Corporate Groups, Financial Development and
Market Structure: Evidence from Europe
June 27, 2011
Abstract
This paper investigates the relationship between …nancial development and the
incentives to form corporate groups. Since cross-country regressions are hard to
interpret in the causal sense, we use exogenous industry measures to investigate a
speci…c channel through which …nancial development may a¤ect group a¢ liation:
internal capital markets. Using a new and comprehensive …rm-level dataset on corporate groups in 15 European countries, we …nd that countries with less-developed
…nancial markets have a higher percentage of group a¢ liates in industries that depend on external sources of capital. This relationship is more pronounced for young
…rms and for a¢ liates of large groups. Our …ndings are consistent with the view
that …rms in countries with less-developed capital markets form groups to bene…t
from their internal capital markets.
Keywords: corporate groups, …nancial development, internal capital markets
JEL Classi…cation: G32, G18, O16
1
1
Introduction
This paper aims to deepen our understanding of …rm boundaries and the incentives to
form inter-…rm groups across nations and industries. By comparatively examining the
ownership structure of organizations across 15 Western European countries, we study
how institutional di¤erences a¤ect the incentives for …rms to organize as groups. We
focus on one speci…c channel through which incentives to band together may operate:
the internal capital markets ("ICM"). In our setting, federations of …rms (for example
the German konzern) are usually referred to as corporate groups.1 We test and quantify
the e¤ect of ICM on group formation by ranking industries according to their level of
external capital needs while also ranking countries according to their relative levels of
…nancial development. Then we compare how the distributions of group-a¢ liated …rms
across industries themselves vary across nations. Our main test is thus whether both
the intensity of industry dependence on external capital and relative level of country
development moderate …rms’propensity to be a¢ liated with groups.
The formation of groups is often viewed as an organizational response to imperfect,
missing, or ine¢ cient markets, whereby groups perform an intermediation role in markets
subject to frictions (Le¤ 1978). Though this is an appealing argument with important
strategic and policy implications, its examination poses signi…cant empirical challenges.
First, while groups are likely to be a¤ected by market development, they may also restrain the development of the institutions they mimic (Granovetter, 1995; Almeida and
Wolfenzon, 2005; Khanna and Yafeh, 2007). Second, omitted or latent macro variables
can be correlated with both market development and the incentive to form or to join a
group. Third, group a¢ liates are often privately-held corporations. In Europe, this often
results in intricate ownership arrangements (Faccio and Lang, 2001) and "pyramiding"
where controlling corporations own stock in other corporations through complex ownership chains. Hence even though groups can be found in highly ine¢ cient as well as highly
1
There are disparate literatures that explore ICM within variously similar types of group organizations.
For example, emerging market business groups have been shown to enable member …rms to share risks by
smoothing income ‡ows and reallocating funds from one a¢ liate to another (Khanna and Palepu, 1997;
Khanna and Yafeh, 2005). ICM mechanisms have been also discussed within pyramidal groups (often
in Europe), as well as within highly integrated, …rm-like organizations (Almeida and Wolfenzon, 2005;
Cestone and Fumagalli, 2005; Morck, Wolfenzon, and Yeung, 2005; Stein, 1997; Belenzon, Berkovitz and
Bolton, 2010). The overlap or lack thereof between corporate, business, pyramidal and other types of
groups is discussed more fully in Section 2, which locates our work within prior studies on groups.
2
e¢ cient economic systems, they can be "relative invisible" in some settings (Granovetter,
1995).
This paper is the …rst to tackle all three of these challenges. First, we alleviate the
reverse causality concern by focusing on internal capital markets, a key channel through
which …nancial development can a¤ect group a¢ liation. If …rms form groups to replace
less developed or less e¢ cient …nancial markets, we would expect a higher probability of
group a¢ liation among …rms in more capital-dependent industries, as these …rms are more
likely to bene…t from the group’s internal capital market. Moreover, we would expect this
relationship to be more prevalent in countries with less-developed …nancial institutions.
Though we do not attempt to establish a direct causal link between the level of …nancial
development and the prevalence of corporate groups, we reduce the likelihood of the reverse
causality argument. This is because a pure reverse causality argument is very unlikely to
explain the interaction e¤ect between industry demand for capital and country level of
…nancial development, since the latter is constant across industries within any country, and
should thus not a¤ect the distribution of groups across industries. Second, we also develop
a comprehensive dataset on group a¢ liation and …nancial information covering about
ninety-thousand European …rms. Having both …rm-level and large-scale data allows us
to substantially mitigate unobserved industry and country heterogeneity when estimating
the e¤ect of country and industry conditions on group a¢ liation. Finally, to mitigate the
invisibility problem, we construct detailed ownership and control hierarchies for groups
by exploiting the strict reporting requirements of the EU, where public and private …rms
have to …le annual reports detailing ownership and …nancial information.
We follow the methodology employed by Rajan and Zingales (1998) to rank the industries in our sample according to their dependence on external sources of funding. We
compute three measures of external dependence: external funds dependence, external equity dependence, and trade credit. The …rms in our sample are incorporated across 15
West-European countries, which are relatively wealthy and enjoy a developed legal environment, but which nonetheless have measurably di¤erent levels of …nancial institution
development. We rank the countries in our sample according to their level of …nancial
development using the world-bank indices developed by Beck, Demirgüç-Kunt and Levine
(2000, 2007), which focus on the stock market and the banking system in each country. To
supplement the hard-data measure of …nancial development, we also include survey-based
3
measures of access to equity and loan markets from the World Economic Forum, Executive
Opinion Survey, 2006-2007 (Claessens and Laeven 2003). Thus, we consider factors which
impact both the supply (development) and demand (dependence) of capital as it a¤ects
…rms’propensity to organize in groups.
We …nd that high-dependence industries have disproportionately more group a¢ liated
…rms than low-dependence industries, but that this di¤erence declines as …nancial development increases. This result suggests that less-developed markets foster the formation of
corporate groups more in sectors where internal capital markets are especially bene…cial.
Consistent with the view that young …rms with a shorter track record are likely to face
higher costs for outside capital (Ritter, 1984; Oliner and Rudebusch, 1992; Gompers 1995),
our results show that the e¤ect of …nancial development on group a¢ liation is more signi…cant for relatively younger …rms. Our results are particularly strong when comparing
standalone …rms to …rms a¢ liated with large groups where ICM are substantial.
The rest of the paper is organized as follows: Section 2 relates our focal corporate
groups to groups studied in related literatures and presents our main hypothesis; Section
3 presents our empirical strategy; Section 4 details our data and descriptive statistics;
Section 5 explains our econometric speci…cation; Section 6 presents our results; Section
7 discusses implications for policy and strategy; and Section 8 concludes and provide
suggestions for future research.
2
2.1
Corporate groups in Europe
What is a corporate group?
One challenge we face in our study is the lack of consensus on the de…nition of a group.
Since Le¤’s seminal work on "the group" (1978), scholars have made great progress in
charting the often-blurry landscape between the polar concepts of …rms and markets. However, there remain variously congruent de…nitions of the observed phenomenon of "…rms
bound together in some formal and/or informal ways, characterized by an ‘intermediate’
level of binding" (Granovetter, 1995, page 95). Often, the focus is on sets of …rms under
some type of "umbrella" (Ghemawat and Khanna, 1998) or under common administrative
and …nancial management (Chang and Hong, 2000). Mostly within strategy, the business
group literature has emphasized concentrated ownership, reciprocal trading arrangements,
4
familial control, diversi…cation across a wide range of businesses, and partial …nancial and
board interlocks, largely within the context of emerging economies (Khanna and Rivkin,
2001, 2006; Kester, 1992). Meanwhile, what can loosely be termed the "pyramidal groups"
literature has grown within …nance (Almeida and Wolfenzon, 2006; Morck, 2005), emphasizing formal ownership structure and often the darker sides of group organization, also in
the context of Europe. This last set has generally demonstrated greater variance in de…ning groups, often using the term interchangeably with corporate groups, conglomerates,
pyramids, and family groups.
For our purposes, we use these two streams of research as guideposts rather than
maps. We do not take a position on whether they speak of the same phenomena, and we
do not claim that our empirical sample overlaps directly with any of these types of groups.
Rather, we employ one speci…c de…nition of a group, the European corporate group. The
unique structure of the European Union provides us with a consistent de…nition for our
sample. The concept of corporate groups within a Western European context is codi…ed
in legal, cultural and economic institutions, and this reduces our needed assumptions for
what constitutes the boundary conditions for group membership. Though prior work
found that ownership links are tepid determinants of group membership in an emerging
market setting (Khanna and Rivkin, 2006), we argue that they are reliable for demarcating
group membership within our limited sample. In the EU, government agencies and legal
scholars speci…cally emphasize the concept of control, which refers to the direct and indirect
ownership stakes the controlling shareholder has in each of the corporate group a¢ liates
(Blum, et al., 2010; Windbichler, 2000)2 . Additionally, the notion of corporate groups is
part of the economic environment in the EU. For example, Figure 1 shows the ownership
structure of a representative group, Berge y Cia., which describes itself as "one of the
major Spanish corporate groups."3 Similarly, a vast number of other …rms in our sample
incorporate group membership into their corporate identity, by including the word "group"
in their letterhead, websites, logos, as well as linking to other group members in their
marketing materials.
2
Direct references to corporate groups are found throughout the EU governing documents, for example
the Fourth Directive of the Council of European Communities (1978), where accounting reporting regulations for groups are stipulated: “Whereas, when a company belongs to a group, it is desirable that group
accounts giving a true and fair view of the activities of the group as a whole be published.” As well, the
notion of controlling …rms is clearly acknowledged, where they are called “Dominant companies.”
3
Berge corporate website main page: http://www.bergeycia.es/index.php?nOp=1&idioma=en
5
Groups also seem to be heterogeneous across time and place (Carney et al., 2011,
Khanna and Rivkin, 2001). It would be hard for us to argue that a German konzern is
similar enough to an Indian business house or a Nicaraguan groupo to draw meaningful
inferences from our results. Thus, the main methodological contribution of the current
paper is its focus on a set of West European economies which: i) share an historical,
institutional, and economical conceptualization of groups that can a¤ord us a clear and
consistent de…nition of what a group is in this context; ii) exists within a narrow enough
range of economic development so that we do not commingle developing and developed
markets in our study, while at the same time; iii) have enough variation in their level of
…nancial development and represented industries, so that we may observe the impact of
the interaction between industry capital demand and country economic development.
Mechanically, our de…nition of a corporate group is consistent with the broad EU
de…nition of groups, and follows the bodies of work which focus on European corporate
groups. Following Faccio, Lang and Young (2009), we classify a …rm as a group member
if it satis…es at least one these four criteria: 1) it is indirectly controlled through a chain
of other corporations (this is the common de…nition of pyramiding); 2) it directly controls
another corporation in the sample; 3) it has the same controlling shareholder as at least
one other corporation in the sample; or 4) its controlling shareholder is a corporation
or …nancial institution that is widely held, such that no single shareholder holds 10% or
more of the …rm’s equity stock. We de…ne control in the same manner as Faccio and Lang
(2001) and La Porta, Lopez-de-Silanes, and Classens et. al. (2000). Thus, a corporation is
considered a controlling shareholder of another corporation if it is the largest shareholder of
at least 10% of voting shares. It is important to note that our focused empirical approach
creates a potential limitation in the degree of generalizability for our study, both in terms
of what conclusions we can draw based on other group literatures, and on what our …ndings
may mean in other contexts. In our discussion section, we address these limitations and
suggest further avenues of research.
2.2
Internal capital markets
It is a well-accepted fact that ine¢ ciencies and imperfections are prevalent in markets
(Coase, 1937; Barney, 1989). Frictions, such as asymmetric information (Akerlof, 1970)
and transaction costs (Williamson, 1975, 1985) are often pervasive and can diminish the
6
e¢ ciency of market institutions even within otherwise very well developed economies. As
a consequence of these frictions, the price system cannot be presumed to be the best
mechanism to allocate resources, and hierarchies often replace it to coordinate exchange
within …rms (Coase, 1937; Williamson, 1975). According to the current mainstream economic view, …rms emerge when the costs of relying on the market exceed the costs of
using coordination by authority, and the appropriate governance mode which minimizes
transaction costs (hierarchy or market) tends to emerge (Williamson, 1985). The ine¢ ciencies that lead from markets to …rms or hierarchies can occur in the exchange of any
type of resources, such as human capital, information, knowledge, property, and …nancial
capital, and these arguments can rationalize why several types of transactions are often
carried out within …rms rather than in arms-length markets. Thus, …rms (an example of
hierarchy) emerge when the costs of relying on the market exceed the costs of using coordination by authority and the appropriate governance mode which minimizes transaction
costs (hierarchy or market) tends to emerge. But sometimes, environmental conditions are
such that …rms themselves organize into higher-level hierarchies such as corporate groups,
which are to the …rm as the …rm is to the individual economic agent (Granovetter, 1995).
In the context of group organizations, as …rms’costs of relying on markets transactions
rise, the incentive to form …rm-like groups would increase.
We can see the e¢ ciency advantages of group binding by examining a typical internal
capital market transaction. A common practice is for a corporate group to have …nancing
subsidiaries in various markets, which raise capital guaranteed by the controlling …rm. This
capital is then reallocated to operating subsidiaries. For example, Novartis’subsidiaries
regularly issue debt that is guaranteed by the parent, such as a $2bn issue by Novartis
Capital Corp., the $3bn issued by the group’s Bermuda unit, Novartis Securities Investment, and the EUR 1.5bn issued by Novartis Finance (Luxemburg). In all three cases,
the debt was guaranteed by the parent, and this was publicly disclosed by statements that
acknowledged the ICM nature of these transactions, such as: "proceeds will be used for
intercompany re…nancing purposes in connection with the pending Alcon acquisition, as
well as for general corporate purposes."
While scholars do not agree on a single group de…nition, there is ample evidence that
ICM are relevant to groups despite geographical variation as well as variation in their level
of cohesion and vertical integration. ICM have been observed across the spectrum from
7
loosely tied groups to vertically integrated conglomerates, albeit for reasons that vary
(e.g. Perotti and Gelfer, 2001; Claessens, Fan and Lang, 2006; Cestone and Fumagalli,
2005; Chang and Choi, 1998; Wulf, 2009, Shin and Park, 1999). Thus, variation in the
structure of groups should not systematically impact the relationship between ICM and
group a¢ liates. Carney et al.’s 2011 meta-study of the broad group literature found
that …nancial infrastructure development generally moderates group a¢ liation negatively,
which lends support to the ICM hypothesis. Similarly, ICM have been found to lower the
cost of capital for business groups and give them access to …nancial institutions (Khanna
and Palepu, 1997; Gertner, Scharfstein and Stein, 1994; Weinstein and Yafeh, 1998). Yet,
ICM do not necessarily arise solely as a response to missing or underdeveloped markets.
For example, within more conglomerate-like organizations, and in countries with welldeveloped …nancial institutions, ICM can still mitigate asymmetric information between
borrowers and lenders or they may provide better governance mechanisms via ownership
than would be possible under lending relationships (Wulf, 2009). In the context of our
analysis, we argue that these issues of information asymmetry and governance, though not
strictly …nancial factors, are likely to be more pronounced within countries with lower levels
of development, where institutions are less sophisticated and information and transparency
are reduced.
The above discussion leads to our main hypothesis: the extent to which internal capital markets drive group a¢ liation decisions depends on the level of the country …nancial
development, especially for …rms that face higher demand for outside capital. As the development of outside markets deteriorates, the frictions and costs of accessing outside capital
drive …rms away from markets to groups, especially when outside capital requirement is
large.
3
Empirical strategy
We examine the e¤ect of …nancial development on group a¢ liation by exploring whether
corporate groups substitute for less developed …nancial institutions. It is important to
recognize that reverse causality between group formation and …nancial development can
make it di¢ cult to establish a causal relationship, primarily because where groups provide e¢ cient internal capital markets, there will be less incentive for …nancial markets to
8
improve.
To deal with potential reverse causality, we analyze a key channel through which
…nancial development a¤ects group a¢ liation: internal capital markets. If …rms form
groups as a substitute for less developed …nancial markets, we would observe a higher
probability of group a¢ liation among those …rms that could gain greater bene…ts from
internal capital markets: companies with a higher demand for external …nance. Most
…rm-speci…c proxies for external …nancial dependence measure external funding set in
equilibrium rather than the demand for external funding, and su¤er from endogeneity
problems. Hence, we follow Rajan and Zingales (1998) and rank industries according to
the extent that they rely on external funds.
We compute the industry measures based on U.S. Compustat …rms. This has several
important advantages: (i) Since the U.S. market is one of the most advanced capital
markets in the world, large publicly-traded …rms face the least friction in accessing …nance.
This means that the amount of external …nance used by these companies is likely to be a
good measure of their industry’s demand for external …nance. (ii) Disclosure requirements
imply that data on external …nancing are comprehensive. (iii) While using U.S.-industry
data is exogenous to European …rms, it is likely that industries are structurally similar,
so an industry’s dependence on external funds in the U.S. is a good measure of that
industry’s dependence on external funds in European countries; (iv) groups are arguably
less common in the U.S., thus the demand of U.S. …rms for external funds is a good proxy
for demand in the absence of options for group ICM’s. The only two assumptions needed
are that technological di¤erences explain why some industries rely on external funds more
than others, and that these di¤erences persist across countries.
Figure 2 illustrates our identi…cation strategy. For each industry we compute a measure
of external dependence. Based on this measure we allocate industries into quartiles (where
the lowest quartile is for industries with the lowest measure of external dependence). Then,
for each country we compute the di¤erence in the percentage of a¢ liates between the
highest and lowest quartiles of external dependence. Countries are ranked according to
their level of …nancial development (countries with lower …nancial development are closer
to the origin).
The emerging pattern supports the hypothesis that groups provide an alternative
source of capital within less developed …nancial markets. First, groups are more promi9
nent in industries with high external dependence, supporting the internal capital markets
hypothesis. On average, industries in the top quartile of external dependence have about
34% more a¢ liates than industries in the lowest external dependence quartile. Second,
as Figure 2 shows, a¢ liation skewness toward industries with high external dependence
varies substantially across countries, apparently systematically over the quality of …nancial
institutions. While in Great Britain the di¤erence in the percentage of a¢ liated …rms between the 1st and the 10th deciles of external dependence is e¤ectively zero, this di¤erence
is above 30% in Italy.
3.1
3.1.1
De…nition of variables
Financial development
To measure countries’…nancial developments we refer to the world-bank indices developed
by Beck, Demirgüç-Kunt and Levine (2000, 2007). For each country we examine two
dimensions of …nancial development: the stock market and the banking system. For stock
market development, we use (i) the ratio between stock market capitalization and GDP,
and (ii) the ratio of stock market total value traded to GDP. For the banking system, we
use (i) the ratio of private credit by deposit money banks and other …nancial institutions
to GDP, and (ii) the ratio of bank deposits to GDP, where bank deposits are the demand,
time, and savings deposits in deposit money banks. We also take mergers and acquisitions
activity at the country level as a measure of private stock market development. This
measure is computed as the value of M&A transactions (including the net debt of the
target) to GDP, based on Thomson SDC Platinum (see also World Economic Forum
Report 2008).
Stock market development is likely to play a central role in small-…rm …nancing for
three main reasons. The …rst is direct …nancing. Small …rms will likely have a harder time
raising debt …nancing because they cannot use secured …nancing (i.e., cannot post collateral). In these cases, investors typically demand an upside share by using equity-linked
securities (such as warrants or convertible debt). The London Stock Exchange Alternative
Investment Market (AIM) is one example of how stock markets provide direct …nancing
for small …rms. AIM was established in 1995 and allows small …rms (average market capitalization of $65mm relative to $1.1bn in the NASDAQ) to raise equity …nancing in the
stock market. More than 3,000 (most are R&D-intensive …rms in the high tech sector, and
10
around 2,500 …rms are British) have raised …nancing through the AIM. Between 1995 and
2008 these …rms raises 64.4 billion GBP, averaging about 21.6 million GBP per …rm. The
importance of AIM for small …rm …nancing was especially clear in 2008 and 2009: During
the global …nancial crisis, 138 …rms were still able to raise 8.5 billion GBP, averaging 61.6
million GBP per …rm. The second reason that stock market development is central to
small-…rm …nancing is private equity and venture capital funding. Developed stock markets encourage private equity, venture capital funds, and angels, as these investors rely
on IPOs for their exit strategy (Black and Gilson 1998).4 The third reason stock market
development will likely in‡uence small-…rm …nancing is competition e¤ects. In countries
with less-developed public markets (equity and debt), small …rms have to compete for
capital with large, established …rms. Assuming that the supply of capital is limited (as
clearly demonstrated during the last decade’s two …nancial crises), raising capital would
be harder for small …rms in less-developed …nancial markets.
To supplement the hard-data measure of …nancial development, we also include surveybased measures of access to equity and loan markets from the World Economic Forum,
Executive Opinion Survey, 2006-2007 (Claessens and Laeven 2003). These measures are:
Access to Loan Market, Access to Equity Market, Access to Venture Capital, and Financial
System Sophistication. Access to Loan Market is based on the question: How easy is it
to obtain a bank loan in your country with only a good business plan and no collateral?
(Answers range from 1— impossible to 7— very easy.) Financial System Sophistication
is based on the question: How sophisticated are the …nancial markets in your country?
(Answers range from 1— lower than international norms to 7— higher than international
norms.) Access to Venture Capital is based on the question: In your country, how di¢ cult
is it for entrepreneurs with innovative but risky projects to …nd venture capital? (Answers
range from 1— impossible to 7— very easy.) Access to Equity Market is based on the
question: How di¢ cult is it to raise money by issuing shares on the stock market in your
country? (Answers range from 1— impossible to 7— very easy).5
4
The venture capital view of groups is discussed by Khanna and Yafeh (2007), who hypothesize that
groups operate as venture capitalists. This suggests that group funding would be more important in
countries with a weaker independent-venture industry, as is likely to be the case in countries with underdeveloped stock markets. We further elaborate on this point below when discussing alternative measures
of country …nancial development.
5
An important issue is whether companies could “migrate”to the most e¢ cient …nancial environments
within Europe and circumvent the de…ciencies of their home country systems. Cross-border migration
of companies in the EU is a complex issue. A detailed treatment of this topic is beyond the scope on
11
3.1.2
External dependence
We compute three measures of external dependence: External Funds Dependence, External
Equity Dependence, and Trade Credit. External Funds Dependence is de…ned as the ratio
between capital expenditures minus cash ‡ow from operations and capital expenditures.
It measures the fraction of the …rm’s investment that cannot be …nanced with internal
cash ‡ows. External Equity Dependence is de…ned as the net amount of equity issued over
capital expenditures. It measures the fraction of the …rm’s investment that is …nanced by
issuing equity. We also follow Nilsen (2002) and Fisman and Love (2003) and focus on
suppliers provision of funds— trade credits. We construct Trade Credits as the ratio between accounts payable and total assets.6 An additional measure we examine is investment
intensity, computed as capital expenditures over total assets. All measures are calculated
using Compustat …rms in 1980-2000 at the three-digit SIC level (176 industries).
4
Data
Our unique dataset relies on ownership structure and accounting information from the 2007
version of Amadeus, a comprehensive European database by Bureau van Dijk (BvDEP),
which covers both private and public …rms. In this section, we explain our methodology
for constructing the data and describe our sample.
We de…ne a corporate group as an organizational form in which at least two legally independent …rms are controlled by the same ultimate owner (Almeida and Wolfenzon 2006a).
To ensure that all ownership links represent control, we make the following assumptions:
among private subsidiaries, we only keep links where the shareholder has at least 50% of
the voting rights; and among public …rms, we only keep links where the shareholder has
at least 20% of the voting rights. For conservatism and simplicity, we de…ne control of a
private …rm as owning more than 50% of the …rm’s voting rights (excluding non-voting
shares). Following previous literature on public …rms (La Porta et al. 1999, Faccio and
our paper, however, a comprehensive discussion of this topic is provided in “Corporate Governance of
Non-Listed Companies”(McCahery and Vermeulen), Chapter 3. The main conclusion on …rm mobility in
Europe can be summarized as follows. “. . . mobility is still largely constrained by member state discretion.
Even though the ECJ [European Court of Justice] has reduced the scope of the real seat doctrine and its
barriers to the freedom of establishment, the Court has not e¤ectively eliminated it.” (p. 97). Mobility
is hindered mostly by “the absence of a reincorporation procedure and exit taxes that continue to block
freedom of establishment and restrict cross-border mobility.” (p. 97)
6
For a detailed discussion of the theory of trade credit provision see Fismal and Love (2003).
12
Lang 2001, and others), which have a more dispersed ownership, we set the threshold for
public …rms at 20%. All our results are robust to di¤erent plausible speci…cations of these
thresholds. These two assumptions leave us with close to one million ownership links. In
order to infer group structure from these links, we apply an algorithm that constructs the
corporate control chains, and then group together …rms controlled by the same ultimate
owner.7 To avoid including economically insigni…cant groups, we exclude groups that have
less than $10 million in total assets and generate less than $1 million in annual sales.
Groups are typically characterized as organizations in which a¢ liates have “long-term”
ties to their parent companies, and one concern in our identi…cation strategy might be
that by looking at cross sectional ownership links, we may be to some extent observing
alliances, rather than proper group links. However we are con…dent that our sample
is not signi…cantly polluted by erroneously including alliances.8 We utilize mergers and
acquisitions (M&A) data from SDC Platinum for the period 1980-2007. We …nd 7,646
…rms that met or exceeded the ownership thresholds, and then keep only those that satisfy
us that we are looking at long-term and stable ownership ties between group a¢ liates.
Thus, we drop 5,183 …rm …rms that had come into their groups between 2002-2007, because
we consider them suspect of not having long-term ties. In the …nal estimation sample,
2,663 …rms participated in an M&A deal in 1980-2001. Alliances are likely motivated
by factors other than access to ICM (Kock & Guillén, 2001), thus any measurement
error introduced by including some remaining unidenti…ed alliances in our sample would
be classical measurement error, which would bias our results downward, attenuating our
results.
Accounting information is taken from Amadeus’s …nancial section. BvDEP has developed a uniform format that maximizes the availability of …nancial items across the various
countries’ …ling regulations, balanced with a realistic representation of European company accounts. A key advantage of these data is that by including private as well public
…rms, we capture a wide range of …rm sizes. In this paper we exploit only cross-sectional
variation across …rms, industries, and countries. Thus, we use cross-sectional accounting
information, such as employment and sales, for 2006, or the most recent year …nancial
information is available. Countries in our sample di¤er in their reporting requirements for
7
More details on the algorithm and the name-matching procedure are provided in Belenzon and
Berkovitz (2010).
8
More discussion about our strategy to deal with alliances is found in the Appendix
13
small …rms. We mitigate the potential bias of voluntary disclosure of …rm …nancial information by eliminating all …rms with less than 50 employees. Also, to ensure that …rms
have real-economic activity, we exclude …rms that have less than $1 million in annual
sales.9
Amadeus includes information for industrial …rms only. In order to complete the
construction of groups, we add information about …nancial institutions from BankScope.
BankScope provides ownership information for about ten thousand banks. We match the
name of the ultimate owner of each bank to the Amadeus sample. We identify 1,809 …rms
that belong to groups that include at least one bank. We use the “clean”ownership sample
to apply our de…nitions of group a¢ liates and standalone …rms. A …rm is de…ned as a
group a¢ liate if (i) the …rm’s ultimate owner controls at least one additional industrial
…rm with real economic activity, or if (ii) the group includes a bank. All other …rms with
complete ownership information in Amadeus are classi…ed as standalone …rms.
We also exclude from the estimation sample very large …rms (…rms that have more
than 10 thousand employees). These …rms are likely to operate across many international
markets and be less a¤ected by domestic …nancial institutions. Banks and other …nancial
companies (industry SICs 600-699) are excluded from the estimation sample as well, as
they are likely to face di¤erent …nancial considerations when joining groups. This procedure leaves us with a cross-section of 94,942 …rms, of which 37,395 …rms are a¢ liated with
corporate groups and the remainder are standalone …rms.
4.1
Descriptive statistics
Table 1 reports the number of standalone …rms and a¢ liates across the 15 countries in our
sample. Germany, Great Britain, and France have the largest number of …rms that meet
our criteria. On average, 39% of our sample …rms are a¢ liated with groups.10 If countries with high …nancial development organize production in industries with high external
dependence, our results would be biased. At the extreme, our di¤erence-in-di¤erence approach would fail completely because industries with high external dependence would be
9
Some …rms form fully-owned subsidiaries in other countries for tax purposes (dormant …rms). Hence,
in de…ning a business group, it is important to focus only on …rms with real economic activity.
10
One has to be cautious when comparing these percentages with previous studies on business groups
(e.g., La Porta et al. 1999, Faccio and Lang 2002) because our sample includes private …rms; previous
studies focused on public …rms.
14
observed only in …nancially developed countries. To test this concern, Table 1 also reports
the industry share of assets and sales for the 1st and 4th quartile of external dependence
for each country. We do not …nd evidence that the organization of production across
countries and industries is systematically related to …nancial development and external
dependence. For example, in Great Britain, 26.3% and 22.3% of sales and assets, respectively, are organized in industries that fall in the 1st quartile of external dependence.
These percentages are quite stable across industries, with values of 24.5% for …nancial
development and 23.8% for the 4th quartile of external dependence in industries with high
external dependence. In France and Germany, where …nancial development is lower than
in Great Britain, the share of production in industries with high external dependence is
actually higher than the share of production in industries with lower dependence. Among
even smaller countries, there is no substantial di¤erence in the distribution of assets and
sales across industries based on external dependence.
Our paper focuses on the distribution of a¢ liates across industries in a given country, but some interesting patterns emerge when comparing the share of a¢ liates between
countries. One striking …nding is the very high share of a¢ liates in Great Britain relative
to Germany and Italy. The distribution of the share of a¢ liates across industries in Great
Britain is quite even, with no substantial di¤erences between high and low external dependence. On the contrary, a¢ liates in Germany and Italy tend to concentrate in industries
with high external dependence. While these patterns are consistent with the internal capital markets view, which suggests that internal capital markets are unlikely to encourage
a¢ liation among British …rms, this paper is silent on the factors that actually drive British
a¢ liation decisions. A closer examination of group characteristics may shed some light
on this issue. British groups tend to have a much-higher ownership concentration than
continental European groups, and to be more specialized across industries. While close to
70% of groups in the full sample have minority shareholders (owning at least 10% of group
assets), only about 25% of group in Great Britain have minority shareholders. Moreover,
in France and Germany, only 10% of groups are specialized (operating in only one threedigit SIC code); in Great Britain more than 30% of groups are specialized. While these
di¤erences in group characteristics should not be systematically related to internal capital
markets, they do suggest that di¤erent factors drive group formation in Great Britain and
continental Europe. For instance, the theory of the …rm o¤ers some potentially promis15
ing explanations. For their role in governing economic transactions, corporate groups
can be considered a middle ground between …rms and markets. The allocation of “soft”
assets, such as technical know-how, managerial talent, and inputs, is likely to be more
prominent is specialized groups than in diversi…ed ones, and to induce higher ownership
concentration. More work is needed to systematically explore this direction.
Table 2 provides summary statistics for …rms and groups in our sample. The average
…rm has 248 employees (with a median of 110) and $65.7 million in sales (with a median
of $26.7 million). Panel B of Table 1 reports corporate group characteristics. Our sample
…rms belong to 11,033 unique groups. The average group has a total of 90 a¢ liates (with a
median of 17, and a 90th percentile of 257. The within-sample average number of a¢ liates
(…rms that are included in the estimation sample) is 22 (with a median of 5).11 Groups
in our sample have abundant resources: the average group holds around $66.5 billion in
total assets (with a median of $679 million and a 90th percentile of $108 billion).
Table 3 reports summary statistics separately for a¢ liates and standalone …rms. A¢ liates tend to be larger in terms of the number of employees, sales, total assets, and labor
productivity, but quite similar in terms of age.
Table 4 shows examples of industries (aggregated to the two-digit level) that fall in the
low and high external dependence categories. High external dependence industries include
drugs, plastic and chemicals, where low external dependence industries include iron and
steel, textile, and metal products.
5
Econometric speci…cation
We estimate the following Probit speci…cation, where the dependent variable is a dummy
that receives the value of one for a¢ liates and zero for standalone …rms:
Pr(a¢ liate i ) = ( 1 Empi +
2 Sharejc
+
3 F inDevc
ExtDepj + 'j +
c)
(1)
Where, Empi is the number of …rm employees, Sharejc is the sales share of industry j
of country c total sales (computed across our …rm sample), F inDevc is the …nancial development measure for country c, ExtDepj is a measure of the external dependence or analyst
11
Within-sample a¢ liates includes only a¢ liates that have between 50 and 10,000 employees, and
generate at least $1 million in annual sales. A¢ liates that do not report employment or sales, or that are
incorporated outside the 15 European countries in our sample, are excluded.
16
disagreement for industry j, 'j and
c
denote complete sets of industry and country dum-
mies, respectively. A key advantage for using …rm-level data is that it allows us to include
complete sets of country and industry dummies, which substantially mitigates potential
biases arising from unobserved heterogeneity (note that the linear e¤ects of F inDevc and
ExtDepj are absorbed by the country and industry dummies, respectively). Yet, a bias
can arise if the distribution of …rms across industry external dependence systematically
varies across country …nancial development (for example, country with highly-developed
…nancial markets specialized in industries with high external dependence, where countries
with low …nancial development organize production in low-external dependence industries). To mitigate this potential bias we include the share of industry j sales of total
country c sales (Sharejc ).
Following the hypothesis that corporate groups are the more e¢ cient option in less
developed …nancial markets, we expect
2
to be negative. Intuitively,
2
< 0 means that
in countries with lower …nancial development, we will see a more pronounced di¤erence
in group a¢ liation between …rms in industries with higher demand for external …nancing
and …rms in industries with lower demand for external …nancing.
Due to the structure of our data, observations can be correlated across blocks of ultimate owners (as we observe multiple a¢ liates of the same corporate group). Therefore, we
always cluster standard errors at the ultimate-owner level. To assess the range of the e¤ect
of …nancial development, we compute the percentage di¤erence in the share of a¢ liates for
moving from the 1st to the 10th decile of external dependence, representing an exogenous
shift in …rms’demand for external …nancing between countries with the highest and lowest
ch ;cl
j10 ;j1
…nancial development. The di¤erential e¤ect is computed as b3
; where
Af f
j10 ;j1
is the di¤erence in external dependence between the highest and lowest decile in-
dustries,
ch ;cl
is the di¤erence in …nancial development between the highest and lowest
countries, and Af f is the average percentage of a¢ liates in the sample.
6
6.1
Results
Main results
Table 5 reports the estimation results for the interaction between a country’s …nancial
development (“…nancial development”) and an industry’s external dependence (“industry
17
dependence”). Consistent with our hypothesis, we …nd that the coe¢ cient on the interaction terms is negative and highly signi…cant in all speci…cations. Panel A examines the interaction between industry dependence and a country’s equity market development (stock
market value, M&As, access to venture capital, and access to equity markets), and panel
B examines the interaction between industry dependence and loan-market development
(private credit, bank deposits, access to loan market, and …nancial system sophistication).
Columns 1-4 in panel A report the e¤ect of stock market value over GDP. The coe¢ cients
on the country-industry interactions are negative and highly signi…cant. For example, the
marginal e¤ect of the interaction between stock market value and external equity dependence is -0.012 with a standard error of 0.002. The di¤erential e¤ect is large. Financial
development explains up to 30% of a¢ liation probability. A similar e¤ect is evident for
alternative measures of external dependence and …nancial development. For M&A value,
the marginal e¤ect of the interaction with trade credit is -5.002 (with a standard error
of 0.797), and the di¤erential e¤ect is -40% (column 7). The interaction of trade credits
with access to venture capital and access to loan markets yields very similar estimates. A
similar pattern continues to hold for loan-market development (panel B). The di¤erential
e¤ect of the interaction of trade credits with private credit is -24.4% (with a marginal e¤ect
of -0.387 and a standard error of 0.095), and with bank deposit is -23% (with a marginal
e¤ect of -0.409). This e¤ect is higher for the survey-based measures. The di¤erential e¤ect
for access to loan markets is -34.6% (with a marginal e¤ect of -0.214 and a standard error
of 0.047) and for …nancial system sophistication is -34.6 (with a marginal e¤ect of -0.179
and a standard error of 0.040).12
We conduct several robustness tests to check the sensitivity of our …nding. For brevity,
we do not report the full set of results. First, we include the linear e¤ect of external
dependence, by not controlling for industry dummies. As expected, the interaction e¤ect
between external dependence and development remains negative and signi…cant and the
level e¤ect is positive and signi…cant. Second, we investigate the robustness of our results
to di¤erent samples of Compustat …rms. Listed U.S. …rms tend to be large and operate in
more than one industry. Thus, measuring industries’external dependence using diversi…ed
12
We also estimate linear probability models using OLS. The estimation results are very similar to the
Probit estimates. For example, the point estimate of the coe¢ cient on the interaction between stock
market value and external funds dependence is -0.011 (a standard error of 0.003), as compared to a Probit
marginal e¤ect of -0.009 (Table 5, Column 2).
18
…rms may be noisy. We use Compustat line-of-business data to characterize the extent to
which …rms operate in more than one three-digit industry code. We classify …rms as specialized if they operate in only one SIC code. The results remain robust for including only
specialized …rms. Third, external dependence of a given industry may vary considerably
over time. However, industry ranking is not likely to change frequently. Moreover, the
e¤ect of countries’…nancial development on a¢ liation may vary non-linearly across industries’ external dependence. We split industries to quartiles of external dependence and
interact each quartile dummy with development. We …nd negative and signi…cant interaction coe¢ cients only for the highest quartile of external dependence. Lastly, we control for
alternative ranking of industries by including …ve additional industry-interaction terms:
the Lerner competition index (computed as the industry mean of pro…ts over sales), R&D
over sales, capital over employees, labor productivity, and …rm growth. Our main results
remain robust.
6.2
Firm life cycle
In this section we test how our results vary with a …rm’s life cycle. There are three main
e¤ects that may in‡uence the results. First, young …rms are typically more dependent on
external …nancing than older …rms (Capron and Mitchell, 2009; Rajan and Zingales 1998).
Therefore, we would expect to …nd a stronger e¤ect for younger …rms. Second, …rm age is
commonly associated with higher levels of asymmetric information between the …rm and
outsiders (Ritter 1984, Oliner and Rudebusch 1992). This is because younger …rms have
shorter track records by which to be evaluated. If asymmetric information is mitigated
within a corporate group, younger …rms should enjoy greater bene…ts from internal capital
markets. Finally, a country’s …nancial development may change, either suddenly or over
time (Ghemawat and Khanna, 1998; Kock and Guillen, 2001). It is possible that older
…rms formed groups at a time when the relative ranking of …nancial development was
di¤erent from the one indicated by our measures. If dismantling a group is costly for the
ultimate owner, as our data suggest, the results of a cross-sectional estimation for older
…rms may su¤er from attenuation bias.13
All three conjectures imply that if we split our sample into younger and older …rms,
13
Similar to …ndings by La Porta et al. (1999), our data suggests that ownership structure is ‘sticky’
over time.
19
we should observe a stronger e¤ect for younger …rms. In Table 6 we estimate the countryindustry interaction separately for young …rms (below our sample median of 19 years) and
mature …rms. The pattern of results is consistent with our hypotheses and suggests that
the negative interaction between industry variables and countries’…nancial development
is evident for young …rms, where for older ones there is no evidence suggesting substitutability between groups and …nancial markets. For example, columns 1 and 5 report the
estimation results for stock market value and external equity dependence for young and
mature …rms, respectively. The di¤erential e¤ect for young …rms is -37%, for mature …rms
it is -15% (and signi…cant only at the 10% level). The same pattern holds for alternative
measures of external dependence. The di¤erential e¤ect for investment intensity is -43%
for young …rms and e¤ectively zero for mature …rms. The country-industry interaction
seems to be particularly sensitive for …rm age for banks. For mature …rms, the countryindustry interactions are never signi…cant, while for young …rms the interaction e¤ect is
signi…cant and large.
6.3
Group characteristics
The ICM theory is more likely to hold when comparing standalone …rms to a¢ liates of
large and diversi…ed groups. This is because a¢ liates of small or non-diversi…ed groups
may face …nancial constraints that are not markedly di¤erent from those of standalone
…rms.14 Larger and diversi…ed groups are also more likely to include a bank, and hence
have a more-active internal capital market. Out of the 1,809 banks in our sample, 1,700
belong to diversi…ed groups with above-median total assets. To further test the internalcapital-markets theory, we separately compare standalone …rms to a¢ liates of large and
small groups groups.
We expect the negative interaction between external dependence
and …nancial development to be stronger for a¢ liates of large groups. We distinguish between small and large groups based on total assets. Table 7 reports the estimation results.
The pattern of results is consistent with our expectation: the negative interaction between
external dependence and …nancial development is especially strong when comparing large
group a¢ liates and standalone …rms. For example, for large group a¢ liates, the di¤eren14
An extreme example is a group in which the industry con…guration is such that all a¢ liates operate in
industries with high external dependence. In this group the internal capital market is essentially inactive,
because the capital supply side is muted. This situation is not likely to arise in groups that hold a
considerable amount of diverse resources.
20
tial e¤ect of the interaction between external equity dependence and stock market value
(column 1) is -74.4% (with a marginal e¤ect estimate of -0.006 and a standard error of
0.001).15 In contrast, comparing standalone …rms to a¢ liates of small groups shows an
insigni…cant e¤ect of …nancial dependence on a¢ liation (with a marginal e¤ect estimate
of 0.003 and a standard error of 0.002). A similar pattern of results holds for the other
measures of industries’external dependence. For bank deposits, the di¤erential e¤ect of
external equity is -54.1% for large-group a¢ liates (with a marginal e¤ect estimate of 0.019
and a standard error of 0.006). For small-group a¢ liates, this e¤ect is not signi…cant (with
a marginal e¤ect of -0.009 with a standard error of 0.007).
6.4
Panel estimation
This section extends our analysis by estimating a panel speci…cation of the e¤ect of …nancial development on a¢ liation probability. The main advantage of using panel data is
controlling for country-industry e¤ects. An important concern is that the distribution of
…rms across industry external dependence could be systematically correlated with country
…nancial development. Our di¤erence-and-di¤erence approach is likely to fail in the presence of such correlation. At the extreme, if more …nancially developed countries organize
their production in industries with high external dependence, and less …nancially developed countries organize production in industries with low external dependence, we will
not be able to observe the same set of industries in high- and low-…nancial-development
countries, causing our identi…cation strategy to fail.
Our data do not allow us to characterize the historical ownership structure of our
sample …rms.16 We generate time variation in the ownership data in the following way.
15
The di¤erential e¤ect is computed relative to the sample share of large and small group a¢ liates.
Fourteen percent of …rms are a¢ liated with large groups. A similar percentage of …rms are a¢ liated with
small groups.
16
The …rst-best experiment for panel estimation is obtaining the cross-sectional ownership data for
previous years. We made considerable e¤orts to obtain these …rst-best data. We acquired previous
versions of Amadeus directly from Bureau van Dijk. Each publication of the data includes a crosssectional ownership characterization of the publication year. We hoped to assemble a panel by running
our ownership algorithm on data about each publication year. However, when we reviewed the data, we
found that the ownership coverage in Amadeus has substantially increased over time. While the 2007
version of the ownership data is extremely comprehensive, coverage in earlier years (late 90s and early
2000s) was substantially lower. Thus, we cannot reliably determine whether a …rm that appears to be
standalone in the early periods is really a standalone …rm, or is an a¢ liate of a group about which we
have no ownership information. This coverage problem can be mitigated by restricting our sample to
larger …rms whose ownership structure has been documented for a relatively long period. However, even
21
For each …rm in the 2007 cross-section, we have the date of incorporation. We use 2007
ownership structure, combined with M&A data, to determine whether …rms were incorporated as standalones or as a¢ liates. Our approach investigates whether new …rms are
more likely to be established as standalones or a¢ liates as …nancial markets become more
developed, especially in industries with high external dependence. Firms can change their
ownership structures either by joining a group, or by separating from one. We use several
sources to identify ownership changes. First, Bureau van Dijk’s Zephyr database, covering
M&As in 1999-2007, is already matched to Amadeus. Second, we expand the M&A time
horizon by downloading all M&A deals from SDC Platinum, which covers a longer period
than Zephyr (1980-2007) but is not matched to Amadeus. We matched all …rms in SDC
to Amadeus by name and identi…ed about …ve thousand …rms that joined groups in our
sample in 1980-2007. We use the M&A data to identify changes in ownership structure
from the year of incorporation to 2007. We make the following assumptions: For …rms
that appear as standalones in 2007, we assume that they were incorporated as standalones
unless our M&A data indicate the …rm has experienced a divestiture, in which case it is
excluded from our sample. For …rms that are classi…ed as a¢ liates in 2007, we assume
that they were incorporated as a¢ liates of the same group unless our M&A data indicate
that the …rm has joined a group, in which case it is excluded from the sample.
Our econometric speci…cation becomes:
Pr(a¢ liate it ) = ( 1 Empit +
Where 'jc and
t
3 F inDevct
are complete sets of industry
ExtDepj + 'jc + t )
(2)
country and year of incorporation
dummies, respectively. F inDevct is country c level of …nancial development at year of
incorporation t. Stock market value is available for 1988-2006, and private credit is available for 1980-2006. Yearly employment data is available for our sample …rms in 1997-2006.
We control for …rm size using the average number of …rm employees in 1997-2006, and
assume this average for the period 1988-1996 as well. The results are robust for allowing
employment data to vary by year, and restrict our estimation sample to 1997-2006. Due
to large number of industry
country dummies we estimate equation 2 using a linear
in a “cleaner” sample, we would have at best about …ve years of data. This short time horizon would
not allow us to identify the e¤ect of changes in …nancial development on …rm ownership structure across
industries.
22
probability model. Standard errors are clustered at the ultimate-owner level.
Estimation results are summarized in Table 8. The general pattern of results continues
to hold. For stock market value, controlling only for linear industry and country e¤ects, the
coe¢ cient on the interaction with external equity is 0.019 and is highly signi…cant (with a
standard error of 0.002). Controlling for industry country e¤ects only slightly lowers the
coe¢ cient estimate (0.017), which remains highly signi…cant. A similar pattern holds for
alternative measures of industry dependence, and for Bank Credit/GDP. Controlling only
for the linear industry and country e¤ects, the interaction coe¢ cient on external equity is
-0.014 (with a standard error of 0.003). Controlling for industry
country e¤ects, this
coe¢ cient drops to 0.010, but remains signi…cant. These results imply that as …nancial
markets improve over time, new …rms are more likely to be established as standalones,
rather than as corporate group a¢ liates.
7
Discussion
This paper contributes to the growing literature on groups by providing higher resolution
on one piece of this eclectic mosaic – European corporate groups. While there may be
substantial di¤erences in the structure of groups between emerging markets and advanced
economies, as well as markedly di¤erent scholarly approaches, the common thread of
internal capital markets seems to appear time and again. Our results highlight the role
that internal capital markets play in the organization decision of …rms across nations and
industries. We thus complement and extend previous research on the …nancial bene…ts of
group a¢ liations such as intra-group lending (Gopalan et al., 2007) and insurance against
negative shocks (Campello, 2002; Khanna and Yafeh, 2005). Because of the imperfect
mapping of our corporate groups onto the subjects of prior group literature, we take into
consideration the speci…c mechanisms and channels at work within our analysis before
making a determination of what implications we can and cannot infer from prior studies.
Our …ndings have important policy implications. On the one hand, corporate groups
may facilitate governance problems, tax avoidance, market power, and dangerously concentrated political in‡uence (Almeida and Wolfenzon, 2005; Cestone and Fumagalli, 2005;
Morck, Wolfenzon, and Yeung, 2005). On the other hand, as shown in this paper and as
suggested by Granovetter (1995), …rms may still elect to organize in groups, even under
23
conditions of relatively high development, if this gives them an advantage via more e¢ cient
internal capital markets in some countries. While we focus on ICM in this paper, there
are several other well documented costs and bene…ts to group membership, including risk
sharing, income smoothing and reallocation of capital among group members (Khanna
and Palepu, 1997, Khanna and Yafeh,2005), as well as internal labor markets (Belenzon
and Patacconi, 2010).
Our work also contributes to the policy debate about dismantling groups, (e.g. Almeida
and Wolfenzon, 2005, Granovetter, 2005, Kester, 1992), which has often been motivated by
a "dark side" of ICM’s. Here, and in contrast to earlier …ndings from the …nance-oriented
pyramidal groups literature, our …ndings are not fully supportive of the predictions that
ICM’s impose substantial costs (Stein, 1997).17 Given that in EU markets are developed,
and corporate groups are not sine qua non for survival, we may infer that these e¤ects
may be not signi…cant in our setting, or that they are possibly o¤set by other bene…ts
from group membership. That is, there must be a rational reason why they persist, and
why we still observe them, given the choices that …rms have. Future work is needed to
improve our understanding of what factors moderate the trade-o¤s involved in ICM, and
how these may vary by country. Our study is relevant here because to the extent that
costs and bene…ts of group membership may vary by nation within the EU, our results may
introduce complications in …nding the right balance between shareholder protections and
incentives to growth, and between individual countries’interests and collective EU goals.
Hence it is possible that, even in a very narrowly de…ned Western European context, no
simple answer will arise to the question of whether groups are "paragons" or "parasites"
(Khanna and Yafeh, 2007).
Casual empiricism lends additional support to our …ndings. If we consider the 20082009 …nancial crisis as an exogenous shock that reduced the level of development for
European countries, we would expect that the …nancial synergies related to internal capital
markets would become a more salient component of M&A valuations (because external
capital was scarce and more expensive). Indeed, evidence suggests that …nancial synergies
17
It has been argued that controlling …rms may have control rights that enable it to engage in "winnerpicking"-the practice of actively shifting funds from one project to another, and its counterpart, "losersticking"- forcing some projects to accept a lower level of funding than they could obtain as stand-alones.
This form of corporate “socialism”has been documented in Rajan et al. (2000) and Scharfstein and Stein
(2000).
24
did became an more important factor in M&A analytics and valuations during the crisis
period. For example, J.P. Morgan (2009) estimates that the portion of total synergies in
M&A transactions attributed to …nancial synergies (such as decreased cost of capital, tax
shields, and …nancial ‡exibility) increased from 21% in 2007 to 40% in 2009. According to
the report and consistent with our …ndings, the increase in …nancial synergies was more
pronounced for smaller and less diversi…ed …rms with lower credit ratings.18
Our …ndings about the importance of internal capital markets in forming groups have
signi…cant strategic implications. First, it may be relevant to …rms engaged in the valuation
of European companies as potential targets for acquisition. If separating a target …rm from
an existing group network deprives it of valuable resources, this may in turn impact its
future performance and support some type of group valuation discount. Second, reliance
on ICM may lead group a¢ liates to maintain less liquidity and reduce market transparency,
thus hampering investment and perpetuating market ine¢ ciencies (Teece, Rumelt, Dosi,
&Winter, 2000). Finally, the process by which …rms join groups often requires approval
by shareholders, who must weigh the pros and cons of remaining independent versus
tapping into the resources available to group members. Several notorious cases, such as
the protracted negotiations between VW and Porsche or KLM and Alitalia, highlight the
importance of protecting and appeasing both major and minor shareholders who may
stand in the way of bringing a …rm into a group. Often, stakeholders cannot adequately
forecast the impact of such transactions on value, and thus, there is a need to improve our
knowledge about the potential consequences of group membership.
The role of internal capital markets in corporate groups may also have negative implications on the level of competition and barriers to entry in capital-intensive industries,
especially in countries with less developed external …nancial markets. An important strategic consideration for both multinational and domestic …rms is the possibility that domestic
group members may have advantages over foreign entrants by allowing them to share risks
by smoothing income ‡ows and reallocating funds from one a¢ liate to another (Khanna
and Palepu, 1997, Khanna and Yafeh,2005). This is an empirically under-studied barrier
to entry facing foreign multi-national …rms seeking new markets in countries where groups
are economically important. On the other hand it could also be possible that highly
18
“A Shifting Landscape for Synergies: How Financial Considerations are A¤ecting Value Creation in
Mergers and Acquisitions”, J.P. Morgan Capital Structure Advisory & Solutions, June 2009.
25
solvent foreign entrants may actually enjoy a competitive advantage in low-development
and high-dependence countries, to the extent that their internal capital markets are more
e¢ cient than that of domestic groups. It has been shown theoretically, for example, that
group-dominated markets may result in anti-competitive environments where only cashrich entrants are able to gain a foothold (Cestone & Fumagalli, 2005). If group a¢ liation
is motivated by access to internal capital markets in these industries, standalone small
businesses may …nd it di¢ cult to compete and penetrate new markets.
At a higher level, our work here relates to that which looks at hybrid organizations.
Pure forms of hierarchy and markets are becoming increasingly rare, due to the growth of
a "swollen" or "swelling" middle (Hennart, 1993; Zenger and Hesterly, 1997), and globalization and technological progress are partly responsible for this. As many have noted,
the "old" vertically-integrated mode of production is breaking up, and is being replaced
by inter…rm collaboration (Feenstra, 1998, Gilson et al., 2009). Some types of groups can
be seen as hybrid forms of organization (Khanna and Yafeh, 2007), and our corporate
groups may perhaps be useful to researchers exploring this type of framework, especially
since "hybrid forms," can mean di¤erent things to di¤erent researchers (Williamson 1991;
Menard, 2004).
8
Conclusion
This paper uses a comprehensive …rm-level database on group a¢ liation in 15 European
countries to study the e¤ect of …nancial development on group a¢ liation. Our results indicate that less developed …nancial markets incentivize the formation of corporate groups.
Since correlations from cross-country regressions are hard to interpret in the causal sense,
we use exogenous industry measures to investigate the channel through which …nancial
development a¤ects group a¢ liation. We …nd that countries with less developed …nancial
markets have a disproportionately higher percentage of group a¢ liates in industries with
high levels of external dependence and asymmetric information. This implies that …rms
in less developed equity and debt markets join corporate groups to bene…t from their
signi…cant internal capital markets.
There is evidence that the determinants and functions of groups are institutionalcontext dependent (Granovetter, 2005; Khanna and Rivkin, 2001), which why in this
26
paper we pay close attention to our focal context in order to better understand our subjects.
While the tight focus of our study makes it feasible to identify groups on a wide scale, and
thus apply large-dataset techniques to our analysis, it also potentially limits the extent
to which we can extrapolate from our …ndings and draw conclusions about other types of
groups. Nonetheless, because ICM has been identi…ed as an important channel in other
groups literatures, we contribute to the extent we inform our understanding of ICM in this
setting. In terms of our data, we acknowledge that since the coverage for very small …rms
is uneven across countries, we do not include many small enterprises in our estimation
sample. Thus, our results may not generalize to very small …rms.
Though we focus on the e¤ect of …nancial development on the incentive to form corporate groups, other bene…ts of group membership may incentivize …rms to form corporate
groups, and we do not take a position on the relative importance of this ICM channel. For
example, organizational dependence has been associated with potential operating bene…ts,
such as strong ties to parent organizations, stable links with key stakeholders and more
sources of knowledge for developing e¤ective structures (Caves & Porter, 1977). Group
membership can also enhance exposure to foreign technologies (Gri¢ th et al. 2007). Yet,
these bene…ts would only a¤ect our results in the unlikely case that they are strongly correlated with country development and industry dependence. Nonetheless, future research
of ICM mechanisms could also explore the interactions between ICM and other types of
non-…nancial resource mobilization a¤orded by group membership.
While much of the existing literature focuses on groups in emerging markets, our
study highlights the incentives to form European corporate groups. Future research can
investigate the di¤erences between emerging market business groups and our European
corporate groups. For example, in some emerging markets direct equity holdings are not
the strongest link amongst certain types of group members (e.g. Khanna and Rivkin,
2006), but our research of the EU’s legal, governmental, and economic intuitions support
the importance of ownership links in more developed economies. More research is required
on the importance of formal links, such as ownership, as institutional contexts become more
developed and formalized. This knowledge could have important implications on how the
competitive advantage of group members changes as countries develop into more highly
industrialized economies. Additionally, future work may look at how exogenous changes,
such as the fall of the Soviet Union, has a¤ected European countries’propensity to form
27
groups.19
19
We thank one of our anonymous reviewers for this suggestion.
28
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34
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