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

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 SchoolGuojian Zheng Sun Yat-sen University

Business Group Structure

v.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

Joseph Fan 3Ownership

Fusun Group (Shanghai, China)

20％ Iron&Steel 25％ (2)

Commerce

Medicine

24.53％Estate

10% 10%22%

5%

11.95%(2)

10％

58%

95%

13.53％90.3%

20％

90％

1.94％

10％ 49％ (2)

15.04％ (2)

26.04％ (1)

70.95％11.36％8.81％％

43.33％(2)

30％3.77％

30％

67.12％

36.03％(1)

48％ (2)

20％

21％

Shanghai Guangxin Technology Development Co. Ltd.

Shanghai Fusun High Technology (Group) Co. Ltd.

NISC (600282)

FORTE(HK2337)YYTM

(600655)

53.92％

Nanjing Iron &Steel United Co.,Ltd.

Shanghai Fusun Pharmaceutical Development Co. Ltd.

Shanghai Fusun I.T. Development Co. Ltd. (Subsidiary)

LRGF(600285)

Tianjin Pharmaceutical Holdings, Ltd.

TJPC(600488)

中国医药控股有限公司 .ACCORD PHARM (000028)

Shanghai Friendship-Fusun (holding) Co. Ltd.

SFGIC(600827) Tangshan

Jianlong Steel Co. Ltd.

Lianhua Supermarket(HK0980)

Fusun Pharm(600196)

Zhaojin Mining Co. Ltd.

JianMin Pharm

(600976)

Shanghai Fusun High Technology Co. Ltd.

Shanghai Fusun Business Investment Co. Ltd.

Liang Xinjun GUO Guangchang Wang Qunbin Fan Wei

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).

Joseph Fan 6

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)

Ownership

C om pany Valuation and the D ifference between C ontrol and Ownersh ip

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

0% 1-5% 6-10% 11-15% 16-20% 21-25% 26-30% 31-35% 36-40%

C ontrol Minus Ownership

Me

an

Ma

rke

t-to-b

oo

k V

alu

e

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

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-

listed status

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.

Business Group and Pyramidal Control Structure in China

SAMB

Parent Co. (Parent)Parent SOE (Parent)

Listed Firm (Listed sub) Listed Firm (Listed sub)

Private Owner

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.

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

constrained than the listed subsidiary.

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.

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

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 when β4

is positive and significant.

16

sYearDummielativeQlowOtherCashFlativeQlowOtherCashFwOwnCashFloCapex

Re*Re 43

210

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

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)

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.

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 available CF 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 underestimate

tunneling. Traditional CF measure may be noisy. It appears that tunneling in China takes less obvious

forms than through the extension of trade credit

21

22

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.

Summary Statistics

23

Variable Obs. Mean Median Mean MedianListed Sub Parent

Capital Expenditure 604 0.1191 0.0761 0.0864 0.0405 Net Trade Credits 604 -0.0392 -0.0362 0.0284 0.0197

Traditional Cash Flow Measure 604 0.1016 0.0966 0.0699 0.0595 Adjusted Cash Flow Measure 1 604 0.0624 0.0664 0.0983 0.0789 Adjusted Cash Flow Measure 2 604 0.0455 0.0474 —— ——Adjusted Cash Flow Measure 3 604 0.0849 0.0847 —— ——

Industry Q 604 1.6380 1.6914 1.5580 1.5422 Relative Q 604 0.0800 0.0952 -0.0800 -0.0952

Industry Growth 604 0.1150 0.0925 0.1070 0.0869 Cash Flow Right of Parent 604 52.0038 54.4250 —— ——Bank Ownership Dummy 604 0.2447 0.0000 —— ——

Size (thousand Yuan) 604 229261 143129 542179 235155

24

Panel A Listed Sub RegressionCash Flow Measure Traditional CF Measure Adjusted CF Measure 1

Own Cash Flow 0.4143 0.4235 0.3601 0.3637(0.1154)*** (0.1261)*** (0.0547)*** (0.0603)***

Other Cash Flow 0.0441 0.0476 0.0223 0.0254(0.0301) (0.0357) (0.0178) (0.0189)

Relative Q 0.0214 0.0243 0.0201 0.0214(0.0126)* (0.0138)* (0.0112)* (0.0119)*

Other Cash Flow * Relative Q

0.0212 0.0168(0.0176) (0.0210)

Adj_R2 604 604 604 604

Panel B Parent Regression

Cash Flow Measure Traditional CF Measure Adjusted CF Measure 1 Adjusted CF Measure2 Adjusted CF Measure 3

Own Cash Flow0.5041 0.5088 0.5114 0.5132 0.5262 0.5251 0.5278 0.5299

(0.0565)*** (0.0579)*** (0.0654)*** (0.0689)*** (0.0502)*** (0.0511)*** (0.0534)*** (0.0541)***

Other Cash Flow 0.0938 0.0802 0.2243 0.2067 0.2012 0.1874 0.1387 0.1031

(0.0445) ** (0.0466) * (0.0564)*** (0.0576)*** (0.0413)*** (0.0389)*** (0.0367)*** (0.0278)***

Relative Q 0.0162 0.0159 0.0177 0.0167 0.0178 0.0166 0.0161 0.0153(0.0081)** (0.0102) (0.0068)** (0.0087)* (0.0101)* (0.0113) (0.0122) (0.0112)

Other Cash Flow * Relative Q

0.0842 0.1504 0.1231 0.0962(0.0551) (0.0750)** (0.0682)* (0.0449)**

Adj_R2 604 604 604 604 604 604 604 604

25

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.

Cash Flow Measure Adjusted CF Measure 1

Own Cash Flow0.5042 0.5085

(0.0434)*** (0.0483)***

Other Cash Flow0.1578 0.1689

(0.0972) (0.0884)*

Relative Q0.0151 0.0156

(0.0093) (0.0089)*

Other Cash Flow * Relative Q0.1343 0.1172

(0.0622)** (0.0618)*

Low Cash Flow Right-0.0347(0.0322)

No Bank Ownership-0.0296(0.0297)

Low Cash Flow Right * Other Cash Flow0.1486

(0.0676)**

Low Cash Flow Right * Other Cash Flow* Relative Q-0.0612

(0.0303)**

No Bank Ownership * Other Cash Flow0.1068

(0.0483)**

No Bank Ownership * Other Cash Flow* Relative Q0.0831

(0.0401)**Obs. 604 604

Adj_R2 0.24 0.24

27

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

28

Cash Flow Measure Adjusted CF Measure 1(1) (2)

Own Cash Flow 0.5110 0.5145(0.0412)*** (0.0475)***

Other Cash Flow 0.1145 0.1062(0.0698) (0.0657)

Relative Q 0.0167 0.0150(0.0084)** (0.0091)

Other Cash Flow* Relative Q 0.1142(0.0693)

D2 0.0312 0.0325(0.0347) (0.0384)

D3 -0.0269 -0.0278(0.0691) (0.0754)

D4 -0.0398 -0.0411(0.0287) (0.0332)

D2* Other Cash Flow 0.1247 0.1124(0.0621)** (0.0642)*

D3* Other Cash Flow 0.1126 0.1004(0.0558)** (0.0527)*

D4* Other Cash Flow 0.2043 0.1924(0.0726)*** (0.0825)**

D2* Other Cash Flow* Relative Q 0.1465(0.0728)**

D3* Other Cash Flow* Relative Q -0.1012(0.0358)***

D4* Other Cash Flow* Relative Q 0.0334(0.0452)

Obs. 604 604Adj_R2 0.24 0.26

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

Dep. Variable ORECTA GORECTA_Parent(1) (2) (3) (4)

Low Cash Flow Right0.0075 0.0096

(0.0040)* (0.0034)***

No Bank Ownership0.0036 0.0049

(0.0019)* (0.0021)**

Low Cash Flow Right * Relative Q

-0.0191 -0.0078(0.0094)** (0.0024)***

No Bank Ownership * Relative Q

0.0252 0.0094(0.0120)** (0.0042)**

Relative Q0.0028 0.0112 0.0036 0.0102

(0.0056) (0.0111) (0.0032) (0.0066)

ROA -0.6070 -0.6147 -0.3169 -0.3117

(0.0344)*** (0.0341)*** (0.0234)*** (0.0231)***

Size -0.0022 -0.0019 -0.0036 -0.0036

(0.0012)* (0.0012) (0.0009)*** (0.0009)***

State-0.0173 -0.0185 -0.0064 -0.0055

(0.0066)*** (0.0066)*** (0.0045) (0.0045)

Marketization-0.0021 -0.0023 -0.0037 -0.0037

(0.0014)* (0.0016) (0.0011)*** (0.0011)***

Layer-0.0077 -0.0074 -0.0055 -0.0053

(0.0035)** (0.0036)** (0.0024)** (0.0024)**Obs. 604 604 604 604

Adj_R2 0.2365 0.2356 0.1918 0.1910

Dep. Variable ORECTA ORECTA_Parent(1) (2) (3) (4)

D2 0.0036 0.0016 0.0064 0.0059(0.0021) (0.0022) (0.0028)** (0.0027)**

D3 0.0095 0.0080 0.0072 0.0065(0.0051)* (0.0052) (0.0031)** (0.0033)**

D4 0.0111 0.0081 0.0102 0.0091(0.0040)*** (0.0042)* (0.0036)*** (0.0049)**

D2* Relative Q 0.0459 0.0208(0.0200)** (0.0105)**

D3* Relative Q -0.0599 -0.0367(0.0193)*** (0.0126)***

D4*Relative Q -0.0242 -0.0188(0.0161) (0.0130)

Relative Q -0.0073 0.0413 0.0028 0.0209(0.0047) (0.0284) (0.0032) (0.0124)*

ROA -0.6082 -0.6009 -0.3174 -0.3167(0.0345)*** (0.0345)*** (0.0234)*** (0.0235)***

Size -0.0019 -0.0019 -0.0037 -0.0038(0.0012) (0.0012) (0.0009)*** (0.0009)***

State -0.0150 -0.0161 -0.0065 -0.0066(0.0067)** (0.0067)** (0.0045) (0.0046)

Marketization -0.0021 -0.0022 -0.0036 -0.0035(0.0016) (0.0016) (0.0011)*** (0.0011)***

Layer -0.0078 -0.0079 -0.0055 -0.0055(0.0036)** (0.0036)** (0.0024)** (0.0024)**

Obs. 604 604 604 604Adj_R2 0.2342 0.2389 0.1910 0.1914

32

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)

Industry Q and Industry Growth

D2* Other Cash Flow0.1046

(0.0512)**

D3* Other Cash Flow0.0941

(0.0486)*

D4* Other Cash Flow0.1525

(0.0684)**

D2* Other Cash Flow* Industry Q

0.1628(0.0714)**

D3* Other Cash Flow* Industry Q

-0.2046(0.0701)***

D4* Other Cash Flow* Industry Q

-0.0512(0.0357)

Obs. 604Adj_R2 0.25

D2* Other Cash Flow0.1040

(0.0516)**

D3* Other Cash Flow0.0747

(0.0486)

D4* Other Cash Flow0.1721

(0.0791)**

D2* Other Cash Flow* Industry Growth

0.1542(0.0472)***

D3* Other Cash Flow* Industry Growth

-0.0576(0.0273)**

D4* Other Cash Flow* Industry Growth

0.0847(0.0619)

Obs. 604Adj_R2 0.26

Capital Market RegulationDep. Variable ORECTA ORECTA_Parent

(1) (2)

Regulation -0.0415 -0.0245

(0.0078)*** (0.0054)***

Regulation * Relative Q0.0103 0.0053

(0.0053)* (0.0020)**

Relative Q0.0128 0.0061

(0.0076) (0.0048)

ROA -0.6180 -0.3140

(0.0341)*** (0.0231)***

Size -0.0019 -0.0036(0.0012) (0.0009)***

State-0.0176 -0.0053

(0.0066)*** (0.0044)

Marketization-0.0021 -0.0037(0.0016) (0.0011)***

Layer-0.0079 -0.0055

(0.0036)** (0.0024)**Obs. 604 604

Adj_R2 0.2341 0.1914

Regulation =1 if sample year is 2004-2005

Cash Flow Measure Adjusted CF Measure 1

(1) (2)

Own Cash Flow0.5012 0.4915

(0.0446)*** (0.0425)***

Other Cash Flow0.2042 0.1733

(0.0655)*** (0.0754)**

Relative Q0.0161 0.0156

(0.0084)* (0.0099)

Other Cash Flow * Relative Q0.1285

(0.0665)*

Regulation 0.0723 0.0685

(0.0226)*** (0.0266)**

Regulation * Other Cash Flow

-0.0624 -0.0542(0.0356)* (0.0288)*

Regulation * Other Cash Flow* Relative Q

0.1156(0.0658)*

Obs. 604 604Adj_R2 0.2438 0.2598

Panel A: Investment-Cash Flow Sensitivity Model Panel B: Capital Flow Determinant Model

Firm SizeDep. Variable ORECTA ORECTA_Paren

t(1) (2)

Small Size 0.0133 0.0042

(0.0044)*** (0.0021)**

Small Size * Relative Q0.0041 0.0097

(0.0020)** (0.0050)*

Relative Q0.0060 0.0084

(0.0041) (0.0048)*

ROA -0.6037 -0.3142

(0.0343)*** (0.0233)***

Size -0.0016 -0.0037(0.0012) (0.0009)***

State-0.0159 -0.0055

(0.0066)** (0.0044)

Marketization-0.0022 -0.0036(0.0016) (0.0011)***

Layer-0.0079 -0.0054

(0.0036)** (0.0024)**Obs. 604 604

Adj_R2 0.2388 0.1918

Small Size=1 when parent firm size is below the median of sample.

Cash Flow Measure Adjusted CF Measure 1

(1) (2)

Own Cash Flow0.4952 0.4978

(0.0528)*** (0.0513)***

Other Cash Flow0.1945 0.1661

(0.0755)** (0.0822)**

Relative Q0.0171 0.0141

(0.0084)** (0.0086)

Other Cash Flow * Relative Q

0.1278(0.0725)*

Small Size -0.1402 -0.1335

(0.0286)*** (0.0301)***

Small Size * Other Cash Flow

0.1047 0.0918(0.0486)** (0.0496)*

Small Size * Other Cash Flow* Relative Q

0.0809

(0.0391)**Obs. 604 604

Adj_R2 0.2447 0.2525

Panel A: Investment-Cash Flow Sensitivity Model Panel B: Capital Flow Determinant Model

36

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.

Thank You!