Corporate Hedging, Family Firms, and CEO Identity  

By | May 27, 2022

Hedging marketable risks is a strategic corporate decision. Locking in interest rates, exchange rates, and commodity prices allows the firm’s expected cash flows and margins to be protected against unexpected changes in these variables. For example, firms that strategically hedged against severe energy price changes are now relatively shielded from surging prices. Most empirical studies in corporate finance show that hedging creates value and firms are generally aware that hedging is beneficial; global surveys (Giambona et al., 2018) confirm that the majority of non-financial firms are hedgers.[1] Bartram (2019) studies a large sample of about 7,000 non-financial listed firms across 47 countries and shows that 60% of them use financial derivatives mainly to reduce risk.[2]

Well-known theoretical rationales for hedging include reducing the cost of financial distress, decreasing expected tax liability, increasing debt capacity, and lowering the cost of external capital. Hedging also has agency implications since it lowers stock volatility and helps shareholders better assess management’s abilities. However, a firm’s ownership structure is a much less investigated hedging determinant. Unlike the US and the UK, where firms are typically widely held, continental European firms are more closely held and controlled by an individual or a family. Such shareholders are long-term investors and their long-term orientation is aimed at firm survival and successful intergenerational transition. They are also emotionally tied to the firm since, in many cases, they have significantly contributed to its birth or growth. Therefore, family shareholders wish to preserve reputation and non-financial socio-emotional value; that is, the stock of affect-related value impounded into the firm. The greater conservatism of family-controlled firms is expected to increase their propensity for hedging.

A recent study by Aminadav and Papaioannou (2020) gives us an idea of the pervasiveness of family-controlled firms in continental Europe.[3] If we consider the first three countries by GDP over the period 2004-2012, family firms represent, on average, 52% of all listed firms in Germany, 54% in France, and 59% in Italy. These figures largely underestimate the incidence of family firms in the economy of these three countries since the vast majority of them choose to remain private.

In our recent paper, we study the likelihood of hedging of family-controlled firms in Italy, a country with high ownership concentration and significant involvement of families. Over the period 2009-2018, we report 70% of family firms and a controlling shareholder’s average voting capital of over 50%. Among the family firms, we study the propensity to hedge of firms led by a CEO who is a member of the founding family compared with an outside professional CEO and the role of a CEO’s generation. Within firms managed by a founding family CEO, we disentangle the effect of a founder CEO compared with a descendant CEO.

The evidence is robust and shows the statistically and economically significant effect of family management on the propensity to hedge, after controlling for other firm and CEO characteristics. In particular, family firms led by a family CEO are 10% more likely to hedge than family firms run by an outside professional CEO and non-family firms. This figure increases to 15% and 25% when the firm is managed by a founding family member and the founder, respectively. Finally, we find that this effect is more pronounced for long-tenured founder CEOs. These CEOs are more prudent probably because they want to preserve the status quo and are tied to their consolidated beliefs.

These findings are consistent with the greater conservatism of family agents who wish to protect socio-emotional wealth and avoid losing reputation and control. However, we identify and test additional (and complementary) channels through which a firm’s “familiness” may increase the hedging propensity. First, underdiversified family owners should be more conservative and hedge more since they have a large portion of their wealth invested in the firm. Second, family-managed firms are more opaque to the market and suffer from higher information asymmetry, making outside financing costlier. Hedging reduces the likelihood of adverse fluctuations in future operating cash flows, which would force the firm to raise expensive external capital. Third, hedging could result from non-value maximizing decisions in a weak corporate governance environment. In family-controlled firms, hedging may be used to favor the largest shareholders, allowing them to extract private benefits and preserve control. Therefore, a higher likelihood of hedging should be found in family-managed firms with weak corporate governance attributes.

We empirically investigate whether these three channels contribute to the results, employing different proxies. We report that information asymmetry and, more weakly, underdiversification significantly increase the propensity for hedging of family-managed firms. On the other hand, corporate governance attributes proxying potential wealth extractions have no impact. We leverage these findings to emphasize two takeaways.

First, our work confirms that family-managed firms behave more conservatively and use hedging to reduce a firm’s exposure to financial risks. Indeed, family firms that hedge successfully reduce cash flow volatility. The propensity to hedge is progressively higher for firms led by a founding family CEO and founder-led firms. Moreover, family-managed firms are more likely to hedge when they are run by a longer-tenured CEO. The underdiversification of family owners and, more importantly, the higher opacity of family-controlled firms help to explain these results.

The second takeaway from our study is that the higher propensity to hedge of family-managed firms does not result in higher agency costs and negative value implications for other shareholders. This is important since the desire for more intense hedging of the controlling shareholder may conflict with the optimal hedging strategy for all shareholders. In our paper, we do not find evidence of value-detrimental implications of hedging for family-controlled firms.

Our study contributes to the large amount of literature which has explored whether family ownership impacts corporate decision-making by analyzing the relatively unexplored area of hedging marketable risks. In light of the recent upsurge in the volatility of market variables, understanding what drives a firm’s propensity to hedge appears more crucial than ever.

Massimiliano Barbi is a Professor of Corporate Finance at the University of Bologna.

Ottorino Morresi is an Associate Professor of Finance at the University of Rome “Roma Tre” (Third University of Rome).

This post is adapted from their paper, “Corporate hedging, family firms, and CEO identity,” available on SSRN.

The views expressed in this post are those of the author and do not represent the views of the Global Financial Markets Center or Duke Law.

[1] Giambona, E., Graham, J.R., Harvey, C.R., and G.M. Bodnar, 2018, The theory and practice of corporate risk management: Evidence from the field, Financial Management 47(4), 783-832.

[2] Bartram, S.M., 2019, Corporate hedging and speculation with derivatives, Journal of Corporate Finance 57, 9-34.

[3] Aminadav, G. and E. Papaioannou, 2020, Corporate control around the world, Journal of Finance 75(3), 1191-1246.

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