Business Groups in Emerging Markets: Paragons or Parasites?

Business Groups in Emerging Markets: Paragons or Parasites? By:Gayathri SaiMehul GahranaSahil SharmaManas MendirattaRajesh TaracadDiversified business groups, consisting of legally independent firms operating across diverse industries, are ubiquitous in emerging markets. Groups around the world share certain attributes but also vary substantially in structure, ownership, and other dimensions.

This paper proposes a business group taxonomy, which is used to formulate hypotheses and present evidence about the reasons for the formation, prevalence, and evolution of groups in different environments.

It argues that business groups are responses to different economic conditions and that, from a welfare standpoint, they can sometimes be "paragons" and, at other times, "parasites."Diversified business (or corporate) groups are ubiquitous in emerging markets (e.g., Brazil, Chile, China, India, Indonesia, South Korea, Mexico, Pakistan, Thailand, and many more) and even in some developed economies (e.g., Italy, Sweden). Bound together by formal (eg. Equity) and Informal (Eg. Family) ties.

The table indicates that, in virtually all emerging markets, group affiliated firms tend to be relatively large and economically important.

Groups around the world vary considerably in form: Some are extremely diversified whereas others are more focused.

In some groups there is considerable vertical integration and intragroup trade; In others, less. Some groups are deeply involved in banking and financial services, whereas others are not. Moving from structure to ownership and control, somebusiness groups are vertically controlled ("pyramids"), whereas others are horizontally linked through cross shareholdings. In certain countries, business groups are a politically important force, enjoying close relations with the government

Diversity of business groups around the world is due to the diversity of the underlying conditions leading to their formationGroup structure: the extent of horizontal diversification; the extent of vertical integration; and the extent of involvement in the financial sector. Group ownership and control: the extent to which the group is pyramidal in structure; the extent to which it is family controlled. Group interaction with society: the nature of the interaction between business groups and the state; the extent of monopoly power wielded by groups This taxonomy is used to derive six testable hypothesisGroups may sometimes play a positive role by making up for underdeveloped economic institutions, but they can also be detrimental to social welfare because of rent seeking or monopoly power. Groups do not only respond to their environment but also shape and influence it. The dynamic effect of groups on their economic environment is sometimes socially welfare-enhancing, and sometimes not. The third contribution of the present study is to question some of the conventional wisdom in the literature. (Groups, we argue, are not purely rent-seeking organizations nor should groups be equated with pyramids, and pyramids are not always the, or even a, way of disenfranchising minority shareholders)The literature on business groups in economics and finance has focused primarily on two themes.

The first regards business groups as diversified entities.

The second regards business groups, especially their pyramidal forms, as a favourite setting for the study of conflicts of interests between controlling and minority shareholders.

The rest of the paper is organized around the taxonomy of business groups around the world:

Focuses on dimensions related to the structure of business groups Examines dimensions related to ownership and control Focuses on two dimensions of the interaction betweenbusiness groups and societyStructure & form of Business GroupDiversificationEliminates firm specific riskMore effective use of asset if company has unused resourcesNegative if driven by motives of empire expansion etc.In US, cost of diversification exceeds benefits

Why then does diversification exist?Hypothesis 1: Diversified business groups should be more common in economies with less developed market institutions-- Some institutions that make div. Costly in developed markets are not present here.-- Capital markets may have informational problems -- Firms avoid external market-- Focus on internal financing-- Labour skills may be inadequate Whether or not a diversification discount exists in emerging markets. The general answer seems to be that the diversification discount tends to be lower in environments where markets, including, but not limited to, financial markets, are less developed.The study has not been able to come to conclusion on this and says that the relation between the costs and benefits of diversification and economic and institutional development is probably more complex than what Hypothesis 1 suggests.

Hypothesis 2: The presence of business groups, the extent of their vertical integration, and the volume of intragroup trade, should all be higher in environments with underdeveloped legal and judicial institutions, where contracting is costly.

One possibility is that vertical integration serves primarily as a means to obtain monopoly power rather than as a tool to overcome contracting difficulties.

In addition, there seems to be considerable variation in the extent of vertical integration across groups within the same country, suggesting that group and industry-specific factors play a role which is sometimes more important than country-specific institutional factors.

Hypothesis 2 (cotd.)Another startling fact is expansion into financial services : when the capital needs increase, firms started expanding in the financial services sector.Astra International, for example, was in process of expanding its automobile assembly lines in 1970s when it started acquiring banks and expanding into other financial services.Structure of Business GroupsInvolvement in business groups due to:Contracting costs e.g. British MNCs in in early twentieth century involved in financial services overseasInstitutional Quality e.g. Indonesian firms used group used group specific institutions to meet their capital needsOwnership and Control of Business GroupsVariation in ownership and control characteristics in business groupsTunneling Effect Hypothesis:Poor investor protectionInadequate rule of law

Ownership and Control of Business Groups (contd.)Family controlled groups in countries where minority share holders are not well protected are associated with expropriation of small shareholders

Widely held firms common in US and UK, family ownership common around the world

Pyramidal groups common in Indonesia, Thailand, Malaysia and Mexico

Some firms are difficult to be classified as pyramids or non-pyramids e.g. Samsung

Evidence of tunnelling in Europe and more predominately in India

Within group takeovers rarely raise the value of bidder but raise the value of other group members

Large shareholding is not all badHistorical Evidence

In Japanese pre war Zaibatsu, control by some large shareholders was considered important

Tunneling was not a major concern for British investors in early twentieth century. Affiliation with one of the family-controlled British merchant houses was apparently viewed as stamp of certification

Tunneling is higher in countries with poor shareholder protection

In some cases, reputation and safeguards come to rescue against tunnelling

Some groups compensate investors for the risk of expropriation

In a nutshell, not all pyramids are associated with tunnelling and tunnelling is not restricted to pyramidal organizations

Family versus Non Family groupsFamily-controlled are likely to be more common in countries with inadequate rule of lawFamily ownership and control is the cause of economic and institutional underdevelopmentExamples:Taiwan considerable family equity stakes and involvement in management in 1988 followed by decline in 1990s, which was accompanied by increase in use of pyramids to maintain family controlSingapore one-third of business groups are family owned. In almost every group, chairman and CEO is family memberMalaysia 35 % of business groups in 1997 were family owned, but the number has declinedFamily versus Non Family groups (cont...)Group structure depends on family history and evolution, number of male sons of the founder and the number of brothers

Family considerations affect number of companies in group and appointment of senior officers

With the focus on not diluting control of family, companies tend to go for debt financingRelation between Mature Groups and GovernmentRelation varies considerably

Business groups are formed with government support, expand and diversify with government nurturing

In emerging markets, groups are first formed with government support. As groups evolve and countries develop, relation becomes complexFamily v/s Non Family Group (cotd..)No clear evidence of whether or not family oriented groups are more prevalent in East Asia. There are non Asian countries with considerable family involvement e.g. MexicoAccording to sociology literature, groups serve social and cultural purposes rather than seeking to achieve economic objectivesOther factors:Inheritance customsKinship structureNational ideology and pride

Evidence on Relations between groups and governmentsThe degree of relationship varies from close ties to acting against the firmsClose ties- Indonesia(Suharto regime, Malaysia, India during License raj)Japanese zaibatsu Mitsui and Mitsubishi controlled one of the major parties in Japanese parliamentTurkish group launched a political party to gain political immunityOn the contrary there have been instances where govt has harmed businesses. E.g. socialist movement in IndiaContd.In S. Korea however, regime changes lead to no differences in favors received by firmsEven within the same group different affiliates maybe or favored or punished depending on the CEOs ties with the regimeRepublic of Samsung- What happens when groups become stronger and independentConclusion- The groups tend to accumulate power and their relationship with the government tends to changefrom government protgs to a strong lobby The welfare implications of tiesDespite the negative implications of govt. favors it is believed that groups have helped orchestrate big push when requiredMalaysia- social equilibrium maintained by favoring ethnic minorityBlack economic Empowerment in South Africa by govt. supportEasy for govt. to collect taxes from groupsTaxes collected from Japanese Zaibatsu during WW2 were substantialContrastingly, US authorities feel it is difficult to collect taxes due to tunneling. This was the reason behind Roosevelts attach on bus groupsAnalysis suggests that government supports business groups formed by state but discriminates against private groups. Ex. ChinaThe political ability of groups to shape their environmentZaibatsu in Japan helped in infrastructure development amd launched new industriesMexican groups helped in pushing for FTA with USALiberalization in India was aided by such groupsOn the contrary groups also can act out of self interest and resist political reforms, improvement in minority shareholder protection like in S. KoreaThey restrict competition and prevent new entrantsSome countries also shape their environment by gaining control on mediaBusiness groups and monopoly powerTaking advantage of their ties with the government they drive out rivals due to their deep pockets and relations with govt.EvidenceRoosevelt sought to dissolve business groups at the time of the Great depressionZaibatsu was dissolved on the grounds of anticompetitive effects and that the social tension caused by them may have contributed to militarism in JapanContrastingly, Japans bank centered groups competed aggressively against each other rather than colludedThere have also been instances of collusion such as in Indonesia which lead to increased concentration of wealth and resources

Direction for Future UsesOrigin & Formation of Business groupsSome studies indicates the formation of business networks in response to limited contract enforcement by the legal system, imperfect property rights. Some factors responsible for group formation- market forces, culture and societal institutionsGovt. involvement in group formation. E.g. liberalization in south china but not in north eastTime variation- From pre independence Tatas and Birlas to later Goenkas and then the 3rd set of firms during License Raj

Evolution & Dynamics of Business groupsThe Japanese prewar zaibatsu provide an obvious opportunity to carry out such an analysis because of the wealth of information about their activities and development, providing over five decades of data. Another possibility is the shorter, but more recent history of the South Korean chaebol

Longevity of Business groupsNo systematic evidence on the question whether or not the longevity of group affiliates exceeds that of other wise comparable, unaffiliated firms,. In some cases, groups have survived, without a substantial change in structure, over a long period from being was poor, all the way to prosperity (e.g., Sweden)

Groups & Macroeconomic CrisesSome studies relate corporate governance in business groups to the financial crisis in East AsiaThe argument is that crony capitalism enabled groups to borrow particularly easily, and moral hazard problems associated with this may have precipitated the crisisBut nothing can be said conclusively as there are vast differences across countries, groups and time periods