“Business groups” are common in many countries, especially in emerging economies. In those economies, the role of collections of legally distinct firms tied together and coordinating on their actions is important. Linkage between member firms is complex. It could be formal or informal, and direct or indirect — ranging from pyramidal holding company structure to cross ownership and to common directorates. This feature can be traced at least back to the Japanese pre-war zaibutsu and its post-war keiretsu. Many economists have been studying the performance and behavior of firms in business groups extensively. Several results of those studies refer to the existence of internal capital markets within business groups. In this paper, I look at the issue in more detail and try to answer related questions: First, do business groups have internal capital markets? Are the internal capital markets deliver the efficient resource allocation within the group? Finally, if some groups tend to have more efficient allocation than others, what are the characteristics that determine this tendency? Using the firm-level data from Thailand’s Ministry of Commerce, this study shows that the degree of efficiency of resource allocation varies across business groups. Groups whose controllers have higher control, groups with more number of member firms, and groups with winthin-group intermediaries tend to have more efficient resource allocation. Groups with larger fraction of listed firms deliver the opposite results while industry diversification seems not to affect the efficiency of resource allocation of the groups.
In this paper, I define “business group” as a collection of legally independent firms that are wholly or partly owned and managed by the same person (or a group of person such as family). What makes business groups different from a collection of firms interacting through the external markets; and what makes business groups different from a collection of segments in a diversified firm? These questions are not new. They are just a variant of what Ronald Coase (1937) posed more than 60 years ago on the nature of firms and markets. Business groups stand between the two of them. I take as a building block Grossman and Hart’s (1986) view of a firm as a nexus of assets, and use their definition of ownership to distinguish activities within business groups from the ones that occur within firms or in the external markets. Grossman and Hart define ownership as residual control rights over the use of assets of the firms. Therefore, an owner of a firm has a right to transfer assets across segments of the firms in order to maximize the value of her firm. In effect, this is just an establishment of internal capital markets within the firm. Similarly, I define a business group as a collection of legally independent firms that are controlled by a person (or a group of persons) that has a right over the use of assets of the member firms. This person has a right to transfer assets across the member firms, hence establishing internal capital markets within a group. What makes a business group different from a firm is that the right over the use of assets is limited because each member firm in a group is independent by law. Since the composition of shareholders of each member firms of a group could be different, the optimal resource allocation in a view of the controller is possibly not the optimal one in other shareholders’ prospect. This conflict of interest between inside (controlling) and outside (non-controlling) shareholders makes the within-group capital markets imperfect, even when there is no agency problem between the owner and the managers of the member firms. The degree of imperfection is lower when the controller has higher ability to control the group. This ability in turn depends on the structure of the group and corporate laws in the economy.
I assume that external capital market is imperfect so external fund is more costly than internal finance. This assumption is natural in emerging economies because their capital markets are not fully developed and firms tend to have credit constraints. As presented in Gilchrist and Himmelberg (1998), the marginal cost of fund determines the firm’s discount factor that is used in discounting the stream of marginal future benefits of the current investment. As a result, the firm’s investment will depend on its financial determinants as well as its profitability. Since a group with absolute control can freely transfer resources across its member firms, the efficient allocation implies that the marginal costs of fund are equalized across firms within the group; therefore, a group firm’s investment should depend only on its group’s financial factor and the firm’s own profitability— but not the firm’s financial determinants.
In this paper, I will study the issue addressed above in two steps. First, I derive two structural models of investment in the presence of costly external finance— one for a non-group firm and the other for firms in a group with absolute control. I derive an empirical counterpart of the model and use it to test whether there is internal capital markets in groups or not, and also whether they deliver an efficient resource allocation outcome. Then, I test which characteristic of groups that affect the efficiency of resource allocation. The potential characteristics include corporate ownership and control of the groups, group size, corporate law and regulation, within group intermediaries, and industry diversification. The results show that (1) corporate control, (2) group size, and (3) within-group intermediaries tend to facilitate the efficient resource allocation in a view of the controlling shareholders. Corporate laws and regulations deliver the opposite results while industry diversification shows no effect on within-group resource allocation. In sum, the paper provides evidence from micro data that the structure of business groups and corporate governance are related to the investment decision of firms.
Before going to the next sections, it is important to address three issues explicitly. First, the main purpose of this paper is not to propose a theory explaining the formation of business groups and I will take the existence of business groups as well as groups’ characteristics as given. However, the results from this paper should suggest some ideas on the nature of business groups that motivate a future research on endogenous group formation and endogenous group structure. Second, modeling the costly external finance is beyond the scope of this paper. Cost of external finance is assume to be increasing and convex a priori. Lastly, with the existence of costly external finance, I define efficient resource allocation as the allocation of fund that equalizes the marginal cost of external finance across firms in a group. If the marginal costs are not equal, the controller can get higher aggregate profit from transfering fund from the firms with low marginal costs to the firms with higher marginal costs. Therefore, the term “efficiency” in this paper is defined in a view of the controller.
The rest of the paper goes as follows. Section 2 reviews related literature regarding capital markets and corporate investment, as well as existing studies on business groups. Section 3 presents the structural model of corporate investment of non-group and group firms when external fund is costly. Section 4 presents an empirical strategy of this study. Section 5 describes Thailand’s firmlevel data and reasons why this data set is good for this study. The empirical results are in section 6. The paper ends with conclusion and appendix.
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