The Cost of Political Connections

February 6, 2019

The Cost of Political Connections 
Marianne BertrandFrancis Kramarz; Antoinette Schoar; David Thesmar
Review of Finance, Volume 22, Issue 3, 1 May 2018, Pages 849–876,

Existing research generally shows that political connections are of significant value to firms, because political leaders grant favors to the connected firms. In a famous paper, Fisman (2001) shows that firms closely connected to former Indonesian President Suarto suffered significant stock price declines when there were rumors about his ill-health. In another famous paper, Faccio (2006) finds that when a large shareholder or top officer enters politics, the firm’s stock price rises significantly – and the rise is particularly strong if elected prime minister. Similarly, politically connected firms enjoy higher profits.

This paper shows that the relationship needn’t be only one-way. In addition to politicians taking decisions to help politically-connected firms, politically-connected firms may take decisions to help politicians – at the expense of firm value. For example, they may fail to shut down plants, or open up new plants, even if not economically justified, to boost employment and help a politician in his re-election campaign.

The authors identify politically-connected firms as ones in which the CEO was previously a cabinet member, i.e. served as a close advisor to a government minister. Studying French local elections, they first confirm that local employment does increase the chances that a local politician is re-elected. So, do politically-connected firms try to exploit this relationship by boosting employment in the run-up to a local election? They do. They’re less likely to fire workers and close plants, and more likely to hire workers and open plants, than unconnected firms. (The authors do this comparison to unconnected firms to control for local economic conditions which may drive hiring and firing behavior). These effects are particularly strong for close elections, where the firm’s decisions might be particularly pivotal for the politicians’ re-election prospects.

What do these results mean? The authors’ hypothesis is that, outside of election years, firms take decisions that maximize firm value. Thus, the different behavior that we see in election years reduces firm value. But a potential alternative explanation is that, outside of election years, CEOs generally shirk and don’t take the effort to open new plants and hire workers. The re-election campaign spurs CEOs to (correctly) open new plants and hire workers, increasing firm value.

The evidence favors the first interpretation. Firms with politically-connected CEOs have 1-2% lower return-on-assets (ROA) than unconnected firms. Similarly, a firm moving from an unconnected to a connected CEO has an ROA that’s 2.2% lower than a firm moving from one unconnected CEO to another unconnected CEO.

Do politically-connected firms benefit in return? Surprisingly not – they don’t enjoy higher subsidies or lower local taxes in election years. While the authors don’t have data on government contracts, they do have data on sales and find that connected firms’ don’t enjoy higher sales either, which might suggest preferential access to government contracts.  The lower ROA of connected firms is also inconsistent with them benefiting in return. Politically-connected CEOs seem to be doing local politicians a favor with no corresponding benefit, harming their firms overall as a result.