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A Theory of Family Business Groups and Pyramidal Ownership * Heitor Almeida New York University [email protected] Daniel Wolfenzon New York University [email protected] (This Draft: August 14, 2003 ) Abstract Existing theories of pyramidal business groups cannot explain recent empirical …ndings about the prevalence of these groups and their characteristics. In this paper, we propose a simple theory of pyramids that helps us understand the empirical evidence. Our theory explicitly recognizes that a full understanding of pyramidal business groups necessitates answering two di¤erent questions in an integrated framework: why business groups arise, and what determines their ownership structure, that is, why …rms are owned through pyramidal chains. In our model business groups arise to substitute for missing …nancial markets, and families choose pyramidal ownership structures when the bene…t of using retained earnings that belong to existing …rms in the group is large. Our model makes a number of empirical predictions that are consistent with available evidence and suggests other implications that can be tested in future research. Key words: pyramids, business groups, investor protection, ownership structure. JEL classi…cation:... * We thank... for valuable comments.

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Page 1: A Theory of Family Business Groups and Pyramidal …...A Theory of Family Business Groups and Pyramidal Ownership * Heitor Almeida New York University halmeida@stern.nyu.edu Daniel

A Theory of Family Business Groups

and Pyramidal Ownership*

Heitor AlmeidaNew York [email protected]

Daniel WolfenzonNew York [email protected]

(This Draft: August 14, 2003 )

Abstract

Existing theories of pyramidal business groups cannot explain recent empirical …ndings about theprevalence of these groups and their characteristics. In this paper, we propose a simple theory ofpyramids that helps us understand the empirical evidence. Our theory explicitly recognizes that afull understanding of pyramidal business groups necessitates answering two di¤erent questions in anintegrated framework: why business groups arise, and what determines their ownership structure,that is, why …rms are owned through pyramidal chains. In our model business groups arise tosubstitute for missing …nancial markets, and families choose pyramidal ownership structures whenthe bene…t of using retained earnings that belong to existing …rms in the group is large. Our modelmakes a number of empirical predictions that are consistent with available evidence and suggestsother implications that can be tested in future research.

Key words: pyramids, business groups, investor protection, ownership structure.JEL classi…cation:...

* We thank... for valuable comments.

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1 Introduction

Many …rms in the world have a controlling shareholder, usually a family or the State (La Porta,

Lopez-de-Silanes and Shleifer, 1999). In fact, in several countries a few wealthy families control a

large number of …rms and consequently a vast amount of capital through the creation of business

groups.1 This concentration of control is usually accomplished with the use of pyramidal ownership

structures. A typical pyramidal business group consists of a collection of legally independent …rms,

controlled by the family through a chain of ownership stakes. Because the family does not need

to retain 100% of the shares to retain control at each chain of the pyramid, pyramidal ownership

structures allow for separation of cash ‡ow and control rights, and can facilitate family control.

There is a large economics and …nance literature that attempts to explain the existence of

pyramidal business groups, and the role they play in the economy. While some authors argue that

pyramidal business groups arise to substitute for missing or poorly functioning markets (Le¤, 1978,

Khanna and Palepu, 1997),2 others believe that pyramids are used by families to retain control over

a country’s corporate sector with a low cash ‡ow stake.3 In particular, because of the potential

separation of cash ‡ow from control rights engendered by pyramids, their existence can exacerbate

agency problems between controlling and minority shareholders.

The fact that pyramidal business groups are more common in countries with poor investor

protection (La Porta, Lopez-de-Silanes and Shleifer, 1999), appears to be consistent with a role

of business groups as substitutes for poorly developed …nancial markets. However, there is also

recent evidence that a …rm’s group membership increases the scope for expropriation of the …rm’s

minority shareholders by the controlling one (Bertrand, Mehta and Mullanaithan, 2002, Bae, Jang

and Kim, 2002). This evidence appears to be more consistent with the view that pyramids are a

mechanism to retain control and extract private bene…ts. Proponents of this view argue that the

reason why pyramids are more common in countries with poorly developed …nancial markets is

that in those countries private bene…ts of control are large (Bebchuk, 1999). Thus, while families

might bene…t from the concentrated control achieved through pyramids, the resulting allocation of1See, among others, Claessens, Djankov, and Lang (2002) for the evidence on East Asia, Faccio and Lang (2002)

for Western Europe, Khanna (2000) for emerging markets, and Morck, Strangeland and Yeung (2000) for Canada.2Khanna and Palepu’s value-enhancing argument is really about all types of business groups, not only about

pyramidal business groups. We come back to this important issue below.3This argument goes back at least to Berle and Means (1932). In their classic book they describe the use of

pyramids in the railroad industry in early 20th century America.

1

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corporate control may become sub-optimal for the country (Morck, Strangeland and Yeung, 2000).

At …rst glance, the agency view of pyramids appears to be broadly consistent with the data, and

one can argue that it has become the traditional view of pyramids in the academic literature.4

Nevertheless, a more detailed examination of the available data on pyramidal ownership struc-

tures reveals some facts that cannot be adequately explained by this traditional view. Notice that

the traditional story revolves around the notion of control of voting rights. If pyramids are simply

a way of minimizing the monetary cost of achieving control, one should never observe cash ‡ow

stakes in individual …rms that are larger than the treshold that is required to achieve control. A

major problem for the conventional story is the substantial empirical evidence that in many coun-

tries families do hold large cash ‡ow stakes in the …rms that they control through pyramids. For

example, Franks and Mayer (2002) …nd that in Germany, for a large majority of the …rms con-

trolled through pyramids the controlling shareholder could have achieved the same level of control

by simply holding shares directly in the …rm. The authors conclude from the evidence they compile

that, in Germany, pyramids are simply not used as a device to achieve control. Similar …ndings

have been reported for other countries such as Brazil (Valadares and Leal, 2001), Chile (Lefort and

Walker, 1999), and Canada (Attig, Fischer and Gadhoum, 2003).

Another problem with the traditional story is that pyramids are not always the only available

method to separate cash ‡ow rights from voting rights. For example, if there are no restrictions

to the use of dual-class shares, any degree of separation is possible by the use of dual-class shares.

In such a case, why would a family choose to control a …rm through a pyramid instead of issuing

dual-class shares? Nevertheless, the evidence compiled by La Porta, Lopez-de-Silanes and Shleifer

(1999) suggests that pyramids are much more common throughout the world than the direct use

of shares with superior voting rights. Of course, in many countries there are restrictions to the use

of dual class shares. If these restrictions exist, there will be an upper bound to the deviation that

can be achieved by a combination of direct holdings and dual-class shares, and the conventional

story would predict that pyramids would appear when the desired deviation from one-share-one-

vote is above the maximum allowed by the law. Empirically, however, we do observe the use of

pyramids to separate cash ‡ows and votes below the upper bound achieved by a combination of

4However, this traditional story does not explain why shareholders agree to buy into business groups that theyknow will expropriate them (see, e.g., Bertrand, Mehta and Mullanaithan, 2002).

2

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direct holding and dual-class shares (see Bianchi, Bianco, and Enriques, 2001, and Volpin, 2002, for

Italian evidence). All this evidence suggests that considerations other than control rights motivate

the creation of pyramidal groups.

Our goal in this paper is to propose a simple theory of business groups and pyramidal ownership

that is consistent with the empirical evidence. Our theory blends elements of the value-enhancing

view with the agency view to build a positive theory that explains when pyramids should arise,

and the properties that pyramidal ownership structures should have.

We use Khanna and Palepu (1997)’s argument that managerial talent is a scarce commodity,

and thus ownership of several …rms by the same family may become a viable allocation of control

in some countries. However, it is unlikely that families are always the best possible managers for

all the …rms they end up controlling. In order to explain how families can end up controlling a

large number of …rms in countries with poor investor protection, we embed Khanna and Palepu

(1997)’s argument in a framework that builds upon Shleifer and Wolfenzon (2002)’s model of the

relationship between investor protection, equity markets and the allocation of capital. In that

model poor investor protection limits the amount of capital that talented entrepreneurs can raise

in …nancial markets. This limitation allows wealthy families to own …rms even when they are not

the best possible managers for these …rms, because they own another scarce resource - their wealth.

These considerations imply that families should own more …rms in countries with poor investor

protection, and thereby explains why business groups are more likely to arise in those countries.

This part of our model can be thought of as a simple formalization of the value-enhancing view

of business groups - they arise to substitute for missing markets, in our particular case …nancial

markets that are endogenously curtailed by poor investor protection.

However, this argument on its own cannot explain why pyramids arise. Even when families

have scarce resources that make them the constrained-e¢cient owners of a …rm, this does not mean

that the ownership structure has to be pyramidal. In fact, the family has a choice of owning the

…rm through a horizontal structure where the …rm will be controlled directly, or placing the …rm

in a pyramid where it will be controlled by the family but legally owned by another …rm that is

also controlled by the family. This simple observation underscores an important point that has

been neglected in previous literature. The questions of why business groups arise and their optimal

3

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ownership structure are two di¤erent questions.5 Clearly, a model that explains pyramidal business

groups must tackle both questions in an integrated framework.

We argue that there are three main di¤erences between the pyramidal and the horizontal struc-

ture. In the pyramidal structure, the family shares the security bene…ts (that is, the fraction of the

bene…ts that is not diverted by the family) of new projects with existing shareholders. Furthermore,

because pyramidal …rms are owned through a chain of control diversion of cash ‡ows tend to be

higher in the pyramid. However, the pyramidal structure also generates a potential bene…t for the

controlling family. Suppose the family already owns a …rm A. If …rm A has been successful in the

past, it will have accumulated a stock of retained earnings that can be used to make investments

in new …rms. Crucially, the family will not be able to use the whole cash that belongs to …rm A

(and thus to the existing shareholders) to set up a new …rm using a horizontal structure, because

the new …rm in this case would belong only to the family (and to new shareholders who make fresh

investments in the new …rm). However, the new project can be undertaken using the whole cash

when the family forms a pyramid, because in this case the new project belongs to all the existing

shareholders.

We allow the family to choose freely whether it will undertake new projects in a pyramid (with

access to the entire stock of cash but sharing the NPV with the existing shareholders), or using a

horizontal structure. Because the family must share the security bene…ts of the new project when

it uses a pyramid, it will have greater incentives to divert the cash ‡ows of the new project from

security holders to its own pockets. This e¤ect tends to create more diversion in pyramids than

in horizontal structures. Because the family internalizes the costs of diversion every time it must

issue new shares, it has an incentive to keep its ownership of cash ‡ow rights in the new project

as high as possible and minimize the issuance of new shares. This intuition might explain why we

observe high cash ‡ow stakes in …rms that are owned through pyramids.

Still, the potential for high levels of diversion in the pyramid remains. We show that pyramids

are chosen over horizontal structures only if the family expects to divert enough cash ‡ows of new

projects away from existing shareholders. E¤ectively, the new investments that are undertaken

through pyramids always become negative NPV investments for existing shareholders, in an ex-

5Again, the exception is Khanna and Palepu (1997), who say explicitly that their theory is about all types ofbusiness groups, irrespective of their ownership structures.

4

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post sense. In other words, existing shareholders would prefer that the cash stock was paid out

as a dividend, but the family may choose to use the cash to invest in new projects. Importantly,

this does not mean that the pyramidal structure is ine¢cient, because using the whole cash (and

investing through pyramids) might be the only way to undertake positive NPV investments when

the project cannot be …nanced using only part of the cash.6 Thus, the excessive diversion that

occurs in pyramids may be a “necessary evil” when the availability of cash is important enough,

and when the family has some talent to manage the project. We believe these observations help

conciliate the two seemingly disparate views of pyramids that have been proposed in the literature.

In addition, our model generates a number of more speci…c empirical implications. Some of them

are consistent with available data and anecdotal evidence, while others have not been systematically

tested. We discuss our implications in detail in section 6. For example, our theory suggests that

pyramids are more likely to arise following successful performance of the existing …rms in the group

(because of the crucial role of the stock of cash). Firms that are owned through pyramids will also

tend to be more capital intensive, and less pro…table (because these …rms are harder to …nance

as stand-alones or in horizontal structures). Finally, the model predicts that the prevalence of

pyramids will be higher when investor protection is lower. There are two reasons for this. First,

the family is more likely to own several …rms in countries with poor investor protection, because

high investor protection will decrease the comparative advantage that families have in undertaking

new projects. Second, families are more likely to choose pyramids over horizontal structures when

investor protection is lower, because pyramids are only chosen when there is enough diversion and

the costs of diversion are lower in countries with poor investor protection. In fact, we show that the

same conditions that are conducive to the appearance of business groups are also conducive to the

appearance of pyramidal structures. This result might explain why most business groups appear

to be organized as pyramids.

In the next section (section 2), we discuss the related literature on pyramids and business

groups. We introduce our model in section 3. In this section we consider a family who already

owns and controls an established …rm and can set up a new …rm. We assume that the second …rm

can only be set up by the family, e¤ectively forming a business group. In section 4 we relax this last

6Notice also that the negative NPV of ex-post investments for existing shareholders does not mean that theycannot break even ex-ante.

5

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assumption and explore the issue of when a business group is formed. Section 5 analyzes the origin

of the business group and discusses the optimality of committing to a particular organizational

structure. Section 6 discusses the empirical implications of the model, and section 7 concludes the

paper.

2 Related Literature

The term ‘business group’ is used in the literature to describe many di¤erent types of organizations.

It is used for a collection of legally independent …rms controlled by a single family, such as the

family groups in Western Europe, Latin America, and East Asia. However, the term has also

been used for organizations with a lower degree of central control achieved through interlocking

directorates, common ethnicity, school ties, etc. Example of these groups are the Japanese keiretsu

in which individual managers have a great degree of autonomy in their …rms but coordinate their

activities through the President Council and a common Main Bank (Hoshi and Kashyap, 2003).

Another example of these loose associations are the horizontal …nancial-industrial groups in Russia,

‘which are more properly industry alliances’ (Perotti and Gelfer, 2001, p. 1604). In this paper we

concentrate on family business groups.7

There is a vast economics’ literature on family business groups (see Khanna, 1999, for a survey).

The literature has suggested a number of arguments about why business groups exist, and why they

use di¤erent ownership structures. To achieve control of the various member …rms, a family can

hold shares directly in each one (‘horizontal structure’) or, alternatively, it can control some of

the …rms through a chain of ownership relations (‘pyramidal ownership’). We consider …rst the

literature on the …rst issue (why business groups exist), and then we discuss the arguments about

ownership structure in business groups. Our goal is not only to review the existing theoretical and

empirical literature, but also to point out to some important questions that we believe are not

well explained by existing theories of pyramidal business groups. We conclude this section with a

brief discussion of the relationship of our approach to other related strands of theory in corporate

…nance, especially the literature on internal capital markets.

7Khanna (1999) also argues that the degree of central control in business groups varies across countries.

6

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2.1 Why business groups?

Most theories explain the presence of business groups as an e¢cient organizational form that adds

value to member …rms. Le¤ (1978) argued that business groups arise to substitute for missing

markets (e.g. labor and …nancial markets).8 The modern reincarnation of this argument is in

Khanna and Palepu (1997, 1999), who argue that business groups provide an important substitute

for active external capital markets in developing countries. Some of the empirical evidence in

La Porta, Lopez-de-Silanes and Shleifer (1999) can be interpreted as being consistent with this

argument. Indeed, La Porta, Lopez-de-Silanes and Shleifer show that pyramids (one type of business

groups) are more common in countries with low investor protection, which are also countries with

less developed …nancial markets (La Porta et al., 1997).9

An alternative value-enhancing argument suggests that business groups add value to member

…rms because they are better positioned to lobby the governments for favors (Pagano and Volpin,

2001). These political economy theories suggest that business groups should be more prevalent

in countries where the government has a stronger role in allocating resources, or in more corrupt

countries.

There is mixed empirical evidence on the direct valuation e¤ects of group membership. Khanna

and Rivking (1999) study 15 countries, and …nd that in only 3 of them a¢liation with a business

group adds value to member …rms. They …nd, however, that a¢liation does not decrease value

in any of the cases. Khanna and Palepu (2000) analyze the performance of business groups in

India and …nd that only the members of the largest groups have valuations higher than those

of independent …rms. Member …rms of medium-sized Indian groups have valuations below their

independent counterparts. Claessens et al. (2002) …nd evidence that …rms in business groups

organized as pyramids (especially those in which the divergence between votes and cash ‡ows is

the greatest) have lower Tobin’s Q. Similar results are found by Lemmons and Lins (2003), Lins

(2003), Mitton (2002) and Joh (2001). Finally, for a sample of East Asian countries, Claessens,

Djankov, and Lang (2002) …nd that group a¢liation has on average no e¤ect on …rm valuation.

8For example, business groups might act as a risk sharing mechanism (Aoki, 1984). Khanna and Yafeh (2001)test the risk-sharing hypothesis and …nd no evidence for it.

9However, this is not necessarily evidence that business groups are more common in countries with low investorprotection, because La Porta, Lopez-de-Silanes and Shleifer (1999) measure the proportion of pyramids as a fractionof the total number of …rms in their sample, some of which could belong to non-pyramidal business groups.

7

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They …nd, however, that there are bene…ts and costs for di¤erent types of member …rms: The

oldest and slowest-growing …rms in the group bene…t at the expense of younger, fastest-growing

…rms.

In contrast to the value-enhancing view, a recent string of papers argues that business groups

exacerbate agency con‡icts and are thus detrimental to …rm value. The main argument is that when

…rms belong to a group, the scope for expropriation of minority shareholders by the controlling

shareholder might increase. Bertrand, Mehta, and Mullanaithan (2002) …nd evidence consistent

with expropriation in Indian business groups, from …rms in which the controlling shareholder holds a

small equity stake to …rms in which the controlling shareholder holds a large stake. Bae, Kang, and

Kim (2002) …nd that Korean chaebols use M&A transactions between member …rms to expropriate

shareholders of the bidder …rm and bene…t the controlling family. These …ndings raise important

questions. Why are business groups so common if they exacerbate agency con‡icts? And if business

groups do increase agency costs, why is it that they arise precisely in countries with low investor

protection, where these costs are high to start with?

2.2 Why pyramidal ownership?

Pyramidal ownership structures are very prevalent around the world, especially in countries with

low investor protection (La Porta, Lopez-de-Silanes and Shleifer, 1999, Claessens, Djankov, and

Lang, 2000, Faccio and Lang, 2002). While these empirical …ndings might appear to be consistent

with the view that groups arise to replace missing markets, they also raise a puzzling question.

One of the key di¤erences between a pyramidal structure and alternative organizational structures

such as a horizontal one is that the pyramid exacerbates the potential for agency con‡icts between

minority shareholders and the family who retains control. One example is suggested by the evidence

in Bertrand, Mehta, and Mullanaithan (2002). Since controllers have incentives to tunnel cash ‡ows

from …rms where they have low cash ‡ow stakes to …rms where they have higher stakes, pyramids

will automatically create an incentive for the controlling family to expropriate shareholders of …rms

that are at the bottom of the pyramid. But if this is the case, then why is the pyramid created

in the …rst place? Even if there is some value-enhancing reason for the …rm to be controlled by

the family, why can’t the family control the …rm directly through a horizontal structure that will

presumably reduce the incentives to steal?

8

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The conventional wisdom for the existence of pyramids gives up value-enhancing explanations

altogether. The traditional view starts from the assumption that families value control because

of the large private bene…ts associated with it. With a pyramidal structure, a family can obtain

control of a …rm with a small equity stake. Furthermore, a family might want to reduce its equity

holdings while retaining control, in order to maximize the amount of capital under its control

(Hilferding, 1910, and Berle and Means, 1932). An alternative, but similar argument is that when

private bene…ts of control are large families might elect to maintain a lock on control by separating

cash ‡ow from voting rights (Bebchuk, 1999, and Bebchuk, Kraakman, and Triantis, 2000). The

common element in these stories is that pyramids are cost-e¢cient mechanisms used by families to

retain control of voting rights. In particular, even though the literature does not explicitly make

this point, pyramids could be more e¢cient than horizontal structures because a group of …rms can

be controlled in a pyramid with a lower aggregate cash ‡ow stake.

Some authors have argued that this traditional view of pyramids can potentially explain why

pyramids are observed in countries with low investor protection, if these are also countries where

private bene…ts of control are particularly large (Bebchuk, Kraakman, and Triantis, 2000). The

evidence in Bertrand, Mehta, and Mullanaithan (2002) can also be consistent with this view of

pyramids. If they are set up to extract private bene…ts of control, the fact that there is tunneling

in pyramids is not particularly surprising.

However, there are several reasons why a more complete theory of pyramids is needed. Notice

that the traditional story revolves around the notion of control of voting rights. If pyramids are

simply a way of minimizing the monetary cost of achieving control, one should never observe cash

‡ow stakes in individual …rms that are larger than the treshold that is required to achieve control.

This treshold is at most 50%, but will in general be lower than that.10 Thus, one can only argue

that pyramids enhance family control above their cash ‡ow stake when the family’s cash ‡ow stake

in individual …rms is su¢ciently low.

A major problem for the conventional story is the substantial empirical evidence that in many

countries families do hold large cash ‡ow stakes in the …rms that they control through pyramids.

For example, Franks and Mayer (2002) …nd that in 2/3 of the …rms controlled through a pyramid,

10For example, La Porta, Lopez-de-Silanes and Shleifer (1999) use empirical control thresholds of 10% and 20%.Deviations from one-share-one-vote reduce these thresholds even further.

9

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the cash ‡ow and voting stake of the controlling shareholder does not straddle a control treshold.

That is, the controlling shareholder could have achieved the same level of control by simply holding

shares directly in the …rm (see also Emmons and Schimd 1998). Valadares and Leal (2001) conclude

that, in Brazil, pyramids are not used to deviate from one-share-one-vote. In a study of ownership

and control of Chilean …rms, Lefort and Walker (1999) …nd that the controlling shareholder owns

more cash ‡ow than necessary to achieve control. They compute the ultimate cash ‡ow ownership

of the controlling shareholder in all the members of a pyramidal group and …nd this ‘integrated’

ownership to be 57%. Thus, the separation of ownership and control achieved through pyramids

is minimal. Attig, Fischer and Gadhoum (2003) …nd that, in Canada, the cash ‡ow stake of the

controlling shareholder in a pyramid is, on average, 31.78% while the controlling stake is only a bit

higher, 41.68%.

Another problem for the traditional story is that pyramids are not always the only available

method to separate cash ‡ow rights from voting rights. For example, in the extreme case in which

there are no restrictions to the use of dual-class shares, any degree of separation is possible by a

combination of direct holding and dual-class shares. In such a case, why would a family choose

to control a …rm through a pyramid instead of issuing dual-class shares? In fact, if the issue is to

control the maximum possible number of …rms with the minimum amount of capital, why waste

valuable capital in the form of high capital investments in individual …rms instead of issuing non-

voting shares? Nevertheless, the evidence compiled by La Porta, Lopez-de-Silanes and Shleifer

(1999) suggests that pyramids are much more common throughout the world than the direct use of

shares with superior voting rights. This evidence suggests that considerations other than control

rights motivate the creation of pyramidal groups.

In many countries there are restrictions to the use of dual class shares. If these restrictions

exist, there will be an upper bound to the deviation that can be achieved by a combination of

direct holdings and dual-class shares, and the conventional story would predict that pyramids

would appear when the desired deviation from one-share-one-vote is above the maximum allowed

by the law. Empirically, however, we do observe the use of pyramids to separate cash ‡ows and

votes below the upper bound achieved by a combination of direct holding and dual-class shares.

For example, Bianchi, Bianco, and Enriques (2001) measure the ultimate ownership in each …rm

of a pyramid and compute the number of units of capital that the controlling shareholder controls

10

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with one unit of his own capital. Then they average this ratio for all the …rms in a pyramid. As a

benchmark, consider a family who holds directly 50% of the cash ‡ows and votes in a …rm. In this

case the ratio is 2. The family can increase this ratio because Italian law allows the issuance of

50% of the …rm’s capital in non-voting shares (savings shares or azioni di risparmio). If the family

uses the maximum fraction of dual class shares and retains 50% of the voting shares (i.e., 25% of

the total capital), it can achieve a ratio of 4. Bianchi, Bianco and Enriques …nd that, while some

pyramids allow the controlling shareholder to control a large amount of capital (e.g., the ratio for

the De Benedetti group is 10.33 and that for the Agnelli group is 8.86), the ratio for other groups

is below 4, and sometimes even below 2 (e.g., for the Berlusconi group, it is 3.66, and for the Pirelli

group it is only 1.95). Volpin (2002) also …nds that, although in the level 3 and above in a pyramid

the separation of ownership and control is very large (CF=6%, V=42.6%), in the second level of a

pyramid the separation (CF=22.5%, V=52.5%) is not high relative to what it could be achieved by

a combination of direct holding and dual class shares. Again, this evidence suggests that there must

other reasons for the existence of pyramids, which are not captured by the traditional argument.11

A partial explanation based on regulatory or tax considerations might help explain some of this

empirical evidence.12 Indeed, regulatory and tax considerations such as taxes on inter-company

dividends do seem to a¤ect the incidence of pyramidal structures (Morck, 2003). Other countries

impose explicit restrictions to prevent some type of …rms (e.g. banks, pension funds, etc.) from

obtaining a controlling interest in others (see Roe, 1991, for the case of the US). These are not

complete theories as the bene…t of pyramids is not spelled out. A related argument suggested in

the literature is that pyramidal structures can be used as an elusive tool to hide the identity of the

ultimate owner from either the market or the state (Bianchi, Bianco, and Enriques, 2001). Our

theory in this paper will not rely on tax and regulatory considerations, even though we believe

these to be important in the real world.

11 In addition, Claessens, Djankov and Lang (2000) and Faccio and Lang (2002) …nd that pyramids are used moreoften than dual class shares even in countries (such as Italy, Brazil and Sweden) where the restrictions on dual classshares do not always bind.12Gomes (2000) also suggests a rationale for why separation of cash ‡ow and voting rights might appear in countries

with poor investor protection in a model where reputation e¤ects are an important governance mechanism. However,and similarly to the traditional view of pyramids, his model cannot explain why pyramids appear to be more commonthan direct issuance of dual-class shares.

11

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2.3 Related theory

The argument that business groups arise as a substitute for missing …nancial markets is directly

related to the idea that internal capital markets in conglomerates mitigate the e¤ect of external

…nancing constraints on the conglomerate’s divisions. There is a vast literature in corporate …nance

which models and tests this idea (see Stein, 2001, for a survey).13 While some aspects of our theory

can be thought of as applications of these ideas to the question of pyramidal business groups, we

believe that there are also important di¤erences in the arguments. The most important di¤erence is

that the literature on internal capital markets does not focus on the question of optimal ownership

structure, which is so crucial for the analysis of pyramidal business groups. In other words, the

literature on internal capital markets considers only the question of whether a division should be

a part of a conglomerate with other divisions, or a stand-alone …rm. This corresponds to one of

the questions that we need to answer when building a model of pyramidal business groups - why

business groups arise. However, the existing literature on internal capital markets has little to say

about the second question that we analyze in this paper - why business groups are organized as

pyramids, as opposed to a horizontal structure.

This second question may seem to be more directly related to the literature on the optimal

design of organizations (see Harris and Raviv, 2002, and Stein, 2002, for recent contributions

that include surveys of this literature). One might conjecture, for example, that a horizontal

structure is a “‡atter” organizational structure than a pyramid, which looks more hierarchical.14

In this literature it might matter whether organizations are ‡atter or more hierarchical because,

for example, of frictions in the ‡ow of information among decision-makers. While we do not deny

the possibility that these considerations might have some explanatory power for the structure of

pyramidal business groups, our approach in this paper follows a very di¤erent route. In fact, we

assume that …rm productivity (gross of diversion costs) is independent of whether business groups

are organized as pyramids or horizontal structures. We believe this is a reasonable assumption,

especially when the controlling family e¤ectively controls and manages all the di¤erent …rms in

13Stein (1997), Fluck and Lynch (1999), and Inderst and Muller (2003) are a few theoretical papers that are mostclosely related to our approach.14 In particular, a pyramid might represent a hierarchy in which managers at the lower levels of the pyramid are

subordinates of managers at upper levels.

12

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pyramids and horizontal structures.15 In such a case, it is not clear whether there are any signi…cant

di¤erences in the ‡ow of information (for example) between the pyramidal and the horizontal cases.

Furthermore, because the empirical evidence indicates very strongly that new …rms are always set

up at the bottom of the pyramid, in order to explain pyramidal ownership as a hierarchy one would

require an organization theory that predicts that managers of new …rms are always subordinated

to the previous managers.

3 Pyramidal and horizontal structures

We introduce now our basic model. Consider the following set up, which has three dates. At date

0 a family (F) sets up a …rm A, keeping a fraction ® of its shares. At date 1, …rm A generates

a free cash ‡ow equal to c, and the opportunity to set up another …rm (…rm B) arises. In this

section we assume that ® and c are given, and that the family is the only possible owner of …rm

B. The latter assumption e¤ectively means that …rm B must belong to a business group that is

controlled by family F. Later we consider the e¤ect of a potential competitor that can own …rm

B, and discuss properties of the optimal contract at date 0, especially whether the family wishes

to rule out pyramids or not. We also assume that the family has all its wealth invested in …rm

A. We analyze the optimal ownership choice of …rm B, that is, whether B will be owned by the

shareholders of …rm A (the pyramidal case), or whether it will be owned directly by the family (the

horizontal structure). In both cases the family can issue new shares in B if it chooses to.

Firm B requires an investment of i and generates revenue of r at date 2. We assume that r > i,

that is, the project is positive NPV. F decides whether to set up …rm B and which structure to use

(pyramidal or horizontal). In a pyramidal structure, F sets up …rm B as a subsidiary of …rm A and

thus can use the cash c in …rm A to set up …rm B. To raise more funds, F can sell additional shares

of …rm B. In an horizontal structure, F sets up …rm B himself. He has access only to his personal

wealth of ®c: In this case, he can also sell a stake in …rm B to raise additional funds.

We assume that F always retains control of …rm B, irrespective of its cash ‡ow stake in B.

This would be the case, for example, if there was no legal limit to the deviation from one-share-

one-vote that can be achieved with dual class shares. This assumption is meant to rule out the

15La Porta, Lopez-de-Silanes and Shleifer. (1999) have direct evidence that the controlling family participatesdirectly in the management of most …rms controlled through pyramids.

13

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advantage that the conventional argument have attributed to pyramids, namely, that they allow

a larger deviation from one-share-one-vote than dual class shares and hence allow a family to

control a …rm with a smaller cash ‡ow stake. Without legal restrictions on dual-class shares, F can

control …rm B in a horizontal structure holding as little a stake as it wants. Thus, in our setting,

the conventional argument is mute as to the choice of structure. While counterfactual in some

countries, this assumption allows us to concentrate on the trade-o¤ that we want to emphasize. We

introduce legal limits to dual class shares in section ?? (to be done).

Control allows F to divert cash from …rm B into his pocket. At date 2, and regardless of the

structure, F can divert funds from …rm B at a cost. We assume that this cost depends on the

amount diverted and on the level of investor protection. In particular, when F diverts a fraction d

of the cash ‡ows he pays a cost (one can think of this as waste involved in the diversion process)

that equals a fraction kd2=2 of cash ‡ow of the …rm. Along the lines of Shleifer and Wolfenzon

(2002), we interpret the parameter k as the level of investor protection: a high cost of diversion

(high k) corresponds to good investor protection.16

The crucial trade-o¤ that we analyze is the following. In the pyramidal structure, F has more

internal cash (the entire c) to invest. However, even though the potential NPV of the project is the

same in the two structures (r ¡ i), the actual NPV that is captured by the family can be di¤erentbecause of two reasons. First, the existing shareholders of …rm A will be entitled to a share (1¡®)of the non-diverted fraction of the payo¤ (fraction 1¡ d). If there is no diversion, for example, theexisting shareholders will get (1¡ ®)(r ¡ i) out of the new project. However, in general there will16We assume that the diversion opportunities are the same regardless of the structure F uses. In a more complete

model, this assumption could be derived from the assumption that F retains control. Control confers F the right totake a number of actions not ruled out by a previous contract or the law. If F retains control regardless of structure,his set of feasible actions and hence his diversion opportunities should be the same. A di¤erent assumption, implicit indiscussion about pyramids (perhaps inspired by the structures’ ‘geometry’) is that, while in the horizontal structurediversion from …rm B goes to the F’s pocket, in the pyramidal structure the diverted must go to …rm A. First,empirically, it is not always the case that diversion goes to the …rms at the top of the pyramids. In some instances,controlling families divert resources from …rms in the pyramid to themselves (in the form of high salaries, for example).It is also the case that families divert from …rms in the pyramid to other …rms they hold that are not part of thepyramid (quote see FT on Turkey). In any case, empirical evidence on actual diversion (an equilibrium outcome) cannot shed light on the diversion opportunities, which is what our assumption is about. As an example assume thatcontrol confers F the right to sell the output of …rm B to any …rm at any price. Our assumption simply states that,since F controls …rm B regardless of the structure he chooses, he also has this right in both structures. Consider nowthe actual diversion level. Since in a pyramid the stake of F in …rm B is smaller, F will have an incentive to sell theoutput of B to …rm A at below market prices (a form of diversion). In an horizontal structure, however, the relativesize of F’s stake in …rm A and …rm B is not mechanically determined. If for example, the stakes are of roughly thesame size, F will have no incentives to price the output of …rm B either above or below the market price. Thus, thefact that we observe actual diversion from …rm B to …rm A in a pyramid but not in an horizontal structure does nottell us anything about diversion opportunities.

14

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be diversion in equilibrium, and the amount of diversion will depend on the ownership structure.

In particular, for a given direct ownership level that the family has in …rm B diversion will be

greater in the pyramid, because of the chain of control - if direct ownership in …rm B is equal to ¯,

the ultimate ownership in the pyramidal case is ®¯. Thus, diversion will tend to be greater in the

pyramid.

To sum up, the pyramidal structure increases the availability of internal funds but it may

decrease the NPV of the project and the fraction of the security bene…ts that is captured by the

family. The horizontal structure decreases …nancing capacity,17 but it also decreases diversion

(increasing the NPV net of diversion costs), and ensures that the family will capture the entire

NPV of the project.

We solve the model by working backwards.

3.1 Date 2

At date 2, F can divert from …rm B to its pocket. Assuming the “ultimate” (taking into account

the chain of control) cash ‡ow stake of F is x, then at date 2 F maximizes:

maxd2[0;1]

x(1¡ d)r + dr ¡ kd2

2r;

The FOC is: ¡x+ 1¡ kd ¸ 0 (with strict inequality only if x = 1) and so:

d(x) =

½1¡xk if k ¸ 1¡ x1 k < 1¡ x : (1)

The level of diversion decreases with ultimate ownership concentration and with the level of investor

protection. For future reference, we de…ne NPV (x) = r ¡ i¡ kd(x)2

2 r as the total value generated

by …rm B when the ultimate ownership concentration is x: Note that NPV 0(x) > 0 because higher

ownership concentration reduces diversion and consequently reduces the total cost of diversion.

17 If F could costlessly divert the cash of …rm A and use the entire c to set up his own …rm, the horizontal structurewould clearly dominate. However, at date 0, it would be impossible for F to sell any shares of …rm A as investor wouldexpect to get nothing in return. As a result all …rms would be …nanced entirely by F, with no outside shareholders.We could consider an intermediate case in which F could divert at a cost some of the cash of …rm A. In this case,however, the results would be similar to those we have, since the same trade-o¤ would appear. In a pyramidalstructure, F would have access to the entire cash c; and in an horizontal structure, F would have access to less cash(possibly, however, more than ®c due to diversion).

15

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3.2 Date 1

We next analyze the choice of ownership structure at date 1. For each structure (horizontal or

pyramidal), we calculate F’s payo¤ and also whether the structure is feasible (that is, whether F

can raise su¢cient funds to set up …rm B). We then characterize the region of the parameter space

over which each structure is chosen.

3.2.1 Horizontal

F has cash of ®c available from his ownership in …rm A. He sells 1 ¡ ¯H of …rm B to the public

and keeps a fraction ¯H (his ultimate ownership). Investors expect F to divert a fraction d(¯H) of

the cash ‡ows. The total cash available to F for investment is:

RH = ®c+ (1¡ ¯H)(1¡ d(¯H))r: (2)

There are two opposing e¤ects of increasing ¯H : On the one hand, the direct e¤ect is that fewer

shares are sold, reducing the amount collected. On the other hand, with higher ownership con-

centration, diversion is lower and as a result the price per share is higher, increasing the amount

collected. We show in the appendix that RH is concave, …rst increasing with ¯H and decreasing.

The maximum …rm size that can be …nanced in an horizontal structure is given by

RH = max¯H2[0;1]

RH =

½®c+ k

4r if k · 2®c+ (1¡ 1

k )r if k > 2:

The function RH attains its maximum when

¯H =

½1¡ k

2 if k · 20 if k > 2

:

Conditional on RH ¸ i; F’s payo¤ at the end of date 2 is given by:

UH = ®c+ r ¡ i¡ kd(¯¤H)

2

2r (3)

= ®c+NPV (¯¤H)

where ¯¤H is the optimal ownership concentration.18 F gets the entire NPV of the project and incurs

the costs associated with diversion. To minimize diversion (i.e., maximize his payo¤), he chooses

18We use an upper bar for variables associated with maximizing the amount raised, and an asterix to denotevariables associated with maximizing F’s payo¤.

16

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the highest level of ¯H that satis…es RH(¯H) ¸ i: By continuity of RH(); ¯¤H is the maximum

solution to

RH(¯¤H) = i (4)

3.2.2 Pyramidal

There is a stock of cash equal to c available in …rm A. Firm A sells ¯P of …rm B to raise more cash

and retains 1¡ ¯P : The ultimate ownership of F in …rm B is then ®¯P and so diversion is given

by d(®¯P ): The total cash available to F for investment is:

RP = c+ (1¡ ¯P )(1¡ d(®¯P ))r: (5)

As in the case of RH ; RP …rst increases and then decreases with ¯P :

The maximum amount that can be raised in a pyramidal structure is given by

RP = max¯P2[0;1]

RP =

8<:c if k < 1¡ ®

c+ (®¡1+k)24®k r if 1¡ ® · k · 1 + ®

c+ (1¡ 1k )r if k > 1 + ®

The corresponding values of ¯P that maximize RP are:

¯P =

8<:1 if k < 1¡ ®

1+®¡k2® if 1¡ ® · k · 1 + ®0 if k > 1 + ®

Finally, conditional on RP > i; F’s payo¤ is

UP = ®¯¤P (1¡ d(®¯¤P ))r + d(®¯¤P )r ¡

kd(®¯¤P )2

2r (6)

= ®c+ ® [(1¡ d(®¯¤P ))r ¡ i] +·d(®¯¤P )¡

kd(®¯¤P )2

2

¸i (7)

= ®c+NPV (®¯¤P )¡ (1¡ ®)[(1¡ d(®¯¤P ))r ¡ i]

where ¯¤P is the optimal direct ownership concentration when the pyramidal structure is chosen.

As in the case of the horizontal structure, ¯¤P is the maximum solution to:

RP (¯¤P ) = i (8)

The second line of the equation 6 follows by using the above equation.

The expression in equation 6 makes it clear what are the di¤erences in payo¤ between the

pyramid and the horizontal structures. In a pyramidal structure the family gets the NPV of the

17

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Pyramidal structure Horizontal structure

Stake Contribution Stake Contribution

Family ®¯P ®c Family ®¯P ®cNon-familyshareholders of A

(1¡ ®)¯P (1¡ ®)c (1¡ ®)¯P (1¡ ®)¯PMVNew directshareholders

1¡ ¯P (1¡ ¯P )MV New directshareholders

+ 1¡ ¯P + (1¡ ¯P )MV1¡ ®¯P (1¡ ®¯P )MV

Table 1: Types of shareholders in …rm B according to structure

project but, since …rm B is set up as a subsidiary of …rm A, F shares part of the value with the

shareholders of …rm A. Since shareholders of …rm A do not participate in the diversion proceeds,

they just get their share (1¡®) of the security bene…ts (i.e, bene…ts after expropriation) created by…rm B. Notice that these bene…ts are not necessarily positive when diversion occurs in equilibrium.

Furthermore, the NPV of the project net of diversion costs is endogenous, and depends on the

ultimate ownership stake held by the family. Of course, the family’s payo¤ in equation 6, as

well as in equation 3, are conditional on the project being taken. The choice between pyramidal

and horizontal structures will also be driven by di¤erences in the …nancing capacity in the two

structures, RH and RP .

3.2.3 Choice of structure

We …nd the optimal structure by comparing F’s payo¤ for all feasible structures. We …rst state

a number of results and then fully characterize the region of the parameter space for which each

structure is chosen.

Result 1 When the pyramid is chosen, shareholders of …rm A realize a negative return. That is,

when the pyramid is chosen the market value of …rm B (1¡d(®¯¤P ))r; is smaller than the investmenti:

The proof of this result, as well as all other proofs, is in the appendix.

The intuition behind this result lies in the shareholder distribution in a horizontal and a pyrami-

dal structure. Table 1 shows this distribution assuming that the ultimate ownership of the family in

…rm B is the same in both structures, that is, ¯H = ®¯P . This assumption makes the comparison

relevant, as it keeps the value of …rm B constant across structures.

18

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When …rm B is a pyramid, it has three types of shareholders: the family, non-family shareholders

of …rm A, and new direct shareholders. New direct shareholders hold a fraction 1¡ ¯P of …rm B

and pay a fair price for their shares, (1¡¯P )MV , where MV = (1¡ d(®¯P ))r is the market valueof …rm B. Non-family shareholders of …rm A hold a stake (1¡®)¯P of …rm B. Since F uses the cashc in …rm A to set up the …rm, these shareholders, in e¤ect, pay (1¡ ®)c for their stake. Similarly,the family holds a fraction ®¯P of …rm B and pays ®c for it.

In an horizontal structure there are only two types of shareholders in …rm B: the family and

new direct shareholders. New shareholders buy a stake of 1 ¡ ¯H = 1 ¡ ®¯P in …rm B and pay

a fair price for it, (1¡ ®¯P )MV: To allow easy comparison, table 1 decomposes the stake of newdirect investors in two stakes of (1¡ ®)¯P and 1¡ ¯P : The family retains a fraction ¯H = ®¯P of…rm B and contributes all his wealth to this …rm, i.e., ®c:

Comparing line by line in the table, it can be seen that the di¤erence between structures is

that while in horizontal structure the stake (1 ¡ ®)¯P is sold at market prices, in the pyramidalstructure, this stake is e¤ectively sold to non-family shareholders of …rm A at a price of (1¡ ®)c:

The result above can now be explained. Suppose the price paid by non-family shareholders of

…rm A is below the market price (that is, c < ¯PMV ). These will be the only cases when the

existing shareholders will end up with a positive gain in the pyramidal structure. We will show

here that in such a case, the family always chooses the horizontal structure. First, notice that the

family prefers the horizontal structure in this case because it does not need to share the positive

non-diverted NPV with non-family shareholders of …rm A. In addition, the family can also invest

more with the horizontal structure, because new shareholders will pay more for the stake (1¡®)¯Pthan do non-family shareholders of …rm A (since ¯PMV > c). Thus, every time the non-family

shareholders of A gain in the pyramidal structure, the horizontal structure is both feasible and

better for the controlling shareholder.19

Next we describe the e¤ect of the parameters in the choice of structure.

Result 2 The pyramidal structure is less likely to be optimal when

² Firm B generates high revenues

19This intuitive proof implicitly assumes that the family issues new shares in both cases. However, the result holdsmore generally even when the family does not need to issue new shares.

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² Firm B requires a small investment

² Firm A generates higher cash ‡ows

² Investor protection is good

The intuition for this result can be derived from result 1. If, when set up in a pyramid, the

market value of …rm B is above the necessary investment (that is, (1 ¡ d(®¯¤P ))r ¸ i), then our

previous result shows that the pyramidal structure will not be chosen because the family prefers

to keep the entire NPV of the project by using a horizontal structure. Now, if the revenue of …rm

B is high, the inequality 1¡ d(®¯¤P ))r ¸ i will be relaxed for two reasons. First, keeping diversionconstant higher revenues translate into higher cash ‡ows for …rm B’s shareholders. Second, when

revenues are high the family needs to sell a smaller cash ‡ow stake in …rm B. This increases

ownership concentration and reduces diversion also contributing to the increase in market value.

When the required investment in …rm B decreases, it is more likely that the market value of

…rm B is above the investment required for two reasons. The …rst is the obvious decrease in the

investment. The second is that when the investment required goes down the family needs to sell

a smaller cash ‡ow stake to raise the necessary funding. As a result, ownership concentration

increases and so does the market value.

The e¤ect of higher c on the availability of internal funds is stronger in the pyramidal case. As

a result the pyramidal structure becomes more attractive.

Finally, when investor protection increases diversion is smaller for any level of ownership con-

centration. As a result, the market value of B is higher and so it is less likely that the value is

below its investment requirements.

Figure 1 shows the regions of the parameter space over which each structure is chosen. The

pyramidal structure is chosen for low levels of r and high levels of i. When investor protection

increases (not shown in the …gure), the curve that separates the regions where horizontal and

pyramidal structures are chosen shifts down, e¤ectively reducing the area over which the pyramidal

structure is chosen.

This …gure also shows a region over which the pyramidal structure is the only feasible structure.

This region exists when the stock of cash c is high enough. Still in this range existing shareholders

of …rm A must lose when the family makes the new investment. However, the existence of such a

20

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region makes it possible that the pyramid is e¢cient for the “coalition” of the controlling family

and the minority shareholders. This happens because the full NPV of the project, net of diversion

costs, might be positive and so the total value generated by the pyramidal investment is positive.

(we haven’t proved yet that the total NPV, net of diversion costs, can really be positive in this

region but we are almost sure this will hold).

In addition to the choice of structure, our model has implications for the ultimate ownership in

each structure, when it is chosen in equilibrium. Of course, whether a structure is chosen or not

is a function of the underlying parameters of the model. Here we focus on variation in ownership

choices induced by the revenue of …rm B (r).

Result 3 Suppose there are a number of families that di¤er only with respect to the parameter

measuring …rm B’s revenue, r, and investment required. Variation in r and i leads to corresponding

variation in ownership structures, with di¤erent ownership concentrations. Ultimate ownership

concentration in any of the resulting pyramidal structures is lower than that of any of the resulting

horizontal structures.

Note that this result is stronger than simply comparing the ultimate ownership for given param-

eter values. It says that the observed ultimate ownership should be lower in a pyramidal structure.

Note also that this result is not trivial. In the pyramidal structure the chain of control mechani-

cally reduces the ultimate ownership. However, the fact that the pyramid has more funds to invest

(compared to the horizontal structure) allows for a higher direct ownership in …rm B. The above

results show that the …rst e¤ect dominates.

It should also be the case that direct ownership will be larger in the pyramid, but we haven’t

proved it yet. In both structures you need to raise i. The horizontal structure has greater …nancing

needs, and thus from this e¤ect we get that direct ownership in the horizontal structure is lower.

However, there is a countervailing e¤ect. The pyramidal needs less external money but it is worse

at raising money than the horizontal (since the chain of control reduces share prices). When c is

large, it is very likely that the direct ownership in the pyramidal is higher.

21

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4 Business groups

We have de…ned a business group as an organization in which a family owns and controls more

than one …rm. In the last section we assumed that F is the only party with the ability to set up

…rm B. This e¤ectively means that we assumed the existence of a business group. In this section

we investigate the conditions under which a business groups arises.

We modify the model by assuming that at date 1 there is an entrepreneur with the ability to set

up …rm B. The set up cost of …rm B for the entrepreneur is also i: In order to capture the possibility

that the family may not be the best owner of …rm B, we assume that the entrepreneur is a better

manager than the family, so that under his control revenues of …rm B are (1 + t)r with t > 0.20

Assume also that the entrepreneur’s wealth is zero. This assumption intends to capture the idea

that the family has higher …nancing capacity than the entrepreneur, because of the accumulation

of internal funds in existing …rms owned by the family. Recall that we also assumed that the

family’s outside wealth is equal to zero, so this assumption really means that the entrepreneur is

less wealthy than the family. We believe this to be the empirically relevant case.

We assume that the market in question only allows for one …rm, and that if the entrepreneur can

raise su¢cient funds he will be the only one to enter the market because of his higher productivity.

If he cannot raise the necessary funds, then the family sets up …rm B using any of the two structures

as described in the last section.

Result 4 Business groups are less likely when investor protection is good and when the pro…tability

of …rm B is high.

The comparative advantage of the family is that they have accumulated wealth, and thus need

to rely less on external capital markets. As investor protection improves, the comparative advantage

of the family eventually disappears and the entrepreneur is able to set up his …rm. The entrepreneur

is also better able to set up the …rm when the …rm is very pro…table, since the higher the revenues

the more the entrepreneur can raise in the external market.

Recall that in section 3 we argued that the horizontal structure is chosen when …rm B is

pro…table and when investor protection is higher. However, it is precisely in these situations that

20The case when the family is the best owner is trivial, because the family also has more …nancing capacity and sowill always own …rm B.

22

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the entrepreneur can set up the …rm. As a result, competition from an entrepreneur reduces the

region of the parameter space over which a business group uses an horizontal structure.

Result 5 Whenever they arise, business groups are more likely to use pyramidal structures than

horizontal ones.

Figure 2 shows the region of the parameter space over which the entrepreneur sets up a …rm,

and the region over which the business group is formed. As the talent t of the entrepreneur,

investor protection or the revenue r increase, the region over which the entrepreneur arises grows

and that over which the business group is formed is reduced. One can also see from the …gure that

the area that used to correspond to the horizontal structure starts to disappear …rst. Thus, the

model suggests that the conditions that are conducive to the formation of business groups are also

conducive to the formation of pyramids.

5 Ruling out pyramidal structures

Section 3 shows that whenever the pyramidal structure is chosen, the shareholders of …rm A lose.

In addition, the ultimate ownership structure in a pyramidal structure is lower than that in an

horizontal structure. This leads to higher diversion levels in a pyramid. These results are consistent

with a growing empirical literature showing signi…cant expropriation of investors in …rms that

belong to pyramidal structures. On the other hand, these results beg the question of why pyramids

are chosen in the …rst place. After all, rational investors who anticipate expropriation discount the

price of the shares they buy. Even more problematic is the fact that pyramidal structures arise in

countries with poor investor protection. It is precisely in these countries that the family would like

to reduce expropriation.

The …rst response that we have to these questions is that families do not set up all their …rms

at one point in time, but rather do it over time.21 Thus, they may face a time inconsistency

problem. Once their …rst …rm is set up and they have sold some of the shares, they will be facing

the type of incentives described in section 3. When projects with low pro…tability or high …nancing

requirements arise, they will prefer to set them up in a pyramidal structure. If their existing

…rms have accumulated enough internal funds, they will be able to …nance them. Absent a good

21This also seems to be the case in the data, as we discuss in section 6.

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commitment mechanism the family will end up using pyramids. In addition, as shown in section 3,

they will be more likely to do so in poor investor protection countries.

The family can solve the time inconsistency problem by committing not to set up a pyramid.

There is, however, a cost of doing this. In particular, as shown in …gure 1, there is a region of

the parameter space over which the only feasible way to set up the …rm is by using the pyramidal

structure (need to prove NPV can be positive in this range). Thus, committing not to use a pyramid

will raise the price of shares of …rm A, but at the expense of a reduced probability of undertaking

…rm B.

6 Empirical Implications

Our theory generates a number of empirical implications, which we list and discuss here. We also

mention empirical and anecdotal evidence that is consistent with our theory, and suggest some

additional implications that can be tested in the future.

1. Family business groups will be more prevalent in countries with poor investor

protection

This implication is a direct consequence of the “value-enhancing” part of our theory (business

groups arise to substitute for missing …nancial markets). We believe there is no systematic evidence

about this, but there is some scattered and anecdotal evidence. For example, La Porta, Lopez-de-

Silanes and Shleifer (1999) show that pyramids (though not necessarily all types of business groups)

are more prevalent in countries with poor investor protection. Claessens et al. (2002) show that in

several developing Asian countries more than 50% of the …rms in their sample are a¢liated with

business groups.

2. Business groups are more likely to be organized as pyramids

In our model, the conditions that are conducive for the choice of pyramids over horizontal

structures (such as low investor protection), are also the same conditions that make business groups

more likely. Thus when business groups tend to arise, they are likely to be organized as pyramids.

Again, there is no systematic evidence on this point. Perhaps the best evidence that groups are

organized as pyramids is the fact that researchers have treated these two terms as synonymous.

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3. It is possible to observe pyramids where the controlling family has high cash

‡ow stakes in member …rms, and thus the separation between ownership and control

is not large

In our model the controlling family has an incentive to issue as few new shares as possible when

undertaking new investments, in order to minimize diversion. This is true both when horizontal

structures or pyramids are chosen. It is also true for una¢liated …rms. However, direct ownership

in pyramidal …rms tend to be particularly high because the pyramid needs to raise the least amount

of capital.

Thus, our model is consistent with the substantial empirical evidence that in many countries

families hold large cash ‡ow stakes in the …rms that they control through pyramids (see also the

discussion in sections 1 and 2). Furthermore, it is not surprising to …nd that pyramids arise even

when families did not exhaust the possibility of issuing dual-class shares to separate ownership and

control. In our model, pyramids are not used to separate ownership and control.

4. Diversion is higher in …rms placed at the bottom levels of the pyramid, than in

…rms controlled directly by the family through horizontal structure and …rms at the

top of the pyramid

In our model, the amount of diversion is determined by ultimate ownership of cash ‡ow rights

(as opposed to direct ownership), taking into account the e¤ect of the pyramid’s chain of control.

We show that every time the pyramid is chosen the ultimate ownership of the family in new …rms

will be lower than in horizontal structures, and thus diversion is higher. Despite the fact that

pyramids replace missing markets in our model, they are associated with high levels of diversion.

This prediction is consistent with empirical …ndings that pyramids increase incentives to expropriate

(Bertrand, Mehta, and Mullanaithan 2002).

One caveat is that the comparison with stand-alone …rms is not entirely clear cut, because these

…rms need to raise more funds in order to invest, and thus may be pushed towards lower ultimate

ownership.

5. Performance will tend to be lower in …rms that are owned through pyramids,

than in una¢liated …rms or horizontal structures

Our model predicts that projects of lower pro…tability will be undertaken inside pyramids.

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Thus, even when the pyramid does not have a direct negative e¤ect on performance, one could

observe a negative relationship between measures of …rm value such as Tobin’s Q and pyramidal

membership. As we discussed in section 2, there is evidence in the literature that …rms in business

groups organized as pyramids have lower Tobin’s Q (Claessens et al., 2002). Similar results are

found by Lemmons and Lins (2003), Lins (2003), Mitton (2002) and Joh (2003). There is also

evidence that low Q predicts pyramidal membership (Attig, Fischer and Gadhoum, 2003), which

is consistent with the idea that pyramids undertake lower pro…tability projects.

However, the evidence on the relationship between pyramidal ownership and value is not unam-

biguous. Some papers …nd little evidence of a correlation between membership in business groups

and value (Claessens et al., 2002), while others …nd a positive e¤ect for some …rms (Khanna and

Palepu, 2000). Our model suggests that the di¤erence in performance between pyramids and un-

a¢liated …rms should become more negative when the divergence between votes and cash ‡ows

is greater in pyramids (the chain of control e¤ect). This prediction is consistent with …ndings in

Claessens et al. (2002).

6. Firms in pyramids are larger or they are in capital intensive industries

As the required investment increases, projects are more likely to be undertaken inside pyramids

(as opposed to horizontal structures and una¢liated …rms). Attig, Fischer and Gadhoum (2003)

…nd evidence consistent with this implication, using Canadian data. Claessens et al. (2002) also

…nd that in East Asia group …rms tend to be larger than una¢liated …rms. Bianchi, Bianco and

Enriques (2001) …nd similar evidence for Italy.

7. Pyramids are created dynamically

Our model suggests that pyramids are created as families use retained earnings from existing

…rms to invest in new ones. Thus, pyramids evolve over time, as a function of the performance of

the existing …rms in the pyramid. There is some anecdotal evidence for this. Khanna and Palepu

(2000) claim that one of the most important role of groups is to set up new …rms in which the

family and the member …rms acquire equity stakes (p. 869). Aganin and Volpin (2003) describe

the evolution of the Pesenti group in Italy, and show that this group was created by adding new

subsidiaries to the …rms the Pesenti family already owned. Claessens et al. (2002) …nd that …rms

with the highest separation of votes and ownership (those at the bottom of the pyramid) are younger

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than those with less separation (those at the top).

8. Pyramids are more likely to be created following good performance of existing

family …rms

In our model previous good performance of the existing group increases the chance that pyramids

arise, because of the crucial role of internal funds in the model. Again, there is some anecdotal

evidence for this. Aganin and Volpin (2003) suggest that, in Italy, business groups expand through

acquisitions when they are big and have signi…cant cash resources.

7 Concluding Remarks

(to be written...)

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References

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Attig, N., K. Fischer and Y. Gadhoum, 2003, On the determinants of pyramidal ownership:Evidence on expropriation of minority interests, working paper, Laval University.

Bae, K. H., J. Kang, and J. M. Kim, 2002, Tunneling or value added? Evidence from mergers byKorean business groups, Journal of Finance, 2695-2740.

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Bebchuk, L., R. Kraakman, and G. Triantis, 2000, Stock pyramids, cross-ownership, and dual classequity, in Randall K. Morck, ed.: Concentrated Corporate Ownership (University of ChicagoPress, Chicago, IL).

Berle, A. and G. Means, 1932, The modern corporation and private property, McMillan.

Bertrand, M., P. Mehta and S. Mullanaithan, 2002, Ferreting out tunneling: An application toIndian business groups, Quarterly Journal of Economics, 121-148.

Bianchi, M., M. Bianco, and L. Enriques, 2001, The separation between ownership and control inItaly, mimeo, Bank of Italy.

Claessens, S., S. Djankov, J. Fan, and L. Lang, 2002, Disentangling the incentive and entrenchmente¤ects of large shareholdings, Journal of Finance 57(6), 2741-2771.

Claessens, S., S. Djankov, and L. Lang, 2000, The separation of ownership and control in EastAsian Corporations, Journal of Financial Economics 58, 81–112.

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Emmons, W. and F. Schmid, 1998, Universal banking, control rights and corporate …nance inGermany, Federal Reserve Bank of St. Louis Review July/August, 19-42

Faccio, M., and L. Lang, 2002, The ultimate ownership of Western European Corporations, Journalof Financial Economics 65, 365-395.

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Joh, S. W., 2001, Corporate governance and pro…tability: evidence fromKorea before the economiccrisis, forthcoming, Journal of Financial Economics.

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Appendix

Proof of Result 1Suppose not, that is, the pyramid is chosen and

(1¡ d(®¯¤P ))r ¸ i: (9)

Recall that ¯¤H and ¯¤P are de…ned (see equations 4 and 8) by RH(¯¤H) = i and RP (¯

¤P ) = i; respectively. From the

last equality

RP (¯¤P ) = c+ (1¡ ¯¤P )(1¡ d(®¯¤P ))r = i (10)

¯¤P (1¡ d(®¯¤P ))r = c+ (1¡ d(®¯¤P ))r ¡ i¯¤P (1¡ d(®¯¤P ))r ¸ c

Where the second line is obtained by rearranging terms and the last line follows from equation 9. Now,

RH ¸ RH(®¯¤P ) = ®c+ (1¡ ®¯¤P )(1¡ d(®¯¤P ))r= ®c+ (1¡ ¯¤P )(1¡ d(®¯¤P ))r + (1¡ ®)¯¤P (1¡ d(®¯¤P ))r¸ ®c+ (1¡ ¯¤P )(1¡ d(®¯¤P ))r + (1¡ ®)c= RP (¯

¤P ) ¸ i

where the …rst inequality follows because RH is the maximum value of RH(¯H), the second line follows from algebraicmanipulations, the third line uses equation 10, and the last line is the de…nition of RP : Two conclusions can be drawnfrom the above. First, RH ¸ i, that is the horizontal structure is feasible. Second, since RH(®¯¤P ) ¸ i andRH(¯

¤H) = i, then it follows from the fact that RH is decreasing that ¯¤H > ®¯

¤P :

Finally,

UH(¯¤H)¡ UP (¯¤P ) = NPV (¯¤H)¡NPV (®¯¤P ) + (1¡ ®)[(1¡ d(®¯¤P ))r ¡ i] > 0:Since ¯¤H > ®¯¤P then NPV (¯¤H) > NPV (®¯¤P )and (1 ¡ d(®¯¤P ))r ¡ i > 0 by equation 9. This is a contradictionsince the horizontal structure is feasible and yields a higher payo¤ to F.¥

Proof of Result 2In the text.¥

Proof of Result 3We show the result for variation in r: The proof for i is almost identical. Suppose that r is the treshold level

such that for r ¸ r the horizontal structure is chosen and for r · r the pyramidal structure is chosen (this is shownin Result 2). We let ¯¤H(r) and ¯

¤P (r) be the direct ownership chosen when revenue of …rm B is r in the horizontal

and in the pyramidal structure, respectively. Note that when r increases so do ¯¤H(r) and ¯¤P (r) since fewer shares

need to be sold to …nance a given investment.We …rst show that ¯¤H(r) ¸ ®¯¤P (r): By de…nition of r; F is indi¤erent between the two structures, that is

UH ´ ac+NPV (¯¤H(r)) = ®c+NPV (®¯¤P (r))¡ (1¡ ®)[(1¡ d(®¯¤P (r))r ¡ i] ´ UP :By Result 1, it must that [(1¡ d(®¯¤P (r))r¡ i] · 0 which implies that NPV (¯¤H(r)) ¸ NPV (®¯¤P (r)): Since NPV ()is increasing, then ¯¤H(r) ¸ ®¯¤P (r):

Take any set of parameters values (indexed by 1) for which the horizontal structure is chosen, and a di¤erentset of parameter values (indexed by 2) for which the pyramidal structure is chosen. By Result 2, it must be thatr1 ¸ r ¸ r2: Finally, ¯¤H(r1) ¸ ¯¤H(r) ¸ ®¯¤P (r) ¸ ®¯¤P (r2);where the …rst and third inequalities follow because both¯¤H(r) and ¯

¤P (r) are increasing and the second inequality was proved above.¥

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Figure 1: Optimal structure in the (r,i) parameter space

r

i

r=iNo structure isfeasible

Horizontal not feasible

Pyramidal

Horizontal

Pyramidal not feasible

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r

i

r=iNo structure isfeasible

Business group(Pyramidal)

Business group(Horizontal)

Entrepreneur enters

No business group

Improvement in investorprotection

Figure 2: Business group formation