Download Explaining the Equilibrium Existence of Business Groups: Mitigating

Revisiting the Bright and Dark
Sides of Capital Flows in Business
Groups
Joseph P. H. Fan
The Chinese University of Hong Kong
Li Jin
Oxford University & Peiking University
Guojian Zheng
Sun Yat-sen University
Basic Business Group Structures
Parent Co
Parent Co
V=C=50%
Y
V=C=10%
Z
V = 20%, weakest link in the chain,
C = 10%. Pyramid structure allows
leveraging up in control
Joseph P.H. Fan
Organization and Value
V=50%
Y
V=20%
Z
2
Wang Qunbin
Liang Xinjun
Fan Wei
GUO Guangchang
22%
10%
10%
58%
Shanghai Guangxin Technology
Development Co. Ltd.
10％
Shanghai Fusun High Technology Co. Ltd.
49％(2)
China Medical
Holding Co.
95%
Shanghai Fusun
Business
Investment Co. Ltd.
10％
Shanghai Fusun High Technology
(Group) Co. Ltd.
90％
20％
Zhaojin
Mining
Co. Ltd.
21％
Iron&Steel
30％
20％
Nanjing Iron
&Steel United
Co.,Ltd.
20％
YYTM
(600655)
70.95％
Commerce
NISC
(600282)
36.03％
(1)
Lianhua
Supermarket
(HK0980)
26.04％(1)
Shanghai
FriendshipFusun (holding)
Co. Ltd.
53.92％
ACCORD
PHARM
(000028)
Estate
1.94％
24.53％
3.77％
25％(2)
FORTE
(HK2337)
Medicine
13.53％
90.3%
Fusun Pharm
(600196)
11.36％
30％
SFGIC
(600827)
5%
43.33％
(2)
Tangshan
Jianlong Steel
Co. Ltd.
8.81％
％Fusun I.T.
Shanghai
Development Co.
Ltd. (Subsidiary)
Shanghai Fusun
Pharmaceutical
Development Co. 15.04％
(2)
Ltd.
LRGF
(600285)
11.95%(2)
Tianjin
Pharmaceutical
Holdings, Ltd.
67.12％
TJPC
(600488)
48％(2)
JianMin
Pharm
(600976)
Fusun Group (Shanghai, China)
Ownership
Joseph Fan
3
Business Group Structure
v.s. Conglomerate Structure


Group-like organizations are commonplace
in the world.
Comparing with the conglomerate organization



Similarity: complex internal resource flows
Difference: legal boundaries, top down control as
oppose to horizontal control, complex ownership
structure
Because divisions are legally separate entities
in a business group, intra-group capital flow
becomes an issue to outside minority owners
Costs of the Group Structure



Expropriation of minority shareholders by the controlling
parent, e.g., tunneling(Johnson et al.,2000)
From the perspective of the whole group, such “tunneling”
might not be a zero-sum game.
 additional resources to cover up tunneling, potential
legal penalties, ex ante distortion of incentives on
investments
Investors not systematically fooled, the insider of the
business group ultimately bears the welfare loss from
tunneling.
 Cost of the tunneling is reflected in lower security
prices (Claessens et al., 2002; La Porta et al., 2002).
Motivation


Given the costly group structure, what explains the
persistent existence and prevalence of business groups?
For the whole group in under-developed financial markets:
tunneling may be a constrained optimum even if not the
first-best outcome , if it
 alleviates severe financing constraints of member
firms, and enables the undertaking of positive NPV
projects
 Many papers in the conglomerate literature (Stein,
1997…)
 Business group literature: Morck, Wolfenzon, Yeung,
2005; Almeida and Wolfenzon, 2006, 2010; Khanna and
Yafeh, 2007; Gopalan et al., 2007; Masulis et al., 2012
Empirical Challenges

Key challenge to empirical research demonstrating this
tradeoff:
 to disentangle the resources diverted to facilitate group
efficiency from those diverted to satisfy the private
benefits of the controlling shareholder
 For minority shareholders: both are tunneling. But
from the business group perspective, sacrificing a
division may benefit the whole group


Parent firms typically not observable because of nonlisted status
Measurement problem (Kaplan and Zingales, 1997,
2000)
Our attempt

In this paper, we make a modest attempt to bypass
the above difficulties by
 focusing on transfers of financial resources
within business groups, and
 testing the hypothesis that intra-group capital
flow may be motivated by both group capital
allocation efficiency and pure expropriation of
minority shareholders.
Business Group and Pyramidal Control
Structure in China
SAMB
Private Owner
Parent SOE (Parent)
Parent Co. (Parent)
Listed Firm (Listed sub)
Listed Firm (Listed sub)
Ningbo Group (China)
Local Government
100%
100%
Textile
NingBo
(Group) Co. LTD.
93.19%
6.13%
Ningbo Industry Investment
Co. LTD.
Holding
2.33%
VEKEN
NINGBO
GROUP CO., LTD
17.5%
29.7%
NINGBO VEKEN ELITE GROUP CO.,
LTD(600152)
Joseph P.H. Fan
Organization and Value
11
Predictions

Cash flowing in the group is almost onedirectional :


from the listed sub to the parent.
We should observe more intra-group cash flow
activity (tunneling) if the parent and the listed sub
are more severely misaligned in incentives, or if
parent faces more financing constraints.
Predictions on magnitude and efficiency of intragroup capital flow activity (tunneling)






D1: High parent incentive alignment with sub, less severe fin
constraint
D2: High parent incentive alignment with sub, severe fin
constraint
D3: Low parent incentive alignment with sub, less severe fin
constraint
D4: Low parent incentive alignment with sub, severe fin
constraint
Magnitude of capital flow: D4 > D2 & D3 > D1
Efficiency of tunneled capital: D2 > D1 & D4 > D3
Sample and Data
624 firm-year observations from 1999-2005 in China

Each obs. includes a pair of firms (Listed sub and Parent).

Financial information from both the listed subs and the
non-listed parents

Parent sample comes originally from National Bureau of
Statistics’ (NBS) Annual Industrial Survey Database .

Exclude :







“Shell” or holding companies
With missing data
Can’t be indentified in NBS
Less than 20% shares of the listed sub
Parent and the listed sub has the same 3-digit industry code
Negative cash flow
16
Regression Model
Measure of ICF activities: investment of group
member firm A out of cash flow of member firm B,
controlling for cash flow of firm A (Shin and
Stulz ,QJE,1998).

Capex   0  1OwnCashFlow   2OtherCashFlow
  3 Re lativeQ   4OtherCashFlow * Re lativeQ  YearDummie s  
Adding firm fixed effects and year dummies.
Run regression for both Listed sub and Parent,
compare the results:




ICF exists when β2 is positive and significant.
For parent, financial tunneling is efficient when β4 is
positive and significant.
17
Relative investment opportunity


Relative Q = difference in industry Tobin’s q
between the parent and the sub
Use industry average q because parent is
not listed and to mitigate measurement bias
if firm level q is otherwise used
Cash flow measures in the literature

Cash flow=income after tax+ depreciation –
dividend payments


Cash flow=earnings before extraordinary items+
depreciation


Kaplan and Zingales (QJE,1997)
Cash flow=earnings before interest and tax
+depreciation + amortization (EBITDA)


Hoshi, Kashyap and Scharfstein (QJE,1991 )
Kaplan and Zingales (QJE,1997)
Cash flow=operating profit+ depreciation

Shin and Stulz (QJE,1998); Shin and Park(JCF,1999)
Cash flow measures in our paper


Traditional cash flow measure: EBIT + depreciation
Three adjusted cash flow measures




Adjusted Cash Flow Measure 1: (EBIT)+ depreciation net change in trade credits
net change in trade credits =increase in accounts
receivables - increase in payables
We do not have amortization data.
Rationale:




(EBIT+ depreciation) is the accounting profit.
Reasonable in conglomerates
(EBIT + depreciation - net change in trade credits ) is the
amount of cash that is available for use by either own
firm or the other firm.
A large fraction of EBIT take the form of trade credits.
Cash flow measures in our paper



Example:
Suppose a listed sub has a total EBIT of $100,of
which $30 is the increase of trade credits, then
available CF is $70.
Two possibilities of this $30 trade credits :
 naturally arise due to normal transactions


only $70 available for tunneling, adjusted
measures is appropriate
implicit loans from one firm to the other

$100 available for tunneling, traditional measures
is appropriate
21
Cash flow measures in our paper

Which one more closely resembles the reality is an
empirical question.


If adjusted CF measure underestimates tunneling
relative to the traditional CF measure, investment
should be less sensitive to the adjusted CF measure than
to the traditional CF measure.
we found stronger sensitivity between
investment of the parent and the adjusted CF
of the listed sub, suggesting that



the adjusted CF measure does not underestimate
tunneling.
Traditional CF measure may be noisy.
It appears that tunneling in China takes less obvious
forms than through the extension of trade credit
22
Cash flow measures in our paper




Adjusted Cash Flow Measure 2: EBIT +
depreciation -net change in trade credits- income
tax
Adjusted Cash Flow Measure 3: EBIT +
depreciation -net change in trade credits - income
tax + net increase of bank debts and equities.
For adjusted cash flow measure1, we have
data from both Parent and Listed sub
For adjusted cash flow measure 2 and 3, we
only have data from Listed sub.
23
Summary Statistics
Variable
Obs.
Mean
Median
Listed Sub
Mean
Median
Parent
Capital Expenditure
604
0.1191
0.0761
0.0864
0.0405
Net Trade Credits
604
-0.0392
-0.0362
0.0284
0.0197
Traditional Cash Flow Measure
604
0.1016
0.0966
0.0699
0.0595
Adjusted Cash Flow Measure 1
604
0.0624
0.0664
0.0983
0.0789
Adjusted Cash Flow Measure 2
604
0.0455
0.0474
——
——
Adjusted Cash Flow Measure 3
604
0.0849
0.0847
——
——
Industry Q
604
1.6380
1.6914
1.5580
1.5422
Relative Q
604
0.0800
0.0952
-0.0800
-0.0952
Industry Growth
604
0.1150
0.0925
0.1070
0.0869
Cash Flow Right of Parent
604
52.0038
54.4250
——
——
Bank Ownership Dummy
604
0.2447
0.0000
——
——
Size (thousand Yuan)
604
229261
143129
542179
235155
24
Panel A
Cash Flow Measure
Listed Sub Regression
Traditional CF Measure
0.4143
(0.1154)***
0.0441
(0.0301)
0.0214
(0.0126)*
Own Cash Flow
Other Cash Flow
Relative Q
Other Cash Flow *
Relative Q
Adj_R2
0.4235
(0.1261)***
0.0476
(0.0357)
0.0243
(0.0138)*
0.0212
(0.0176)
604
604
Panel B
Adjusted CF Measure 1
0.3601
(0.0547)***
0.0223
(0.0178)
0.0201
(0.0112)*
604
0.3637
(0.0603)***
0.0254
(0.0189)
0.0214
(0.0119)*
0.0168
(0.0210)
604
Parent Regression
Cash Flow Measure Traditional CF Measure Adjusted CF Measure 1 Adjusted CF Measure2 Adjusted CF Measure 3
0.5041
Own Cash Flow
Other Cash Flow
Relative Q
0.5114
(0.0565)*** (0.0579)*** (0.0654)***
0.5132
(0.0689)***
0.0938
0.0802
0.2243
0.2067
(0.0445) **
(0.0466) *
(0.0564)***
(0.0576)***
0.0162
(0.0081)**
0.0159
(0.0102)
0.0842
0.0177
(0.0068)**
0.0167
(0.0087)*
0.1504
Other Cash Flow *
Relative Q
Adj_R2
0.5088
(0.0551)
604
604
0.5262
604
0.5278
0.5299
(0.0502)*** (0.0511)*** (0.0534)*** (0.0541)***
0.2012
0.1874
0.1387
0.1031
(0.0413)*** (0.0389)*** (0.0367)*** (0.0278)***
0.0178
(0.0101)*
(0.0750)**
604
0.5251
0.0166
(0.0113)
0.1231
0.0161
(0.0122)
(0.0682)*
604
604
0.0153
(0.0112)
0.0962
(0.0449)**
604
604
25
Impact of corporate governance and financing
constraint on ICF
Ownership is fundamental to – and cash flow rights
theoretically at the core of – corporate governance.


Empirically strongly related to the incentives of large
shareholders to tunnel the listed firms that they control
(Bertrand et. al, 2002; Claessens et.al, 2002). Especially
when legal protection for outside investors is weak (La
Porta,et.al, 1997, 1998, 1999)
Bank ownership has been argued to be important to
firms for raising external finance(e.g, Hoshi, et.al,1991)


Bank ownership in this paper: A dummy variable whether
listed sub(under Parent’s control ) owns shares of local
financial banks.
26
Cash Flow Measure
Own Cash Flow
Other Cash Flow
Relative Q
Other Cash Flow * Relative Q
Low Cash Flow Right
No Bank Ownership
Low Cash Flow Right * Other Cash Flow
Low Cash Flow Right * Other Cash Flow* Relative Q
No Bank Ownership * Other Cash Flow
No Bank Ownership * Other Cash Flow* Relative Q
Obs.
Adj_R2
Adjusted CF Measure 1
0.5042
0.5085
(0.0434)***
(0.0483)***
0.1578
0.1689
(0.0972)
(0.0884)*
0.0151
0.0156
(0.0093)
(0.0089)*
0.1343
0.1172
(0.0622)**
(0.0618)*
-0.0347
(0.0322)
-0.0296
(0.0297)
0.1486
(0.0676)**
-0.0612
(0.0303)**
0.1068
(0.0483)**
0.0831
(0.0401)**
604
604
0.24
0.24
Putting the two effects together
We next examine the joint effects of
corporate governance and financing
constraints.
Consider four types of interactions of
corporate governance and financing
constraints:







D1: high cash flow right and with bank ownership;
D2: high cash flow right and without bank ownership;
D3: low cash flow right and with bank ownership;
D4: low cash flow right and without bank ownership
D 1 as the benchmark
28
Cash Flow Measure
Own Cash Flow
Other Cash Flow
Relative Q
Adjusted CF Measure 1
(1)
0.5110
(0.0412)***
0.1145
(0.0698)
0.0167
(0.0084)**
Other Cash Flow* Relative Q
D2
D3
D4
D2* Other Cash Flow
D3* Other Cash Flow
D4* Other Cash Flow
0.0312
(0.0347)
-0.0269
(0.0691)
-0.0398
(0.0287)
0.1247
(0.0621)**
0.1126
(0.0558)**
0.2043
(0.0726)***
D2* Other Cash Flow* Relative Q
D3* Other Cash Flow* Relative Q
D4* Other Cash Flow* Relative Q
Obs.
Adj_R2
604
0.24
(2)
0.5145
(0.0475)***
0.1062
(0.0657)
0.0150
(0.0091)
0.1142
(0.0693)
0.0325
(0.0384)
-0.0278
(0.0754)
-0.0411
(0.0332)
0.1124
(0.0642)*
0.1004
(0.0527)*
0.1924
(0.0825)**
0.1465
(0.0728)**
-0.1012
(0.0358)***
0.0334
(0.0452)
604
0.26
29
Robust Tests Using Alternative
Measure of Intra-group Cash Flows


Conventional measure of investment-cash
flow sensitivity still comes as an estimate of
the true capital flows
Two more direct measures for intra-group
capital flow :


ORECTA : Other Receivables deflated by total assets
 Jiang et al (2010)
ORECTA_Parent：Other Receivables provided to
controlling shareholder deflated by total assets
Dep. Variable
Low Cash Flow Right
ORECTA
(1)
0.0075
(0.0040)*
0.0036
(0.0019)*
No Bank Ownership
Low Cash Flow Right *
Relative Q
-0.0191
(0.0094)**
No Bank Ownership * Relative
Q
Relative Q
ROA
Size
State
Marketization
Layer
Obs.
Adj_R2
(2)
0.0028
(0.0056)
-0.6070
(0.0344)***
-0.0022
(0.0012)*
-0.0173
(0.0066)***
-0.0021
(0.0014)*
-0.0077
(0.0035)**
604
0.2365
0.0252
(0.0120)**
0.0112
(0.0111)
-0.6147
(0.0341)***
-0.0019
(0.0012)
-0.0185
(0.0066)***
-0.0023
(0.0016)
-0.0074
(0.0036)**
604
0.2356
ORECTA_Parent
(3)
(4)
0.0096
(0.0034)***
0.0049
(0.0021)**
-0.0078
(0.0024)***
0.0094
(0.0042)**
0.0036
0.0102
(0.0032)
(0.0066)
-0.3169
-0.3117
(0.0234)***
(0.0231)***
-0.0036
-0.0036
(0.0009)***
(0.0009)***
-0.0064
-0.0055
(0.0045)
(0.0045)
-0.0037
-0.0037
(0.0011)***
(0.0011)***
-0.0055
-0.0053
(0.0024)**
(0.0024)**
604
604
0.1918
0.1910
Dep. Variable
D2
D3
D4
ORECTA
(1)
0.0036
(0.0021)
0.0095
(0.0051)*
0.0111
(0.0040)***
D2* Relative Q
D3* Relative Q
D4*Relative Q
Relative Q
ROA
Size
State
Marketization
Layer
Obs.
Adj_R2
-0.0073
(0.0047)
-0.6082
(0.0345)***
-0.0019
(0.0012)
-0.0150
(0.0067)**
-0.0021
(0.0016)
-0.0078
(0.0036)**
604
0.2342
(2)
0.0016
(0.0022)
0.0080
(0.0052)
0.0081
(0.0042)*
0.0459
(0.0200)**
-0.0599
(0.0193)***
-0.0242
(0.0161)
0.0413
(0.0284)
-0.6009
(0.0345)***
-0.0019
(0.0012)
-0.0161
(0.0067)**
-0.0022
(0.0016)
-0.0079
(0.0036)**
604
0.2389
ORECTA_Parent
(3)
(4)
0.0064
0.0059
(0.0028)**
(0.0027)**
0.0072
0.0065
(0.0031)**
(0.0033)**
0.0102
0.0091
(0.0036)***
(0.0049)**
0.0208
(0.0105)**
-0.0367
(0.0126)***
-0.0188
(0.0130)
0.0028
0.0209
(0.0032)
(0.0124)*
-0.3174
-0.3167
(0.0234)***
(0.0235)***
-0.0037
-0.0038
(0.0009)***
(0.0009)***
-0.0065
-0.0066
(0.0045)
(0.0046)
-0.0036
-0.0035
(0.0011)***
(0.0011)***
-0.0055
-0.0055
(0.0024)**
(0.0024)**
604
604
0.1910
0.1914
Other Robust Tests
Alternative proxy for investment
opportunities:



Industry Q: industry average Q matched from
listed firms in China’s stock market.
Industry Growth: Industry average sale growth
calculated from NBS
Event of corporate governance change:


Capital market regulation against expropriation
by controlling shareholder from 2003.
Alternative proxy for financing constraints:


Firm size (Almeida and Campello, 2007;
Erickson and Whited, 2000)
33
Industry Q and Industry Growth
D2* Other Cash Flow
D3* Other Cash Flow
D4* Other Cash Flow
D2* Other Cash Flow*
Industry Q
D3* Other Cash Flow*
Industry Q
D4* Other Cash Flow*
Industry Q
0.1046
(0.0512)**
D2* Other Cash Flow
0.0941
(0.0486)*
D3* Other Cash Flow
0.1525
(0.0684)**
0.1628
(0.0714)**
-0.2046
(0.0701)***
-0.0512
D4* Other Cash Flow
D2* Other Cash Flow*
Industry Growth
D3* Other Cash Flow*
Industry Growth
0.1040
(0.0516)**
0.0747
(0.0486)
0.1721
(0.0791)**
0.1542
(0.0472)***
-0.0576
(0.0273)**
0.0847
(0.0357)
D4* Other Cash Flow*
Industry Growth
Obs.
604
Obs.
604
Adj_R2
0.25
Adj_R2
0.26
(0.0619)
Capital Market Regulation
Panel A: Investment-Cash Flow Sensitivity Model
Cash Flow Measure
Own Cash Flow
Other Cash Flow
Relative Q
Adjusted CF Measure 1
(1)
(2)
0.5012
0.4915
(0.0446)***
(0.0425)***
0.2042
0.1733
(0.0655)***
(0.0754)**
0.0161
0.0156
(0.0084)*
(0.0099)
Regulation * Other Cash
Flow
Dep. Variable
Regulation
Regulation * Relative Q
0.1285
Other Cash Flow * Relative Q
Regulation
Panel B: Capital Flow Determinant Model
Relative Q
ROA
(0.0665)*
0.0723
0.0685
(0.0226)***
(0.0266)**
-0.0624
-0.0542
(0.0356)*
(0.0288)*
Size
State
Marketization
0.1156
Regulation * Other Cash
Flow* Relative Q
(0.0658)*
Layer
Obs.
Adj_R2
Obs.
604
604
Adj_R2
0.2438
0.2598
Regulation =1 if sample year is 2004-2005
ORECTA
ORECTA_Parent
(1)
-0.0415
(0.0078)***
0.0103
(0.0053)*
0.0128
(0.0076)
-0.6180
(0.0341)***
-0.0019
(0.0012)
-0.0176
(0.0066)***
-0.0021
(0.0016)
-0.0079
(0.0036)**
604
0.2341
(2)
-0.0245
(0.0054)***
0.0053
(0.0020)**
0.0061
(0.0048)
-0.3140
(0.0231)***
-0.0036
(0.0009)***
-0.0053
(0.0044)
-0.0037
(0.0011)***
-0.0055
(0.0024)**
604
0.1914
Firm Size
Panel A: Investment-Cash Flow Sensitivity Model
Cash Flow Measure
Own Cash Flow
Other Cash Flow
Relative Q
Adjusted CF Measure 1
(1)
(2)
0.4952
0.4978
(0.0528)***
(0.0513)***
0.1945
0.1661
(0.0755)**
(0.0822)**
0.0171
0.0141
(0.0084)**
(0.0086)
0.1278
Other Cash Flow * Relative
Q
Small Size
Small Size * Other Cash
Flow
Panel B: Capital Flow Determinant Model
Dep. Variable
Small Size
Small Size * Relative Q
Relative Q
ROA
(0.0725)*
-0.1402
-0.1335
(0.0286)***
(0.0301)***
0.1047
0.0918
(0.0486)**
(0.0496)*
Size
State
Marketization
0.0809
Small Size * Other Cash
Flow* Relative Q
(0.0391)**
Layer
Obs.
Adj_R2
Obs.
604
604
Adj_R2
0.2447
0.2525
ORECTA
(1)
0.0133
(0.0044)***
0.0041
(0.0020)**
0.0060
(0.0041)
-0.6037
(0.0343)***
-0.0016
(0.0012)
-0.0159
(0.0066)**
-0.0022
(0.0016)
-0.0079
(0.0036)**
604
0.2388
Small Size=1 when parent firm size is below the median of sample.
ORECTA_Paren
t
(2)
0.0042
(0.0021)**
0.0097
(0.0050)*
0.0084
(0.0048)*
-0.3142
(0.0233)***
-0.0037
(0.0009)***
-0.0055
(0.0044)
-0.0036
(0.0011)***
-0.0054
(0.0024)**
604
0.1918
Conclusion

We document the existence of two aspects of intragroup financing using 604 pair-years of Chinese
listed firms and their non-listed parents :



cross-financing to mitigate severe financing constraints,
and
the exploitation of minority shareholders due to weak
corporate governance.
Both can account for the rise of intra-group
financing, but they have opposite impacts on group
capital allocation efficiency:


highest when the motivation is purely the mitigation of
financial constraints, and
lowest when it is purely expropriation of outside investors.
37
Thank You!