Investors need to adjust their assessments of what makes firms valuable when circumstances change. A firm with favorable political or government ties may benefit, say, by landing lucrative contracts, while its rivals that hobnob with NGOs may not win those contracts. But those equations could do a 180-degree reversal in an anti-corruption crackdown.

Recent research by Wharton management professor Aline Gatignon and other experts captured investors’ immediate responses to “institutional transitions” such as anti-corruption investigations, as they show up in stock prices and in media reports. Their research findings are presented in a paper titled, “The Returns to Nonmarket Strategies During Institutional Transitions: Investor Reactions to Actor and Tie Characteristics.” Gatignon’s co-authors are Marina Amado Bahia Gama, professor at the Sao Paolo School of Business Administration in Brazil, and Rodrigo B. DeMello, management professor at Merrimack College in North Andover, Massachusetts.

The study’s findings show that “investors quickly react to institutional transitions and do so in a nuanced way by assessing the relative value of different nonmarket strategies,” the paper stated. The utility of those findings is they help companies and investors better understand which “nonmarket strategies” could pay off and which of those could backfire. “Our findings can help predict which firms will be better situated to weather institutional transitions of this nature,” the paper added.

Essentially, the study found that before the police raids, investors had favorable perceptions of companies with strong political connections. But after the raids, investors viewed those ties as unfavorable. “The core mechanism is legitimacy, and [the raids are] changing the basis on which different types of corporate practices are seen as legitimate or not,” said Gatignon. “Donations to NGOs might be a preferable way of having influence, because that is seen as more legitimate than having political ties.”

The study showed that “firms ultimately benefitted the most when they had made prior donations to NGOs and suffered the most when they had politically connected board members,” Gatignon continued.

Signals from Operation Car Wash

The authors tested their hypotheses by studying investor responses in the aftermath of seven police raids on Brazilian companies in 2014. The raids launched an anti-corruption probe called “Operation Car Wash,” which led to indictments of prominent businesses, business leaders, and politicians, including former presidents of the country.

“Firms ultimately benefitted the most when they had made prior donations to NGOs and suffered the most when they had politically connected board members.”— Aline Gatignon

The study covered between 100 and 125 firms across different event windows, and tracked the “cumulative abnormal returns” reflected in their stock prices over the seven days of the raids. The authors identified the “abnormality” in those returns by comparing them with “what the returns would have been” had the raids not occurred, based on historical data going back up to 200 days before the event, Gatignon explained. The statistical techniques they used are designed to capture short-term investor reactions and not long-term trends, she added.

The study measured nonmarket ties such as political donations by the number of politicians who received support through campaign donations in the 2010 election, using publicly available data. The paper identified two features of those donations: “First, a campaign donation establishes a tacit contract between donors and recipients that facilitates access during the political actor’s mandate. Second, these ties were evident to investors and complied with legal parameters.”

It measured political board ties as the number of political connections corporate board members held, as revealed in publicly available resumes; it tracked nearly 5,500 such resumes of board members in its sample firms. The study’s data canvas included media articles to understand what new information investors received about the raids during the seven-day window. It measured NGO donations as the total number of NGOs supported with financial or in-kind gifts, as reported at the time of the events.

How Connections Work

In settings where companies have direct political connections, they try “to exert influence in such a way as to generate private rents, which will be seen as less legitimate than it was before these police raids,” Gatignon said. “Those direct ties are meant to interfere with the system in such a way that benefits a company. They are not illegal, but investors will see these practices as less legitimate.” Investors will see more legitimacy in indirect means of influence, such as developing coalitions with NGOs, she added.

That shift does not assume that ties with NGOs “are cleaner” than direct political connections or that they have greater regulatory compliance. The main difference is that investors see ties with NGOs as “a more indirect means of influence compared to ties to political actors and board ties,” Gatignon noted. “It’s more of an arm’s length transaction. It’s meant to support what other actors are doing, but not necessarily to unduly influence them for your benefit.” At the same time, not all types of NGO connections are equally beneficial for the firm, “as the tie’s nature can undermine the actor’s legitimacy,” the paper cautioned.

Takeaways for Regulators, Companies, and Investors

The study showed that “when there’s a signal of change that investors see as credible, they will react very fast, and they’re not going to stick to the status quo,” said Gatignon. “They will reassess the basis on which they assess firm value in ways that could radically change what types of corporate nonmarket strategies are valuable.”

“When there’s a signal of change that investors see as credible, they will react very fast, and they’re not going to stick to the status quo.”— Aline Gatignon

According to Gatignon, one takeaway from the study for regulators could be to focus on anti-corruption reforms. “There’s an optimistic message here that if you can set up the conditions where investors think there’s an improvement, then they will change,” she said. “After that, you need to make sure that these circumstances endure over time. There can’t be a reversal. If there is a reversal, potentially those investors could change back [to their earlier valuation criteria]. Gatignon said she and her co-authors are working on a follow-up paper to see if firms actually change their behavior after a shock like a police raid, and the longer-term effects.

“Our study’s contributions lie at the intersection of research on nonmarket strategy and institutional change,” the paper stated. “Specifically, its findings advance our understanding of how institutional dynamics affect the returns to nonmarket strategy. Our results can also contribute to our understanding of anti-corruption shocks in particular and their effects on firms.”

“Our paper shows that we shouldn’t think of corporate political activity and corporate social activity in silos, but rather as distinct strategies that investors will compare in function of what’s perceived to be a legitimate form of engagement at a given point in time,” said Gatignon. “That could change really fast, but investors are adept at swiftly weighing whether both the nature of the actor and the tie that connects it to the firm are aligned or misaligned with the institutional environment.”

Firms cannot adapt their nonmarket ties as swiftly as investors can, Gatignon said. “Therefore, managers should analyze the likelihood of future institutional transitions when deciding which types of nonmarket strategies to invest in.”

Those shifts are particularly relevant in emerging markets, “where the pendulum can swing back and forth swiftly between legal capture and legal compliance,” Gatignon said. The study is especially significant against the backdrop of attempts by governments in recent years to curb corruption. The paper pointed to examples such as the 2014 election of Indian Prime Minister Narendra Modi on the back of an anti-corruption movement and the Chinese anti-corruption reform launched in 2012. Not all such attempts bring lasting change; for instance, in Brazil, the environment after the 2014 anti-corruption drive showed that “such efforts have not necessarily been successful – or only temporarily or superficially so,” it added.