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Relationship-Specific Investment, Contracting Environment and Financial Performance

Firms that engage in long-term bilateral relationships with their buyers or suppliers are usually required to make relationship-specific investments. We examine how the values of these long-term specific investments are affected by the quality of governmental contract enforcement. We find that firms in relationship-specific industries have higher valuations, measured by Tobin’s Q, when their countries of origin are able to strongly enforce contractual agreements. Our finding is robust to a variety of empirical specifications and regression methods. We also show that as legal quality improves, these relationship-specific firms exhibit lower operating performance presumably due to risk or in order to motivate further investments from their stakeholders. Further analysis of the cross-section of stock returns supports a risk-based explanation.