News Corp.’s bumpy pursuit of Dow Jones has rekindled the debate over the merits of dual-class stock arrangements. At Dow Jones, as at the roughly 1 in 11 publicly traded U.S. firms with dual-class stock, a handful of investors with a relatively small economic stake in the company hold roughly two-thirds of the voting power. Such deviations from the one-share, one-vote system create potential conflicts of interest between insiders who control the votes and outsiders who provide the majority—75 percent in the case of Dow Jones—of the firm’s equity capital.
Do two-tiered voting arrangements amount to poor governance? We present two pieces of evidence that suggest the answer is yes. We tracked 253 dual-class firms that went public from 1990 to 1998 and compared them with 2,369 single-class firms that conducted initial public offerings during the same period. First, we asked whether the market values dual-class and single-class firms differently. The answer was a resounding yes.
Comparing price-to-earnings multiples between the two groups, we found that at the IPO date, and for at least the next five years, single-class firms trade at higher multiples than dual-class firms. The value gap for the average dual-class IPO in our sample was about $30 million.
Of course there are many factors that contribute to differences in P/E ratios across firms. For example, one might ask whether dual-class firms trade at lower P/E multiples because they tend to come from different industries than single-class IPOs (e.g., newspaper publishing rather than technology). Or perhaps dual-class P/E ratios are lower because the market expects these firms to grow more slowly, to invest less in research and development, or to earn lower profits.
Our statistical analysis demonstrates that although these factors are important, they cannot explain away the valuation differences. In short, holding all other factors constant, dual-class firms simply trade at lower prices relative to fundamentals than do single-class firms.
Naturally, this raises a second question: Why does the market assign lower valuations to duals? The simplest explanation would be that singles outperform duals over time. However, we found no evidence that single-class firms generate more cash flow than dual-class stocks. On average, the operating performance of both types of firms was similar, but there was considerable variation around the average. It is when performance deviated from the average, particularly when performance was poor and corporate governance matters most, that differences between singles and duals emerged.
Shake-up Protection
In a well-governed firm, what is supposed to happen when the company underperforms? If poor management is the cause, then it is the board’s responsibility to act, possibly by firing senior managers and hiring new ones. For the firms in our sample, we found 978 cases in which firms replaced their CEOs within five years of the IPO. For single-class firms, a CEO’s departure is preceded by stock returns that trail the market by roughly 17 percent. For dual-class firms, there was no pronounced abnormality in stock returns leading to the CEO’s departure.
However, this pattern reversed when we looked at stock returns preceding takeovers. For single-class firms that are ultimately acquired by other companies, stock returns leading up to the takeover more or less tracked the market. But for dual-class firms, takeovers were preceded by stock returns that trailed the market by almost 30 percent.
What does this tell us? First, CEOs of single-class companies do not hold onto their jobs for long if they are not delivering value for investors. Below-market returns lead to management changes. At dual-class firms, managers enjoy the protection of superior voting power, so there is no correlation between poor stock returns and CEO turnover. However, if returns are low enough, an outside investor may come in and offer a substantial premium, effectively buying out the management team’s voting power.
Murdoch’s Premium Bid
That brings us back to Dow Jones. From January 2004 to April 2007, Dow Jones shares trailed the S&P 500 by roughly 70 percent. On May 1, Rupert Murdoch offered Dow Jones shareholders a 65 percent premium over the April 30 trading price. That offer seemed unambiguously good to most Dow Jones shareholders, but it was the Bancrofts who ultimately determined whether Murdoch’s offer would succeed or fail. So it goes with dual-class companies.
Just last year, Emmis Communications’ CEO, Jeff Smulyan, offered $15.25 per share to buy the 83 percent of the company he didn’t already own. Institutional investors complained that Smulyan’s offer was far too low, but in making the offer, Smulyan made it abundantly clear that he would not entertain competing offers from other bidders. With a mere 17 percent of the stock, Smulyan was in the catbird seat because he controlled a majority of votes through a dual-class stock arrangement.
The two-tiered structure is still a common fixture of today’s IPOs. Google used it when it went public in 2004. Could the search giant’s stock have performed even better without it?
For current or prospective directors of dual-class firms, we offer the following advice: First, if possible, work to eliminate the dual-class voting structure. In our study, firms that rescinded the superior voting rights of Class B shares experienced an immediate value gain of at least 5 percent, which we believe is almost certainly an understatement of the ultimate effect of switching from dual- to single-class stock. Second, if the dual-class structure cannot be eliminated, work to ensure that other mechanisms are in place to align the interests of managers and outside shareholders. Equity-linked compensation plans can help, but only if they expose managers to both the upside and downside risks that shareholders face.