computed as averages over the two-year period. In confirmation of the effects described in the findings, the results were robust to the models including the lag of PAC expenditures when using the original two-year cycle value.
5.5 Moderating Variables
The study seeks to investigate in what way CG mechanisms impact the relationship between CPA and CFP, to determine whether managerial motives have an effect on political performance, as an indicator of political investments’ financial performance implications. Core et al. (1999) underscore how firms with weak CG experience greater agency problems, and how the latter are generally associated with weaker performance. For this reason, we investigate two distinct measure associated with strong CG. On one hand, monitoring CG mechanisms are operationalised as the board of directors’ (BOD) share of directors with no material tie to the firm other than their directorship that includes customary fees. On the other, we use total stock compensation as our measure for bonding CG mechanisms, following what previously done in Bhagat and Bolton (2008) and Agrawal and Knoeber (1996). The typically Anglo-American single-tier board system allows us to represent shareholders and CEOs as a principal-agent relationship, in which monitoring and bonding CG mechanisms act as a proxy for managerial motives due to their role monitoring the agency relationship and bonding owner-manager interests (Oliver and Holzinger, 2008).
5.6 Controls
The models control for the logged size of assets, employee pool and revenues, following the example of prior CPA studies (Shaffer, Quasney and Grimm, 2000; Greve and Goldeng, 2004; Okhmatovskiy, 2010). In addition, to control for idiosyncratic entity effects through time, the estimations include an industry dummy based on firms’ SIC classification code and a year dummy (Shaffer, Quasney and Grimm, 2000; Bonardi, Holburn and van den Bergh, 2014). Firm’ prior performance is logically anticipated to strongly influence the performance of the current year. Thus, in line with Dahan, Hadani and Schuler (2013) the model includes firms’ lagged performance by one, two and three years. Due to their comparable outcome, the study only reports the single lag. Lastly, the degree of dependency of firms is expected to affect financial performance when observing the impact of
