GCOE Discussion Paper Series
Global COE Program

Human Behavior and Socioeconomic Dynamics
Discussion Paper No.41

Managerial Entrenchment and Corporate BondFinancing:Evidence from Japan

Takanori Tanaka

March 2009GCOE Secretariat
Graduate School of Economics

OSAKA UNIVERSITY

1-7 Machikaneyama, Toyonaka, Osaka, 560-0043, Japan

Managerial Entrenchment and Corporate Bond Financing:
Evidence from Japan∗

Takanori Tanaka†

Abstract
This paper investigates whether managerial entrenchment of controlling shareholders affects corporatebond financing. Using data on Japanese manufacturing firms, we find that firms with controllingshareholders issue less straight corporate bonds than other firms. The results show that managerial
entrenchment of controlling shareholders has an influential impact on corporate bond financing.

JEL classification code: G32
Keywords: Managerial entrenchment; Large corporate shareholders; Corporate bonds∗

I would like to thank Kazuo Ogawa for valuable comments and suggestions. The usual disclaimer applies.
Institute of Social and Economic Research, Osaka University, 6-1 Mihogaoka, Ibaraki, Osaka 567-0047, Japan.
E-mail address: t-tanaka@iser.osaka-u.ac.jp.
†1. IntroductionConcentrated ownership provides shareholders with incentives to monitor managers, and to exercise
influence over decision-making within the firm. Such controlling shareholders tend to entrench managers
against other corporate governance mechanisms to pursue their own interests, and enjoy private benefits ofcontrol.
Managerial entrenchment of controlling shareholders could have a significant effect on costs of bondfinancing. Controlling shareholders often have incentives to enjoy the private benefits of control that aredetrimental to bondholders. Such conflicts of interest between controlling shareholders and bondholders
result into potentially higher likelihood of default. If bondholders perceive expropriation by controllingshareholders as increasing the agency risk in the evaluation of potential default risk, bondholders charge
firms with controlling shareholders a higher rate to cover costs arising from divergent interests (Bhojraj andSengupta, 2003). Furthermore, credit rating agencies that evaluate potential default risk may also beconcerned about expropriation by controlling shareholders, and assign lower bond ratings to firms with
controlling shareholders, thereby resulting in higher cost of bond financing (Ashbaugh-Skaife et al.., 2006).
As a consequence, agency costs (higher bond yields and lower bond ratings) adversely affect the bondissuance of firms with controlling shareholders.
On the other hand, in a managerial approach to capital structure choice, entrenched managers face lossof control over management when firms experience hostile takeovers or go into bankruptcy. Hostile
takeovers and bankruptcies reduce managerial entrenchment because they affect the likelihood ofmanagerial replacement (e.g., Novaes, 2003). To defend against unwanted takeover attempts, entrenchedmanagers increase debt, thereby reducing raiders’ takeover incentives (e.g., Berger et al.., 1997). In contrast,
entrenched managers have an incentive to reduce debt to prevent bankruptcies. In choice of debt level,
entrenched managers face a trade-off between lower debt levels that avoid bankruptcies and higher debt
levels that deter hostile takeovers. However, if the threat of hostile takeover is absent, entrenched managers
have an incentive to reduce debt to avoid bankruptcies. Consequently, in an environment in which thethreat of hostile takeover is absent, managerial entrenchment provides controlling shareholders with lessincentive to issue corporate bonds.
In this paper, we examine whether managerial entrenchment of controlling shareholders affects
corporate bond financing. Given the discussion above, equity ownership by controlling shareholders could
be negatively associated with levels of corporate bonds in an environment in which the threat of hostile
takeover is absent－hostile takeover activities themselves are rare or higher equity ownership defend
against hostile takeovers.
Using data on Japanese manufacturing firms, we find that equity ownership by large corporateshareholders is negatively related to levels of straight corporate bonds after controlling for other
determinants of straight corporate bonds. This indicates that firms with controlling shareholders issue lessstraight corporate bonds than other firms. As a consequence, managerial entrenchment of controlling1

shareholders has an influential impact on corporate bond financing.

2. Data
Our data come from financial statement dataset compiled by the Japan Development Bank which includes
the unconsolidated data of the non-financial firms traded on the stock exchange. We use data on
manufacturing firms listed on the stock exchange from March 1994 to March 1999. As a result, our sample
consists of 1049 firms.
We focus on Japanese manufacturing firms because large corporate shareholders as controllingshareholders are prevalent. The relationship between owned firms and large corporate shareholders is often
characterized as a vertical business linkage between subcontracting firms as suppliers and core firms as
manufacturers. Large corporate shareholders as stable shareholders have long-term relationships withowned firms through repeat business transactions. Such large corporate shareholders have strong incentives
to entrench managers to maintain long-term relationships with owned firms. Moreover, hostile takeovers
rarely occurred in the 1990s in Japan.1 Although mergers and acquisitions (M＆A) increased in the late
1990s, most of them were friendly takeovers. Therefore, data on Japanese manufacturing firms in the 1990s
are suitable for testing our hypothesis.
To test our hypothesis, we estimate the following equation:Straight corporate bond ratio=ββ Large corporate shareholder ownership+β ROA

β Loan ratio+β Sales growth

β Cash ratio

β Firm size

β Firm age

β Financial institution ownership
β Other corporate bond ratio
εwhere straight corporate bond ratio is the ratio of straight corporate bonds to total assets, large corporateshareholder ownership is equity ownership by corporate shareholders as top shareholder, financial
institution ownership is equity ownership by financial institutions, ROA is the ratio of pre-tax income tototal assets, loan ratio is the ratio of loans (short- and long-term loans) to total assets, cash ratio is the ratioof cash and deposits to total assets, other corporate bond ratio is the ratio of convertible and warrant bonds
to total assets, sales growth is the growth rate of sales over the previous year, firm size is the logarithm oftotal assets, firm age is the logarithm of years elapsed since establishment, t is the time subscript, β is aconstant, and ε is the error term.
In the equation, our key variable is large corporate shareholder ownership.

We here use two variables:equity ownership of more than 10％ (large corporate shareholder ownership 10) and more than 20％(large corporate shareholder ownership 20). Higher equity ownership could serve as effective way of
averting hostile takeovers, and provide shareholders with incentives to entrench managers. We expect thecoefficients on these variables to be negative. Data on equity ownership by large corporate shareholders
come from Japan Company Handbook. Financial institution ownership is included to capture the strength1

Xu (2006) documents that hostile takeover activities in Japan increased drastically from January 2000.
2

of the relation between financial institutions and firms.2 Return on assets (ROA) is intended to control forfinancial conditions. We include the variables for loans, cash and other corporate bonds to capture theeffects of funds that could substitute for corporate straight bonds. Sales growth is included to capture theeffect of bond demand. Firm size and firm age are included because they are proxies for thecreditworthiness of the firm. Typically, larger and older firms could have easy access to the bond market.
Descriptive statistics for variables are provided in Table 1. Note that we remove the extreme values toensure robust results.3

3. Results
Table 2 provides tobit regression estimates for the determinants of straight corporate bonds. To avoid
potential endogeneity problem, we use one period lagged values of the independent variables except forfirm size and firm age.

Because data on equity ownership by large corporate shareholders are notavailable for all firms for all years, the number of observations varies with specifications. All ourspecifications include industry dummy variables and year dummy variables.
Column 1 contains the results for the specification without the variable for large corporate shareholderownership. We find significantly higher levels of straight bonds in firms with higher equity ownership byfinancial institution, lower ROA, less other funds (loans, cash, and other corporate bonds), higher sales
growth, and larger firms.
Column 2 contains the results for the specification with large corporate shareholder ownership 10.
Negative and significant coefficient on large corporate shareholder ownership 10 indicates that firms with
controlling shareholders issue less straight corporate bonds than other firms because of higher agency costs
and incentives to avoid bankruptcies. The results for other variables are similar to those in column 1 except
for financial institution ownership. This may be driven by higher correlation between two ownershipvariables. Indeed, the correlation coefficient of the two is －0.59.4 Column 3 contains the results for thespecification with large corporate shareholder ownership 20, which could serve as more effective way of
averting hostile takeovers. The coefficient on large corporate shareholder ownership 20 remains
significantly negative. Results for other variables do not change.5

4. Conclusion
This paper examines whether managerial entrenchment of controlling shareholders has an essential impact

2Kang and Liu (2007) document that bond issues of firms closely affiliated with banks are more likely to beunderwritten by banks.
3Extreme observations are defined as those for which any one of the variables has a value more than fourstandard deviations away from the mean value.
4The negative correlation between them may suggest that financial institutions tend not to have shares of firms
with large corporate shareholders (Barucci and Mattesini, 2008).
5In columns 2-3, we obtain similar results when financial institution ownership is not included.

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on corporate bond financing. Using data on Japanese manufacturing firms, we find that equity ownershipby large corporate shareholders is negatively associated with levels of straight corporate bonds aftercontrolling for other determinants of straight corporate bonds. This indicates that firms with controllingshareholders issue less straight corporate bonds than other firms because of higher agency costs andincentives to avoid bankruptcies. As a consequence, managerial entrenchment of controlling shareholders
has a substantial impact on corporate bond financing.

4References
Ashbaugh-Skaife, H., Collins, D. and LaFond, R. (2006) The effects of corporate governance on firms'
credit ratings, Journal of Accounting and Economics, 42, 203-243.
Barucci, E. and Mattesini, F. (2008) Bank shareholding and lending: complementarity or substitution? someevidence from a panel of large Italian firms, Journal of Banking and Finance, 32, 2237-2247.
Berger, P., Ofek, E. and Yermack, D. (1997) Managerial entrenchment and capital structure decisions,
Journal of Finance, 52, 1411-1438.
Bhojraj, S. and Sengupta, P. (2003) Effect of corporate governance on bond ratings and yields: the role ofinstitutional investors and outside directors, Journal of Business, 76, 455-475.
Kang, J-K. and Liu, W-L. (2007) Is universal banking justified? evidence from bank underwriting ofcorporate bonds in Japan, Journal of Financial Economics, 84, 142-186.
Novaes, W. (2003) Capital structure choice when managers are in control: entrenchment versus efficiency,
Journal of Business, 76, 49-81.
Xu, P.

(2006) Which firm is the target for hostile takeover ? RIETI Discussion Paper Series 06-J-008. (inJapanese)5

Table 1. Descriptive statistics
Variable

MeanStandard deviation

Straight corporate bond ratio

0.022

0.044

Large corporate shareholder ownership 100.309

0.154

Large corporate shareholder ownership 200.371

0.133

Financial institution ownership

0.313

0.158

ROA

0.023

0.045

Loan ratio

0.191

0.181

Cash ratio

0.100

0.077

Other corporate bond ratio

0.035

0.062

Sales growth－0.001

0.104

Firm size

10.902

1.333

Firm age

3.994

0.299

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Table 2. Managerial entrenchment and corporate bond financing
Dependent variable: straight corporate bond ratio

1

Independent variable2－0.120*(0.016)Large corporate shareholder ownership 100.090*(0.019)－0.516*(0.066)－0.068*(0.016)－0.009(0.023)－0.517*(0.066)－0.077*(0.016)－0.108*(0.016)0.003(0.023)－0.517*(0.066)－0.077*(0.016)－0.095*(0.033)－0.128*(0.035)0.072*(0.026)0.028*(0.002)0.010(0.008)－0.122*(0.034)－0.115*(0.035)0.074*(0.026)
0.031*(0.002)0.012(0.008)－0.120*(0.034)－0.116*(0.035)0.074*(0.026)
0.031*(0.002)0.012(0.008)4025
0.563－251.125

4010
0.611
－222.864

4010
0.606
－225.925

Large corporate shareholder ownership 20
Financial institution ownership
ROA
Loan ratio
Cash ratioOther corporate bond ratio
Sales growthFirm size
Firm age

No. of observations
PseudoLog likelihood

3Notes
The table reports tobit regression estimates for 1049 Japanese manufacturing firms listed the stock
exchange from March 1994 to March 1999. All regressions include a constant, industry dummy variables
and time dummy variables. Numbers in parentheses are standard errors. * denotes significance at the 1 %level.

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