Revisiting The Bright and Dark Sides of Capital Flows in Business Groups

1. Revisiting The Bright and Dark Sides of Capital Flows in Business Groups Joseph P. H. Fan The Chinese University of Hong Kong Li Jin Harvard Business School GuojianZheng Sun Yat-sen University

2. Business Group Structurev.s. Conglomerate Structure • Complex group-like organizations are commonplace in the world. • Comparing with the conglomerate organization • Similarity: complex internal resource flows • Difference: legal boundaries, top down control as oppose to horizontal control, complex ownership structure • Because divisions are legally separate entities in a business group, intra-group capital flow becomes an issue to outside minority owners

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4. Costs of the Group Structure • A body of literature focuses on expropriation of minority shareholders by the controlling parent, e.g., tunneling(Johnson et al.,2000) • Even from the perspective of the whole group, such “tunneling” might not be a zero-sum game. • additional resources to cover up tunneling, potential legal penalties, ex ante distortion of incentives on investments • Investors not systematically fooled, the insider of the business group ultimately bears the welfare loss from tunneling. • Cost of the tunneling is reflected in lower security prices (Claessens et al., 2002; La Porta et al., 2002).

5. Firms controlled by Pyramids are traded with a discountacross all public traded East Asian Firms(Claessens, Djankov, Fan, Lang, Journal of Finance 2002; Based on 3000 East Asian Firms) Joseph Fan

6. Motivation • Given the costly group structure, what explains the persistent existence and wide prevalence of business groups? • For the whole group in under-developed financial markets: tunneling may be a constrained optimum even if not the first-best outcome , if it • alleviates severe financing constraints of member firms, and • enables the undertaking of positive NPV projects. • Morck, Wolfenzon, Yeung, 2005; Almeida and Wolfenzon, 2006, 2010; Khanna and Yafeh, 2007; Gopalan et al., 2007; Masulis et al., 2010

7. Empirical Challenge • A key challenge to empirical research demonstrating this tradeoff: • to disentangle the resources diverted to facilitate group efficiency from those diverted to satisfy the private benefits of the controlling shareholder • For minority shareholders: both are tunneling! • But from the business group perspective, sacrificing a division may benefit the whole group • Parent firms typically not observable because of non-listedstatus

8. Our attempt • In this paper, we make a modest attempt to bypass the above difficulties by • focusing on transfers of financial resources within business groups, and • testing the hypothesis that intra-group capital flow may be motivated by both group capital allocation efficiency and pure expropriation of minority shareholders.

9. Business Group and Pyramidal Control Structure in China SAMB Private Owner Parent SOE (Parent) Parent Co. (Parent) Listed Firm (Listed sub) Listed Firm (Listed sub)

10. A Model of Financial Tunneling • Suppose an owner of a business group carves out a subsidiary and lists it, which results in • pair of a publicly listed sub (listed sub) and a non-listed parent company (parent). • Control is one-directional in the firm pair • The public listing allows the owner to raise external capital and create a class of minority shareholders in the listed subsidiary.

11. Assumptions of the Model • Financial transactions between the pair serve to • fund investment projects in parent or subsidiary • or be consumed by the controlling owner as private benefits. • Legal environment is unable to fully prevent such tunneling activities (Johnson et al., 2000) . • The parent company cannot effectively commit to refraining from tunneling because of • the opportunity losses from private benefits and investment opportunities, or • the costs of self-imposed corporate governance constraints. • The non-listed parent is much more financially constrainedthan the listed subsidiary.

12. Predictions • Cash flowing in the group is almost one-directional : • from the listed sub to the parent. • We should observe more intra-group cash flow activity(tunneling) if the parent and the listed sub are more severely misaligned in incentives, or if parent faces more financing constraints.

13. Predictions on magnitude and efficiency of intra-group capital flow activity (tunneling) • D1: High parent ownership stake in sub, less severe fin constraint • D2: High parent ownership stake in sub, severe fin constraint • D3: Low parent ownership stake in sub, less severe fin constraint • D4: Low parent ownership stake in sub, severe fin constraint • Magnitude of capital flow: D4 > D2 & D3 > D1 • Efficiency of tunneled capital: D2 > D1 & D4 > D3

14. Sample and Data • 624 firm-year observations from 1999-2005 in China • Each obs. includes a pair of firms (Listed sub and Parent). • Financial information from both the listed subs and the non-listed parents • Parent sample comes originally from National Bureau of Statistics’ (NBS)Annual Industrial Survey Database . • Exclude : • “Shell” or holding companies • With missing data • Can’t be indentified in NBS • Less than 20% shares of the listed sub • Parent and the listed sub has the same 3-digit industry code • Negative cash flow

15. Regression Model • Measure of ICF activities: investment of group member firm A out of cash flow of member firm B, controlling for cash flow of firm A (Shin and Stulz ,QJE,1998). • Adding firm fixed effects and year dummies. • Run regression for both Listed sub and Parent, compare the results: • ICF exists when β2 is positive and significant. • For parent, the financing tunneling is efficient whenβ4is positive and significant.

16. Relative investment opportunity • Relative Q = difference in industry Tobin’s q between the parent and the sub • Use industry average q because parent is not listed and to mitigate measurement bias if firm level q is otherwise used

17. Cash flow measures in the literature Cash flow=income after tax+ depreciation –dividend payments Hoshi, Kashyap and Scharfstein (QJE,1991 ) Cash flow=earnings before extraordinary items+ depreciation Kaplan and Zingales (QJE,1997) Cash flow=earnings before interest and tax +depreciation + amortization (EBITDA) Kaplan and Zingales (QJE,1997) Cash flow=operating profit+ depreciation Shin and Stulz (QJE,1998); Shin and Park(JCF,1999)

18. Cash flow measures in our paper Traditional cash flow measure: EBIT + depreciation Three adjusted cash flow measures Adjusted Cash Flow Measure 1:(EBIT)+ depreciation - net change in trade credits net change in trade credits =increase in accounts receivables - increase in payables We do not have amortization data. Rationale: (EBIT+ depreciation) is the accounting profit. Reasonable in conglomerates (EBIT + depreciation - net change in trade credits )is the amount of cash that is available for use by either own firm or the other firm. A large fraction of EBIT take the form of trade credits.

19. Cash flow measures in our paper • Example: • Suppose a listed sub has a total EBIT of $100,of which $30 is the increase of trade credits, then availableCF is $70. • Two possibilities of this $30 trade credits : • naturally arise due to normal transactions • only $70 available for tunneling, adjusted measures is appropriate • implicit loans from one firm to the other • $100 available for tunneling, traditional measures is appropriate

20. Cash flow measures in our paper • Which one more closely resembles the reality is an empirical question. • If adjusted CF measure underestimates tunneling relative to the traditional CF measure, investment should be less sensitive to the adjusted CF measure than to the traditional CF measure. • we found stronger sensitivity between investment of the parent and the adjusted CF of the listed sub, suggesting that • the adjusted CF measure does not underestimatetunneling. • Traditional CF measure may be noisy. • It appears that tunneling in China takes less obvious forms than through the extension of trade credit

21. Cash flow measures in our paper Adjusted Cash Flow Measure 2: EBIT + depreciation -net change in trade credits- income tax Adjusted Cash Flow Measure 3: EBIT + depreciation -net change in trade credits - income tax + net increase of bank debts and equities. For adjusted cash flow measure1, we have data from both Parent and Listed sub For adjusted cash flow measure 2 and 3, we only have data from Listed sub. 22

22. Summary Statistics

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24. Impact of corporate governance and financing constraint on ICF Ownership is fundamental to – and cash flow rights theoretically at the core of – corporate governance. Empirically strongly related to the incentives of large shareholders to tunnel the listed firms that they control (Bertrand,et.al, 2002; Claessens,et.al, 2002).Especially when legal protection for outside investors is weak (La Porta,et.al, 1997, 1998, 1999) Bank ownership has been argued to be important to firms for raising external finance(e.g, Hoshi, et.al,1991) Bank ownership in this paper: A dummy variable whether listed sub(under Parent’s control ) owns shares of local financial banks. 25

26. Putting the two effects together We next examine the joint effects of corporate governance and financing constraints. Consider four types of interactions of corporate governance and financing constraints: D1: high cash flow right and with bank ownership; D2: high cash flow right and without bank ownership; D3: low cash flow right and with bank ownership; D4: low cash flow right and without bank ownership D 1 as the benchmark 27

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28. Robust Tests Using Alternative Measure of Intra-group Cash Flows • Conventional measure of investment-cash flow sensitivity still comes as an estimate of the true capital flows • Two more direct measures for intra-group capital flow : • ORECTA : Other Receivables deflated by total assets • Jiang et al (2010) • GORECTA：Other Receivables provided to controlling shareholder deflated by total assets

31. Other Robust Tests Alternative proxy for investment opportunities: Industry Q: industry average Q matched from listed firms in China’s stock market. Industry Growth: Industry average sale growth calculated from NBS Event of corporate governance change: Capital market regulation against expropriation by controlling shareholder from 2003. Alternative proxy for financing constraints: Firm size (Almeida and Campello, 2007; Erickson and Whited, 2000) 32

32. Industry Q and Industry Growth

33. Capital Market Regulation Panel A: Investment-Cash Flow Sensitivity Model Panel B: Capital Flow Determinant Model Regulation =1 if sample year is 2004-2005

34. Firm Size Panel A: Investment-Cash Flow Sensitivity Model Panel B: Capital Flow Determinant Model Small Size=1 when parent firm size is below the median of sample.

35. Conclusion We document the existence of two aspects of intra-group financing using 604 pair-years of Chinese listed firms and their non-listed parents : cross-financing to mitigate severe financing constraints, and the exploitation of minority shareholders due to weak corporate governance. Both can account for the rise of intra-group financing, but they have opposite impacts on group capital allocation efficiency: highest when the motivation is purely the mitigation of financial constraints, and lowest when it is purely expropriation of outside investors. 36

36. Thank You!