Ebook Internal Capital Markets And Capital Structure: Bank Versus Internal Debt
During the last decade, a growing number of theoretical and empirical studies have compared financing via internal capital markets of conglomerates, business groups or multinational corporations, with external market finance. Contrary to the case of the conglomerates described in the theoretical literature, where external financing is often assumed to be raised by headquarters and passed through to divisions (e.g. Gertner et al., 1994; Stein, 1997), in practice member firms of business groups and multinationals are often separate legal entities which may also directly access the external capital markets. Within these types of organizations, the external/internal financing decision is likely to be a complex group wide trade-off between benefits and costs of internal and external financing. Empirical evidence of this phenomenon is found by Desai et al. (2004), who show that foreign affiliates of US multinational corporations use parent debt as a substitute for external debt, especially in countries where access to external financing is limited or expensive. They argue that the possibility of raising debt where it is cheapest and the potential for tax arbitrage offers multinational corporations an important advantage over their local competitors. However, many large domestic firms are also tied together through ownership to form a domestic group. Especially in Continental Europe, South East Asia and several emerging market regions (e.g. India) this group organizational form is important. For instance, almost one third of the top 100,000 non-financial companies in the Euro-zone have domestic group ties. The vast majority of these groups does not have a stock exchange quoted component.
This paper is the first to analyze in detail, if and how, internal capital markets within domestic business groups are used to minimize the costs of attracting external financing. It offers the opportunity to evaluate whether or not - likewise international groups - domestic groups can offer their subsidiaries important financing advantages as well. To ensure clean testing we examine the capital structure of large domestic subsidiaries of Belgian private business groups. Firstly, this implies all companies we consider operate under the same tax regime and within the same institutional framework. Secondly, confounding effects are further reduced because of the limits on financing alternatives imposed by the private nature of the groups: external financing will almost always be bank debt. Finally, only larger subsidiaries have an obligation to report detailed information on internal financing. Limiting ourselves to this type of affiliate has the additional advantage that effects from typical financing problems of small firms are avoided within the sample. Within this setting, we contribute to the literature by developing testable hypotheses about the costs and benefits of bank and internal debt5 within global group optimization, and about the nature of the choice between both sources of funding. Using a sample of 553 subsidiaries which are part of 253 different business groups, we model the determinants of the bank and internal debt concentration (i.e. the importance of bank and internal debt as a fraction of total liabilities). Novel to the literature on debt type concentration, we use information from multiple financial statements (at company level and at consolidated group level), which allows us to investigate the importance of affiliate versus group characteristics. Moreover, we use a sample of comparable stand-alone firms as a benchmark to pinpoint the impact of group membership on bank debt concentration.
Our focus is different from that of most of the empirical literature on business groups’ internal capital markets, which mainly concerns explaining the general leverage level of group firms. As a by-product, this literature does offer some inferences on the use of external debt by subsidiaries. Manos et al. (2001) demonstrate that group issues matter in determining the leverage levels of quoted Indian firms. Bianco and Nicodano (2006) show that in Italian business groups, subsidiaries use less external debt as compared to the group holding company. Verschueren and Deloof (2006) find similar results for large Belgian firms and conclude that internal debt is a substitute for external debt. Direct empirical evidence on the drivers of the different components of debt taken on by subsidiaries is scarce. An exception to this is the case of Japanese keiretsu (e.g. Hoshi et al., 1990; Hoshi et al., 1993; Gul, 1999). However, due to the presence of group banks the keiretsu capital structure problem is unique (e.g. bank debt and internal debt can often not be distinguished).
The empirical aim of our study is also different from that of most of the general capital structure literature, which either concerns the choice between public debt and equity (Marsh, 1982; Easterwood and Kadapakkam, 1991; Shyam Sunder and Myers, 1999, among many others – see Myers, 2001 for a survey), or public debt vs. private debt vs. equity (e.g. Houston and James, 1996, Johnson 1997, 1998; Hooks, 2003; Denis and Mihov, 2003). For companies without access to public debt or equity, the key financing decision concerns the creation of an optimal mix of different private debt types. As argued above, for private business group affiliates in a bank-based financial system, the most important dimension of the debt source decision is likely to be the choice between bank and internal debt.
Previewing our main results, we find that cost savings from centralising financing within groups are an important driver of internal debt use by subsidiaries. Moreover, as the depth of the internal capital market increases, bank debt at subsidiary level is replaced by internal debt. This preference for internal financing increases with the size and age of the group, but decreases with group leverage. Contrary to the relative use of internal debt, which is mainly driven by the characteristics of the internal capital market, individual subsidiary characteristics play a more important role in explaining bank debt concentration. We find that internal debt has a strong negative impact on bank borrowing by subsidiaries, while, in reverse, bank borrowing does not shape internal debt concentration. The data therefore indicate that groups use a pecking order in favour of internal financing. Also, as compared to stand-alone firms, where cash flow shortages often have to be filled with bank debt, in subsidiaries this role is largely taken over by internal debt. Nevertheless, we find evidence indicating that, if needed, groups can facilitate access to bank borrowing by their subsidiaries by adding internal debt, as in practice the latter is subordinated to bank debt. Furthermore our results suggest that as groups use more leverage, moral hazard and dissipative costs from centralizing external borrowing increase. Groups tend to solve this problem by placing bank debt within subsidiaries and hence offer banks seniority rights on the assets of these affiliates. Overall, the evidence consistently supports the notion that the optimisation of group-wide financing costs is an important driving factor of domestic group subsidiaries’ financing choices.
The remainder of the paper is organized as follows. Section 2 develops a general perspective on the advantages and disadvantages of bank and internal debt. Section 3 develops hypotheses about the link with firm level and group level variables. The sample and univariate statistics are discussed in Section 4. Section 5 contains the empirical analysis. Finally, Section 6 summarizes the main conclusions.
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