A common view supported by the empirical research is that the efficient allocation of capital is a key factor for economic growth and sustainable development in developed, developing and post-communist countries. However, the interactions between the efficiency of the external capital market and the internal capital markets for group firms (parent firms and their subsidiaries) are not clear. On the other hand, the literature on the internal capital markets stress on their two opposing effects on the investment performance of subsidiaries. First, authors argue that internal capital markets may substitute for missing external capital markets, especially in less developed countries. (Khanna and Palepu, 1999). In the presence of capital market imperfections, subsidiaries are able to access the external markets that parents provide (Inderst and Muller, 2003), they benefit from the access to finance from other affiliates within the multinational network (Stein, 2003). Parents may also impose discipline on subsidiaries by reallocating funds to those with investment proposals with a positive net present value and lower internal cash flows (Stein, 2002). Second, other authors reveal, however, that the redistribution of capital between subsidiaries may weaken classical managerial incentives and lead to wasteful business activities (Milgrom and Roberts (1988); Meyer, Milgrom and Roberts (1992). Under the conditions of soft budget constraints, internal capital markets allocate too many resources to firms with bad investment opportunities and too few to firms with high investment opportunities (Shin and Stulz, 1998; Rajan, Servaes and Zingales, 2000; Scharfstein and Stein, 2000).
Recently, Carlin, Charlton and Mayer (2006) present evidence in favour of the existence of internal capital markets that reallocate finance to member firms with superior investment opportunities. The stake held by the parent, the geographical distance, as well as the financial development of the subsidiary country play a role in alleviating cash constraints. The main advantage of this study is that listed subsidiaries allow the calculation of subsidiary Tobin's Q and thus investment opportunities. However, the exclusion of unlisted subsidiaries is also its main drawback. First, unlisted subsidiaries far outweigh listed subsidiaries in importance thus the largest part of the picture is blanked out. Second, the reasons why internal capital markets exist is to substitute for missing external capital markets with respect to the financing and control (i.e. corporate governance) functions within a firm. Thus, unlisted subsidiaries are most likely to face cash constraints and/or control problems as if they were stand alone firms, and thus benefit most from the workings of an internal capital markets. Those firms have not gone to the stock exchange in the first place and potential reason for that would be the particularly severe asymmetry of information leading to under pricing of assets and consequently prohibiting an IPO. Looking only at listed subsidiaries is thus likely to severely limit the analysis.
Our paper follows the branch of research focusing on the institutional determinants on investment of the parent firms and their subsidiaries. These studies show that the form of business organization and the country institutional context may have quite different effects on the various aspects of investment behavior (e.g. intra-industry diversification, multi nationality, soft budget constraint and the like). They reveal that the access to internal capital markets leads to systematic differences in investment between firms with different affiliation types. They contrast on the one hand, firms affiliated to family business groups in South-East Asia, divisions of conglomerates in the United States, firms affiliated to large ‘Konzernen’ in Germany, overseas subsidiaries of the MNC, and state-owned firms in post-communist countries in the early transition; and the so-called “independent” firms, on the other hand.
Authors observe a great amount of variation in the institutional characteristics of both firm-owners and owned firms. First, firm-owners may have 100 percent ownership participation of their subsidiaries or they may establish joint-ventures having ownership stakes between 50 and 100 percent (typical parent firms, e.g. MNCs). The largest shareholder may also have minority control preserving between 20 and 50 percent ownership stake of the owned firms or less than 20 percent ownership participation. Second, the ultimate owners may stay at the apex of business groups (pyramidal structure) or they may engage in cross-shareholdings with the other members of the business group (non-pyramidal structure). The usual ultimate ownership types are the families, state or widely held firms, both non-financial and financial institutions. Third, the subsidiaries are legally independent entities (like firms affiliated to business groups or overseas subsidiaries of MNC) or establishments owned by a single firm (e.g. divisions in conglomerates in the US). Fourth, studies show a strong association between the quality of country institutions, corporate governance and development of capital markets. However, the interactions patterns among firms originating from different institutional environments are not clear (e.g. the export of both good corporate governance practice and corporate scandals from parent firms from “good” system to subsidiaries in “bad” system).
In this paper, we empirically study three basic questions. How do internal capital markets work for both listed and unlisted subsidiaries? Which are the effects of the parent firm ownership stake on the subsidiary’s investment? Which are the effects of country governance and financial institutions on the subsidiary’s investment?
