Business Groups in Emerging Markets: Paragons or …...2007/05/11 · Chile to about two-thirds in Indonesia. The table also indicates that, in virtually all emerging markets, group

Journal of Economic LiteratureVol. XLV (June 2007), pp. 331–372

Business Groups in Emerging Markets:Paragons or Parasites?

TARUN KHANNA AND YISHAY YAFEH∗

Diversified business groups, consisting of legally independent firms operating acrossdiverse industries, are ubiquitous in emerging markets. Groups around the worldshare certain attributes but also vary substantially in structure, ownership, and otherdimensions. This paper proposes a business group taxonomy, which is used to formu-late hypotheses and present evidence about the reasons for the formation, prevalence,and evolution of groups in different environments. In interpreting the evidence, theauthors pay particular attention to two aspects neglected in much of the literature: thecircumstances under which groups emerge and the historical evidence on some of thequestions addressed by recent studies. They argue that business groups are responsesto different economic conditions and that, from a welfare standpoint, they can some-times be “paragons” and, at other times, “parasites.” The authors conclude with anagenda for future research.

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1. Introduction

Diversified business (or corporate)groups are ubiquitous in emerging

markets (e.g., Brazil, Chile, China, India,Indonesia, South Korea, Mexico, Pakistan,Thailand, and many more) and even insome developed economies (e.g., Italy,Sweden). These groups typically consist oflegally independent firms, operating in

multiple (often unrelated) industries, whichare bound together by persistent formal(e.g., equity) and informal (e.g., family)ties. Varying degrees of participation byoutside investors characterize many busi-ness groups around the world. Table 1 sug-gests that, in all countries for which dataare available, the fraction of firms classifiedby domestic sources as group affiliated issubstantial, ranging from about a fifth in

∗ Khanna: Harvard Business School. Yafeh: HebrewUniversity, CEPR, and ECGI. We are very grateful to theEditor, Roger Gordon, to two anonymous referees, and toKee-Hong Bae, Sea-Jin Chang, Chi-Nien Chung, StijnClaessens, Arturo Condo, Mariassunta Giannetti, GustavoHerrero, Umit Izmen, Raja Kali, Eugene Kandel, Jun-Koo Kang, Bahattin Karademir, Luc Laeven, WoosungLee, Dani Maman, Ishtiaq Mahmood, Gerry McDermott,Noel Maurer, Randall Morck, Aldo Musacchio, RamanaNanda, Giovanna Nicodano, Kris Samphantharak, AndreiShleifer, Jordan Siegel, Daniel Wolfnezon, BernardYeung, and seminar participants at Hitotsubashi

University (Tokyo), Yonsei University (Seoul), the CEPREuropean Summer Symposium in Financial Markets(Gerzensee), the Bank of Israel and the CopenhagenBusiness School for many helpful comments and sugges-tions. Khanna is particularly grateful to his coauthors,Geoffrey Jones, Yasheng Huang, Jan Rivkin, and, espe-cially, Krishna Palepu for many stimulating conversations.We also thank Shai Harel, Liora Johnpoor, and HyunjeeKim for excellent research assistance. Financial supportfrom the Division of Research at Harvard Business School(Khanna) and the Krueger Center at the HebrewUniversity (Yafeh) is gratefully acknowledged.

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Chile to about two-thirds in Indonesia. Thetable also indicates that, in virtually allemerging markets, group affiliated firmstend to be relatively large and economicallyimportant.

But groups around the world vary consid-erably in form: some are extremely diversi-fied whereas others are more focused. In

some groups there is considerable verticalintegration and intragroup trade; in others,less. Some groups are deeply involved inbanking and financial services, whereas oth-ers are not. Some of this diversity is illustrat-ed in table 2, which displays partial data onthe extent of group diversification, verticalintegration, and involvement in financial

332 Journal of Economic Literature, Vol. XLV (June 2007)

TABLE 1GROUP AFFILIATION AROUND THE WORLD

Years Number Number (Median size Median Median Median Medianof of firms of group of group ROA of ROA of standard standard

data affiliated affiliated affiliated unaffiliated deviation deviationfirms firms)/ firms firms of ROA, of ROA,

(Median size (percent) (percent) group unaffiliatedof affiliated firms

unaffiliated firms (percent)firms) (percent)

Argentina 1990–97 25 11 5.5 3.9 7.8∗∗ 3.7 4.9∗∗

Brazil 1990–97 108 51 2.5 3.3 1.8∗∗ 4.1 5.1

Chile 1989–96 225 50 18.7 5.9 2.2∗ 4.4 4.1.

India 1990–97 5446 1821 4.4 11.7 9.6∗ 4.6 4.4∗

Indonesia 1993–95 236 153 2.8 7.3 7.8 1.9 2.5∗

Israel 1993–95 183 43 5.0 6.3 3.9∗ 2.1 2.6

South Korea 1991–95 427 218 3.9 4.8 5.1 1.9 2.6∗

Mexico 1988–97 55 19 2.3 8.2 6.1 3.1 2.6

Philippines 1992–97 148 37 3.4 7.3 4.0 2.5 2.9

Taiwan 1990–97 178 79 2.0 5.1 6.2 1.7 2.3∗∗

Thailand 1992–97 415 258 2.3 2.9 4.4∗ 4.3 4.9∗∗

Turkey 1988–97 40 21 1.0 24.6 26.3 6.2 9.1

Prewar Japan 1932–43 58 17 6.8 5.5 6.4 4.4 7.1

Notes: The table shows summary statistics on group risk and operating performance for twelve emerging marketsas well as for prewar Japan. Firm numbers, as well as statistics on firm size (total assets) and median return onassets (ROA), are all based on the year for which we have maximal coverage for the country in question. In pre-war Japan, group affiliation refers to affiliation in the largest three zaibatsu only. Significance levels for the com-parisons of medians are based on Wilcoxon signed-rank tests. Firms with profit rates above 100 percent or below–100 percent are excluded from the analysis. ∗ and ∗∗ denote a difference between group-affiliated and otherfirms that is significant at the 5 percent and 10 percent levels, respectively. See Khanna and Yafeh (2005) for datasources and for more information on the sample and variable definitions.


services in nine emerging markets.1 Groupsin Chile, for example, are far more diversi-fied than groups in South Korea, which, inturn, are more diversified than groups inTaiwan; groups in the Philippines are farmore vertically integrated than groups inIndia and far more involved in financial serv-ices than groups in Thailand. Moving fromstructure to ownership and control, somebusiness groups are vertically controlled(“pyramids”), whereas others are horizontallylinked through cross shareholdings. Theextent of family involvement also varies con-siderably across groups. Finally, in certaincountries, business groups are a politicallyimportant force, enjoying close relations withthe government; in others the relationsbetween groups and governments tend to bemore turbulent.

The ubiquity and diversity of businessgroups make the study of this institution fas-cinating. Conceptually, this hybrid organiza-tional form between firm and market canshed new light on the theory of the firm andits boundaries. Empirically, the ubiquity ofbusiness groups outside the United Statesand the United Kingdom makes them rele-vant to a variety of fields within economics,including industrial organization, corporatefinance, development and growth, and evenopen-economy macro to the extent that itdeals with financial crises. In addition, thecomparative study of business groups inemerging markets may shed new light onsome economic phenomena in developedeconomies. For example, although manybusiness groups are highly diversified, unlike

American conglomerates each group firm isan independent entity, and the equity stakeof outside investors can vary across groupfirms. Why are diversified entities in theUnited States organized as conglomeratesrather than business groups? Is the answerrelated to economic and financial develop-ment? Or is it perhaps due to differences inthe rule of law, social structure, or politicaleconomy? Is it due to unique historical devel-opments in the United States? The study ofbusiness groups in emerging markets couldpotentially offer some answers.

The present paper attempts to make threecontributions to the literature on businessgroups. The first is motivated by the viewthat the diversity of business groups aroundthe world is due to the diversity of theunderlying conditions leading to their for-mation. This approach is at the basis of anovel taxonomy of business groups alongthree dimensions:(1) Group structure: the extent of horizontal

diversification; the extent of vertical inte-gration; and the extent of involvement inthe financial sector.

(2) Group ownership and control: theextent to which the group is pyramidalin structure; the extent to which it isfamily controlled.

(3) Group interaction with society: thenature of the interaction between busi-ness groups and the state; the extent ofmonopoly power wielded by groups.

This taxonomy is used to derive six testablehypotheses about the reasons for the forma-tion of business groups, their prevalence indifferent economic environments, and thewelfare implications associated with theirpresence. In general, the framework inwhich economic agents form business groupsin response to the economic and institutionalenvironment within which they operate is inthe spirit of work by Masahiko Aoki (2001) orAvner Greif (2006), who emphasize thatinstitutions should be analyzed within a par-ticular economic context. Because groupsarise for different reasons and in different

333Khanna and Yafeh: Business Groups in Emerging Markets

1 Group diversification is measured by the number oftwo-digit industries in which the group operates. Verticalintegration is measured as follows: Group firms are classi-fied into two-digit ISIC industries and, for each pair offirms (x, y), we observe the fraction of inputs from x’sindustry to y’s and vice versa. We then record the highervalue for each pair and average over all pairs in the groupto obtain the group’s vertical integration index.Involvement in financial services is measured as the frac-tion of all group assets in group financial firms. See TarunKhanna and Yishay Yafeh (2005) for further details onthese measures.


environments, we argue that their impact onsocial welfare is ambiguous, even thoughmuch of the existing literature suggests thatthey are uniformly welfare-reducing: groupsmay sometimes play a positive role by makingup for underdeveloped economic institu-tions, but they can also be detrimental tosocial welfare because of rent seeking ormonopoly power. There is therefore no clearverdict on the extent to which groups shouldbe viewed as “paragons” or “parasites,” andthe answer is likely to vary across countries,groups, and possibly time periods.

The second contribution of the presentstudy is the presentation of new stylized dataand evidence on several facets of businessgroups which go beyond the existing litera-ture. In particular, we present comparabledata on the origins and emergence of busi-ness groups around the world. This is keybecause group membership should generallybe viewed as endogenous and because mostof the empirical literature on business groups

is plagued by lack of data on group origin.Another example of novel data in this paperis preliminary evidence supporting the viewthat groups do not only respond to their envi-ronment but also shape and influence it.Although econometric evidence on this pointis almost entirely absent, historical evidencein several countries is supportive of this view.This dynamic effect of groups on their eco-nomic environment is sometimes sociallywelfare-enhancing, and sometimes not.

The third contribution of the present studyis to question some of the conventional wis-dom in the literature. For example, groups,we argue, are not purely rent-seeking organ-izations as some of the literature has por-trayed them. Nor should groups be equatedwith pyramids, and pyramids are not alwaysthe, or even a, way of disenfranchisingminority shareholders.

The literature on business groups in eco-nomics and finance has focused primarily ontwo themes. The first regards business


TABLE 2GROUP HETEROGENEITY AROUND THE WORLD

Country Group Group vertical Group assets in diversification integration financial firms

Brazil 1.4 0.04 N/A

Chile 5.1 0.06 0.24

India 4.2 0.04 0.05

Indonesia 2.1 0.04 0.45

South Korea 1.7 0.04 N/A

Mexico 2.7 0.02 0.05

Philippines 3.1 0.08 0.60

Taiwan 1.6 0.02 0.01

Thailand 3.5 0.04 0.35

Notes: Group diversification is measured as the number of two-digit industries in which the group oper-ates. Group vertical integration is the average input–output coefficient across all pairs of firms within thegroup (see footnote 1), and involvement in financial services is measured as the fraction of all group assetsin group financial firms. See Khanna and Yafeh (2005) for data sources and for more information on thesample and variable definitions.


groups as diversified entities, and studies therelations between this feature and variousquestions in industrial organization and cor-porate finance. The second, more recent,research theme on business groups followsAndrei Shleifer and Robert W. Vishny’s(1997) survey on corporate governance andsubsequent work by Rafael La Porta et al.(1997, 1998). Studies in this line of researchregard business groups, especially theirpyramidal forms, as a favorite setting for thestudy of conflicts of interests between con-trolling and minority shareholders; the lat-ter’s expropriation is often referred to as“tunneling.”2 Beside diversification and tun-neling, a small number of economic studiesemphasize rent seeking and the sometimesclose relations between business groups andthe governments of the countries in whichthey operate. An even smaller number ofstudies attempt to relate groups to monopolypower and imperfect competition.

Outside economics and finance, groupshave attracted a lot of academic interest insociology, where they are viewed as networksof social, not only economic, significance(e.g., Michael L. Gerlach 1992; MarkGranovetter 2005; Gary G. Hamilton 1997;Lisa A. Keister 2004; Marco Orrù, NicoleWoolsey Biggart, and Hamilton 1997).Studies of business groups are also commonin business history, where the unit of analysisis typically the history of one group (e.g., JohnG. Roberts 1973 on the house of Mitsui;Richard M. Steers 1999 on the Hyundaigroup, and many more) or on groups in a sin-gle country (e.g., Alice H. Amsden’s 1989study of South Korea and its chaebol groupsor Gita Piramal’s 1998 study of Indian busi-ness houses). Although extensive, the litera-ture on business groups leaves manyinteresting questions unanswered.

The present papers builds on our own ear-lier surveys of business groups—a short

overview by Khanna (2000) on emerging mar-kets and by Yafeh (2003) on Japan. There arealso two complementary, concurrent surveysthat readers should consult—Granovetter(2005) reviews the economic sociology litera-ture, and Randall Morck, Daniel Wolfenzon,and Bernard Yeung (2005) discuss pyramidalgroups and corporate governance.

The rest of the paper is organized aroundthe taxonomy of business groups around theworld: section 2 focuses on dimensions relat-ed to the structure of business groups; insection 3 we examine dimensions related toownership and control; section 4 focuses ontwo dimensions of the interaction betweenbusiness groups and society; and the con-cluding section, section 5, delineates afuture research agenda. All sections containone or more hypotheses derived from thetaxonomy of business groups, which are fol-lowed by subsections presenting the existingevidence.

2. Structure and Form of Business Groups

2.1 Structure of Business Groups:Diversification

Prevailing managerial theories advocatethat companies should discover their sourceof competitive advantage and remain true toit. This “conventional wisdom” is not basedon unambiguous theoretical predictions: cor-porate diversification can be beneficial toshareholders if a firm has certain resourcesthat can be profitably deployed outside theindustry in which it operates, such as entre-preneurial skills, technology, etc. In addition,when equity markets function poorly, it maybe possible to lower risk through diversifica-tion across industries. In contrast with thesepositive arguments for diversification, thereare also theoretical foundations for the viewthat diversification can be harmful if it isdriven by managerial objectives such as“empire building” or risk aversion, or if itleads to agency problems among divisionmanagers (e.g., Raghuram Rajan, Henri


2 The term “tunneling” has become popular followingSimon Johnson, La Porta, Florencio Lopez-de-Silanes, andShleifer (2000) who trace its origins to the expropriation ofminority shareholders in the Czech Republic.


Servaes, and Luigi Zingales 2000; David S.Scharfstein and Jeremy C. Stein 2000).Empirically, the common view in the UnitedStates, that diversification “destroys share-holder value,” has been supported by evi-dence on the relative performance of firmsfocused on a small number of industries incomparison with diversified firms—whichsuggests that, in the United States, the costsassociated with diversification typicallyexceed the benefits.3

The ubiquity of diversified (and often fair-ly successful) business groups in many coun-tries outside the United States is therefore insharp contrast with the prevailing conven-tional wisdom. Why then is diversification inthe form of business groups so common inemerging markets? Leaving aside (for now)the question why the typical institutionalmechanism for diversification is conglomer-ates in the United States and businessgroups in emerging markets, the followinghypothesis offers one possible explanation:

Hypothesis 1: Diversified business groupsshould be more common in economies withless developed market institutions.

Hypothesis 1 is based on the conjecturethat corporate focus need not necessarily be agood strategy in environments less economi-cally developed than the United States, wherethe benefits of diversification may exceedthe costs. The main reason is that some ofthe institutions that make diversification

unnecessary or even harmful in developedeconomies do not exist or are underdevel-oped in poorer countries. Capital markets areincomplete and may be plagued with infor-mational and other problems, making riskreduction through diversification and the useof internal capital markets relatively efficientin comparison with poorly regulated externalmarkets. Labor markets may also lack institu-tions training skilled labor and management,making diversified business groups, wheretrained personnel can be used for a variety oftasks across many group firms, a possible sub-stitute for these institutions.4

2.1.1 Evidence on Groups and theDiversification Discount in Emerging Markets

A starting point in the discussion of thevalidity of Hypothesis 1 is the questionwhether or not a diversification discountexists in emerging markets. The generalanswer seems to be that the diversificationdiscount tends to be lower in environmentswhere markets, including, but not limited to,financial markets, are less developed, in linewith Hypothesis 1. In some cases, diversifiedentities are even traded at a premium ratherthan a discount. For example, Larry Fauver,Joel Houston, and Andy Naranjo (2003), who,following U.S. studies, rely on stock marketdata, find that the diversification discount is afeature of high income countries, with devel-oped (financial) markets and institutions. Bycontrast, in low-income countries, there is nomarket discount—and sometimes there iseven a premium—for corporate diversifica-tion. Qualitatively similar results are reportedby Stijn Claessens et al. (2003), who use bothstock market and accounting variables tomeasure the value of diversification. Theyfind a diversification premium in the relative-ly poor countries in East Asia (Indonesia, thePhilippines, or Thailand) and a diversification


3 See surveys by Cynthia A. Montgomery (1994) andJohn D. Martin and Akin Sayrak (2003). The association ofdiversification with a loss of firm value in modern U.S. datais sometimes called the “diversification discount.” This dis-count is interpreted as evidence of a causal link (corporatediversification is the cause of the reduction in shareholderwealth) in studies such as Yakov Amihud and Baruch Lev(1981); Morck, Shleifer, and Vishny (1990); Larry H. P.Lang and Rene M. Stulz (1994); Philip G. Berger and EliOfek (1995); and Robert Comment and Gregg A. Jarrell(1995). Several more recent studies have cast some doubton the causal interpretation of the diversification discount,focusing on the endogeneity of the decision to diversify andon measurement problems of both performance and diver-sification; see, for example, Jose Manuel Campa and SimiKedia (2002); Judith Chevalier (2004); Belen Villalonga(2004a) and (2004b); and Toni M. Whited (2001).

4 For earlier formulations of this hypothesis, seeKhanna and Krishna Palepu (1999a, 2000b, and 2000c).An even earlier descriptive reasoning is due to NathanielH. Leff (1976, 1978).


discount in the richer countries in the region(e.g., Hong Kong or Taiwan). Although bothFauver, Houston, and Naranjo (2003) andClaessens et al. (2003) refer to multisegmentfirms in general, not specifically to corporategroups, there is some time series evidence onbusiness groups indicating that the relativeadvantage of groups declines as market insti-tutions develop. For example, Khanna andPalepu (2000c) document the declining(stock market and accounting profitability-based) group premium over a decade associ-ated with economic reform and developmentof market institutions in Chile. KeonbeomLee, Mike Peng, and Keun Lee (2001)observe that companies affiliated with theSouth Korean business groups, the chaebol,used to be traded at a premium until the early1990s—but the premium turned into a dis-count starting around 1994 (see also StephenP. Ferris, Kenneth A. Kim, and PattanapornKitsabunnarat 2003). A number of otherstudies discussed below concur and claimthat in recent years the relative performanceof group affiliated companies in South Koreahas not been very good, although this aggre-gate statistic masks considerable variationbetween some groups which have done verywell (e.g., Samsung) and some group thathave done very poorly (e.g., Daewoo).

Table 1, where unconditional risk andreturns characteristics of diversified businessgroups around the world are displayed, sug-gests a more nuanced picture, which castssome doubt on the view that the benefits ofdiversification are higher in institutionallyunderdeveloped emerging markets. Although

firms within certain diversified groups, forexample, in Brazil, Israel, and the Philippines,outperform their non-group affiliated peers,the relative performance of firms affiliatedwith diversified groups cannot be easily relat-ed to economic development, to the often-cited differences in legal origins acrosscountries (La Porta et al. 1997, 1998) or tomeasures of financial development. Indeed,country-specific institutional characteristics,especially those associated with financial mar-kets,5 suggest that it is hard to find commoninstitutional features among the countrieswhere group firms seem to do relatively well:contract enforcement is relatively efficient inIsrael and poor in the Philippines (Brazil is inbetween). Similarly, among the countrieswhere group firms are characterized by lowrisk and low return, South Korea ranks rela-tively high in contract enforcement andArgentina relatively low.6 We conclude thatdiversified business groups are sometimesassociated with good performance of affiliatedfirms, but the relation between the costs andbenefits of diversification on the one hand,and economic and institutional developmenton the other, is probably more complex thanwhat Hypothesis 1 suggests. The ambiguity ofthe results implies that in emerging marketstoo, there are certainly cases of diversifiedgroups which destroy shareholder value inline with the evidence on the United States.7

Ignoring the ambiguity of the evidence intable 1, leaving aside sample selection issues,8

and assuming that a causal interpretation canbe assigned to the correlation between diver-sification and performance, the particular


5 See, for example, the World Bank, Doing Businessdata set, http://rru.worldbank.org/DoingBusiness, featur-ing information on the duration and cost of bankruptcyprocedures as well as on the efficiency of contractenforcement.

6 Although table 1 displays unconditional statistics,multivariate regressions generate a similarly ambiguouspicture; see Khanna and Jan W. Rivkin (2001) and Khannaand Yafeh (2005).

7 An important distinction between the literature onemerging market groups and the literature on conglomer-ate diversification in the United States is that U.S.-basedstudies typically look at the relation between the diversity

of an entire conglomerate and its performance, whereas inthe literature on emerging markets the unit of analysis istypically an individual group firm, which resembles a “lineof business” activity in U.S. data (see Khanna and Palepu2000b).

8 Comparisons of group versus nongroup firms areplagued with selection issues, the most obvious one beingthe assumption that group affiliation is exogenous, or atleast historically predetermined. Another selection prob-lem is related to the choice of groups to list some but notall companies. This makes comparisons based on listedfirms potentially biased.


reason(s) why diversification may be optimalin (at least some) environments with relative-ly underdeveloped institutions is not clear.We examine several possible explanations.

2.1.2 Evidence on Groups, Diversificationand Internal Capital Markets

Historical observations on the U.S. econo-my suggest that capital markets may be theunderdeveloped institution driving theempirical correlation between diversifica-tion and shareholder value in different envi-ronments. There is evidence suggesting thatthe “diversification discount” may have beensmaller in the United States in earlier peri-ods when financial markets (more than otherinstitutions?) were less developed.9 Thismight suggest that, in such an environment,raising capital in an internal capital marketof a diversified entity might have been moreefficient than communicating with externalpotential providers of capital, primarilybecause of information problems.

But are internal capital markets the mainreason why diversified business groups areformed in underdeveloped countries? And ifso, are information problems in financial mar-kets the crucial factor? Direct evidence onthese questions is scarce. A series of studieson business groups in South Korea is indirect-ly supportive of the underdeveloped financialmarkets version of Hypothesis 1: Sea-JinChang and Unghwan Choi (1988), one of the

earliest studies of diversified groups in SouthKorea, find that group-affiliated firms weremore profitable than other South Koreancompanies in the 1980s, but several morerecent studies on the South Korean chaebolreport relatively poor performance of group-affiliated companies in the 1990s (althoughsome groups have continued to do very well).One interpretation of this pattern is that, asthe South Korean economy became moremature and financial markets more liberalizedin the 1990s, the advantage of business groupsin accessing capital was gradually eroded.Nevertheless, other explanations for this pat-tern, not related to underdeveloped institu-tions (capital or other) are certainly possible:For example, South Korea faced a severe cri-sis in 1997–98, for which some observersblamed business groups. In the aftermath ofthe crisis, the government’s approach towardthe big business groups underwent deepchanges, and this may have affected the abili-ty of group-affiliated firms to generate profits.In addition, the fact that the founding gener-ation of owners-managers had to turn over thekeys to the second generation, typically withinthe family, may also have had adverse effects.It is very difficult to disentangle the impact ofthese different forces; the focus on one eco-nomic force or another in the existing litera-ture seems to be somewhat arbitrary.10

More evidence on the conjecture that theperformance of diversified business groups is


9 J. Bradford De Long (1991), for example, argues thatfirms that were part of the J. P. Morgan group (hadMorgan men on their boards) were traded at a premiumin the early decades of the twentieth century (althoughcausality is hard to infer from this). Moving to the 1960s,John G. Matsusaka (1993) and Robert Glenn Hubbardand Darius Palia (1999) report that acquisitions of compa-nies in industries unrelated to the bidder’s core industrywere not penalized by U.S. financial markets at that time.Furthermore, Hubbard and Palia (1999) emphasize thatthe returns to bidders tended to be especially high whenthe acquired target firms were financially constrained.

10 Chang and Choi (1988) interpret their finding ofsuperior performance of group firms as evidence that thegroup structure enhances efficiency through effectivemanagement and lower transaction costs, not necessarilyin financial markets. They do not test this hypothesisagainst other possible explanations that may have made thebiggest and most diversified South Korean groups relatively

profitable in the 1980s. Among the studies documentingthe poor performance of members of South Korea’s busi-ness groups in the 1990s, Terry L. Campbell and Phyllis Y.Keys (2002) report lower profits (but higher sales growth)for group-affiliated firms and relate this finding to inade-quate corporate governance: executive turnover, theyargue, is not closely related to performance. Ferris, Kim,and Kitsabunnarat (2003), who use stock market data, findthat chaebol-affiliated firms currently trade at a discountand suggest that this may be due to low profits, overin-vestment, or inefficient cross-subsidization within thegroups. Similar arguments on overinvestment, typicallyfinanced by (often state-subsidized) debt, are made byDong Gull Lee and Lee (2002) and by Jeong-Pyo Choi andThomas G. Cowing (1999). Other studies, such as KeunLee, Keunkwan Ryu, and Jung Mo Yoon (2000), attributethe poor performance of chaebol firms to low productiveefficiency, presumably also due to overexpansion.


related to internal capital markets (and imper-fections in external capital markets) can befound in studies estimating investment-cashflow sensitivities for group and non-groupfirms (in the spirit of Steven M. Fazzari,Hubbard and Bruce C. Petersen 1988; TakeoHoshi, Anil Kashyap, and Scharfstein 1991;and Hyun-Han Shin and Stulz 1998). Shinand Young S. Park (1999) apply this method-ology to South Korean business groups, andEnrico C. Perotti and Stanislav Gelfer (2001)to Russian financial–industrial groups (FIG),and find that individual group firms are notvery sensitive to their own cash flows whenmaking investment decisions; they are, how-ever, sensitive to the cash flows of the rest ofthe group suggesting the existence of aninternal capital market which transfersresources across firms. The welfare implica-tions of this internal capital market are, how-ever, ambiguous: on the positive side, a groupcan include a main bank (or a cash cow) andprovide funding to affiliated firms too small oropaque to have easy access to outside finan-cial markets. This should be particularly valu-able when the protection of creditors andaccounting standards are weak, so that arms-length lending will be limited. The very limit-ed evidence in the literature is insufficient toevaluate this conjecture: Shin and Park (1999)argue that internal capital markets within theSouth Korean chaebol are actually inefficient(supporting too much investment by groupfirms with weak investment opportunities),whereas Perotti and Gelfer (2001) do not takea stand on the efficiency of such transfers inRussia. Overall, these studies provide mixedevidence on the validity of Hypothesis 1.11

Another approach to evaluate whetherdiversified groups emerge in response to cap-ital market imperfections is that of Khannaand Yafeh (2005), who test the extent towhich diversified groups make up for under-developed financial markets by providing

mutual insurance or risk sharing amonggroup firms. They find that risk sharing is acharacteristic of business groups only in asmall number of emerging markets, mostnotably South Korea, and to a lesser extentThailand and Taiwan. They do not find aclear relation between the extent of groupdiversification and the prevalence of within-group risk sharing, and neither do they findany evidence that risk sharing is more com-mon where external financial markets areless developed. This study is therefore incon-sistent with Hypothesis 1 with respect to theprovision of insurance in environmentswhere the availability of state-contingentclaims is very limited.12

2.1.3 Evidence on Group Diversification forReasons Unrelated to Capital Markets

There is some evidence supporting a ver-sion of Hypothesis 1 in which diversificationis beneficial in emerging markets for rea-sons unrelated to financial markets.Imperfections in labor markets (both forskilled employees and for executives), limit-ed enforcement of contracts, inadequaterule of law and other institutional deficien-cies may give rise to business groups thatgenerate these public goods for the benefitof group members. In line with this argu-ment, Hyundai, for example, established atraining center for technical personnel to beused by the entire group, as well as anapplied research institute.13


11 See also Krislert Samphantharak (2003) who uses adifferent methodology to discuss internal capital marketsin Thai business groups.

12 Khanna and Yafeh (2005) document also somedegree of risk sharing in India through within-grouptransfers. For more on risk sharing in Indian businessgroups, see Radhakrishnan Gopalan, Vikram K. Nanda,and Amit Seru (forthcoming) who discuss group assis-tance to firms in distress, and Vijaya B. Marisetty andMarti G. Subrahmanyam (2006) who discuss the survivalprobability of group firms after going public.

13 See also Khanna and Palepu (1997) on the Tatagroup in India, and Chang (2003a) on human resourcemanagement in South Korean business groups. Greif andEugene Kandel (1995) discuss the underdevelopment ofcontract enforcement institutions in Russia in the early1990s, which may have precipitated the emergence offinancial–industrial groups.


Diversified groups may be efficient if theymake up for missing institutions related tothe process of entrepreneurship: new ven-tures initiated by business groups rely notonly on capital infusion from the group, butoften also on the group brand name andimplicitly on its reputation, providing a guar-antee that is scarce in emerging markets(Noel Maurer and Tridib Sharma 2001).There is also an internal (within-group) mar-ket for talent. In this sense, some businessgroups are perhaps closer to private equityfirms than to conglomerates. Geoffrey Jones(2000) makes this point in relation to Britishtrading houses in the early twentieth centu-ry: one of the primary functions of theseearly groups (which, like many venture capi-tal funds today, were often organized as part-nerships) was “identifying opportunities andplacing potential British investors in touchwith them” (pp. 50–51). It may be possibleto argue that, in India today, Tata Industriescomes close to this view of a business groupas a quasi-venture capitalist, albeit withlonger investment horizons than typicalAmerican private equity funds (Khanna andPalepu 2005). Another Indian group, Birla,helped found and finance new firms, whichwere later spun-off using the entrepreneur-ial talent of its employees. The process of“spawning” new companies by establishedbusiness groups may potentially be impor-tant in emerging markets where it is proba-bly difficult to start de novo.14

Khanna and Palepu (1999a) use surveydata to in order to try and identify sources ofbenefits from affiliation with a diversifiedgroup. Their analysis, which is based onintragroup confidential information, indi-cates that in both Chile and India groupactivity increased during periods followingextensive liberalization and pro-marketreforms, and in a way which apparently

enhanced profitability. Their survey evi-dence suggests that this was primarily due togroup advantages in product and labor(rather than capital) markets.

At present, the precise identification ofthe sources of group advantage remains anempirical challenge. Studies such as Khannaand Palepu (2000b) and (2000c), who findthat in India and in Chile the relationbetween diversification and profitabilityamong business groups is nonlinear (beyonda certain level diversification is associatedwith higher profits), can be interpreted inmany ways. One way forward is perhaps toexploit variations in the nature of marketimperfections across different countries.This is difficult if types of market imperfec-tions are positively correlated (e.g., wherecapital markets are underdeveloped, labormarkets may also be so), but some interest-ing examples can nevertheless be found. Forexample, diversification in Chile, wherefinancial markets are fairly developed andthe rule of law is relatively good, is unlikelyto be due to the same mix of reasons that ledto the emergence of diversified groups inSuharto’s Indonesia. Another related possi-bility is to try and disentangle various rea-sons for the existence of diversified groupsby looking at changes in their activities andscope in response to shocks (PankajGhemawat and Khanna 1998). For example,a business group whose primary function isto form an internal capital market is likely toshrink or disappear in response to financialmarket development, whereas other groupswould not. Not much research has been car-ried out along these lines.15

Despite the ambiguity of the results in thissection, our impression is that there is sometentative evidence suggesting that, at leastunder some circumstances, groups can make


14 See Paul Gompers, Josh Lerner, and Scharfstein(2005) for a discussion of entrepreneurial spawning in theUnited States. In this context, diversification may be theresult of within-group entrepreneurial activities ratherthan their cause.

15 Chi-nien Chung and Ishtiaq Mahmood (2006), forexample, document a trend of increasing diversificationover the last three decades in Taiwanese business groups,which coincided with a period of deregulation. They donot provide a full explanation for this trend, and suggestthat tax considerations may be involved.


up for underdeveloped institutions in bothcapital and labor markets (Khanna andPalepu 1997; Khanna 2000). Although it isdifficult to draw firm conclusions from this,one possible implication might be that theprofit maximizing level of diversification(and perhaps also the level of diversificationwhich maximizes social welfare) may behigher for companies (or groups) operatingin emerging markets than it is for Americanfirms. It is not clear, however, why the busi-ness group form (rather than a fully ownedconglomerate) is the most popular way toattain this level of diversification in manyless developed economies. One possibility isthat, from the point of view of controllingshareholders, the group structure is prefer-able, and only a unique historical event pre-vents the existence of business groups in theUnited States as well—diversified Americangroups were common through the mid-1930suntil tax policies introduced by PresidentRoosevelt induced either the integration ofgroups into conglomerates or the spin off ofcontrolled subsidiaries (Morck 2005; wereturn to this historical episode below). Apossible rationale for the superiority and pre-dominance of the group form in emergingmarkets is that the group structure insulatesthe controlling shareholder from institutionalinvestor pressure and takeovers, and bestowsundisputed control and economic influencewith limited capital investment. The groupform may be preferred also because of legalconsiderations, especially in relation to cor-porate liability and the ability of the control-ling shareholder to choose not to bailoutailing group firms (Giovanna Nicodano2003). By contrast, the conglomerate formmay be more appropriate than a businessgroup for the purpose of tax reducing incomesmoothing across divisions.

2.2 Structure of Business Groups: TheExtent of Vertical Integration

Limited contract enforcement, weak ruleof law, corruption, and an inefficient judicialsystem should all lead to high transaction

costs between unrelated parties. Under suchcircumstances, intragroup trade, within thecontext of long-run relationships supportedby family and other social ties, may be rela-tively cheap and efficient. This argument issummarized in the following hypothesis:

Hypothesis 2: The presence of businessgroups, the extent of their vertical integra-tion, and the volume of intragroup trade,should all be higher in environments withunderdeveloped legal and judicial institu-tions, where contracting is costly.

2.2.1 Evidence on Groups, VerticalIntegration, and Contracting Costs

Surprisingly, we are not aware of any directevidence testing this prediction—which issimilar to the Coase–Williamson argumentson the boundaries of the firm—in the contextof business group structure.16 Data on thevolume of intragroup trade are not readilyavailable, and the rudimentary data on verti-cal integration in table 2 are ambiguous(probably in part due to the dubious quality ofthe available data). On the one hand, verticalintegration among groups in the Philippinesis high, in line with the poor institutionalinfrastructure in that country. But the extentof vertical integration in relatively uncorruptChile is higher than in Indonesia, suggestingthat there may be other explanations besidescontracting costs which may account for thisvariation. One possibility is that vertical inte-gration serves primarily as a means to obtainmonopoly power or alleviate the doublemonopoly problem, rather than as a tool toovercome contracting difficulties (althoughthe existence of contracting difficulties and


16 Daron Acemoglu, Johnson, and Todd Mitton (2005),who use firm (not group) level data, argue that, control-ling for financial development and industrial structure,there is no relation between contracting costs and a verti-cal integration index across countries. A recent workingpaper by Joseph P. H. Fan et al. (2006) reports prelimi-nary evidence of more vertical integration in Chineseprovinces with weak protection of property rights in com-parison with other provinces. There is no distinction inthis study between vertical integration within a single firmand integration within a business group.


opportunities to exercise monopoly powermay be correlated). This view is corroboratedby the CEO of the Indonesian group AstraInternational who described in a privateinterview the motivation for the vertical inte-gration strategy of his group as driven by thepursuit of monopoly power rather than by theinadequacy of contracting institutions. Thefood production within the Thai CP Grouphas been considerably vertically integrated,but again, the stated purpose was not con-tracting difficulties. In addition, there seemsto be considerable variation in the extent ofvertical integration across groups within thesame country, suggesting that group andindustry-specific factors play a role which issometimes more important than country-spe-cific institutional factors.17 The more system-atic evidence on vertical integration providedby Chang (2003a) is consistent with this view:he constructs group and industry-specificmeasures of vertical integration for SouthKorea and finds it to be considerable in thelargest groups and in certain industries (e.g.,automobiles). He argues that vertical integra-tion may have been an efficient strategy in thepast (in line with Hypothesis 2), but itinvolves considerable difficulties today.18

2.3 Structure of Business Groups:Involvement in the Financial Sector

Group involvement in banking, insuranceand other aspects of the financial systemmay be related to transaction costs consider-ations similar to those driving vertical inte-gration. A variation of Hypothesis 2 mayapply to this context as well: contractingcosts, institutional quality, and financial

development should explain business groupinvolvement in financial services, in additionto country-specific government regulations.

2.3.1 Evidence on Group Involvement inFinancial Services

Historically, British multinational businessgroups in the early twentieth century wereheavily involved in financial services over-seas, in line with Hypothesis 2 on high finan-cial contracting costs in these environments(Jones 2000). Chilean business groups werealso involved in finance prior to the liberal-ization and financial development of the1980s. Large Indonesian groups typically usea group-specific financial institution, a fea-ture that became more pronounced whentheir capital needs increased: AstraInternational, for example, was in process ofexpanding its automobile assembly lines in1970s when it started acquiring banks andexpanding into other financial services. InTurkey, almost all banks are group-affiliated(B. Burcin Yurtoglu 2000). The contempo-rary cross sectional evidence on groupinvolvement in financial services and finan-cial development provided in table 2 sug-gests, however, that there is considerablevariation in group involvement in financialservices even among countries where finan-cial contracting is presumably costly, perhapsbecause of regulatory differences.

Beyond the prevalence of group involve-ment in the financial sector, the fragmentaryexisting evidence on the performance ofgroup-affiliated financial institutions is, tosome extent, consistent with the view thatgroup involvement in this sector makes upfor its underdevelopment. Maurer (1999)and Maurer and Stephen Haber (2006)emphasize the positive roles of related lend-ing within Mexican business groups in theperiod 1888–1913, when contracting institu-tions were in their infancy.19 By contrast, La


17 For example, the Turkish group Eczacibasi is fully ver-tically integrated in its core pharmaceutical business, butother Turkish groups exhibit much less vertical integration.

18 Robert C. Feenstra, Deng-Shing Huang, andHamilton (2003) and Feenstra and Hamilton (2006) alsoprovide evidence showing that South Korean businessgroups, especially the very large ones, are more verticallyintegrated (and more horizontally diversified) thanTaiwanese groups. They propose a model with multiplecompetitive outcomes, rather than differences in transactioncosts, to explain these differences.

19 See also Naomi R. Lamoreaux (1994) for a positiveview of related lending by New England Banks in the lateeighteenth and early nineteenth centuries.


Porta, Lopez-de-Silanes, and GuillermoZamarripa (2003) document the negativesides of “related lending” in contemporaryMexican groups. In the early 1980s, Chileangroups were implicated in a financial crisisand the associated failure of the first wave ofprivatization in that country, allegedlybecause of related lending.20 A conceptualdifficulty in the discussion of this issue is theendogeneity of financial underdevelopment,which may actually be due to group influ-ence; this makes the relation between busi-ness group involvement in financial servicesand the development of these services com-plex. These issues are related to the recentliterature on the political economy offinance, where investor protection andfinancial system institutions are modeled asendogenous outcomes of political processes(see Morck, Wolfenzon, and Yeung 2005).

3. Ownership and Control of BusinessGroups

3.1 Pyramidal versus Other Groups

We now turn to variation in ownership andcontrol characteristics in business groupsaround the world. Perhaps the most impor-tant distinction in this category is betweenpyramidal and other organizational struc-tures. This is because of the strong link in theliterature, dating back to Adolf Berle andGardiner Means (1932, book 1, chapter 5),between pyramids and the expropriation ofminority shareholders: in pyramidal groupsthere is typically a large divergence betweenthe large shareholder’s “control rights” (whichare often very high) and “cash flow rights”which are typically much smaller (e.g.,Lucian Arye Bebchuk, Reiner Kraakman,and George G. Triantis 2000; MarcelloBianchi, Magda Bianco, and Luca Enriques2001). This, in combination with the inade-

quacy of some of the regulatory institutions inmany emerging markets, generates an envi-ronment in which “tunneling” (the expropria-tion of minority shareholders) can become acommon feature of the economy:

Hypothesis 3: (a) Pyramidal groupsshould be particularly common in countrieswith poor investor protection and inade-quate rule of law. (b) These countries shouldhave under-developed equity marketsbecause investors will demand a discountwhen buying shares of companies affiliatedwith a pyramidal group.21

3.1.1 Evidence on Pyramids, Tunneling, andFinancial Development

The literature on pyramidal groups andconflicts of interest between majority andminority shareholders is discussed in greatdetail in Morck, Wolfenzon, and Yeung(2005). Their reading of the evidence is con-sistent with Hypothesis 3: family-controlledpyramidal business groups in countries whereminority shareholders are not well protectedare associated with the expropriation of smallshareholders, and this adversely affects finan-cial development.22 In line with Hypothesis3, tunneling has become the main focus ofmuch of the recent literature on businessgroups: table 3, which summarizes many ofthe existing studies on groups in South Korea,illustrates how the initial research interest ingroups as diversified entities has been nearlycompletely replaced by studies of conflictsbetween majority and minority shareholders.In what follows we raise a number of concep-tual issues related to the literature onpyramidal groups and tunneling.

First, how many of the business groupsaround the world are actually vertically-controlled pyramids and where are they locat-ed? Despite the centrality of this question,


20 See also Chang (2003a), chapter 5, on related lend-ing in South Korea, and Robert Cull, Haber, and MasamiImai (2006) for a discussion of conditions under whichrelated lending has positive effects.

21 Hypothesis 3 focuses on equity finance; this logicseems somewhat less applicable to debt finance, which isdiscussed below.

22 See also Heitor Almeida and Wolfenzon (forthcoming)for a theoretical discussion of these issues.



TABLE 3STUDIES ON BUSINESS GROUPS IN SOUTH KOREA

Study

Chang and Choi(1988)

Shin and Park(1999)

Choi and Cowing(1999)

Chang and Hong(2000)

Bae, Kang, andKim (2002)

Campbell andKeys (2002)

Chang and Hong(2002)

Main Argument, Sample Size,Sample Period

Business groups with multidivisionalstructure show superior economicperformance because of reducedtransaction costs. 63 group affiliatedand 119 independent firms, 1975–84.

Internal capital markets in the chae-bol alleviate financing constraints,but are associated with inefficientallocation of funds. 123 group affiliat-ed firms and 194 independent firms,1994–95.

Group firms exhibited relatively lowprofit rates before 1989; firms affili-ated with the largest groups appearto have somewhat higher growthrates and lower variation in profitrates compared with unaffiliatedfirms. 91 group affiliated firms and161 independent firms, 1985–93.

Group firms benefit from groupmembership through sharing intangi-ble and financial resources with othermember firms. Various forms ofinternal business transactions, such asdebt guarantees, equity investmentsand internal trade are extensivelyused for the purpose of cross-subsi-dization. 1,248 companies, associatedwith 317 business groups, 1996.

When a chaebol-affiliated firm makesan acquisition its stock price typicallyfalls. Minority shareholders of theacquiring firm lose, but controllingshareholders benefit because theacquisition enhances the value ofother firms in the group. Consistentwith tunneling. 107 mergers, 87firms, 1981–97.

Corporate governance problemsamong the top chaebol may haveexacerbated the recent financial cri-sis. 356 firms, 1993–99.

Business groups play an importantrole in developing countries by cir-cumventing market inefficiencies;these effects tend to be smaller inlarge business groups, and todecrease over time. 1,666 companiesaffiliated with 368 business groups,1985–96.

Category

Groups as diversifiedentities




Corporate governance/pyramids/tunneling

Corporate governance/pyramidstunneling


ListedFirmsOnly?

Yes

Yes

Yes

Listed orstatutorilyauditedcompanies

Listed onthe KSE

Listed onthe KSE

Listed orstatutorilyauditedcompanies

Groups asPyramids?

No reference

No reference

No reference

No reference

Assumed

No reference

No reference

InformationaboutFamilies?

No specificinformation



Reference toSamsung andHyundai



Samsungmentioned

(continued)



TABLE 3 (continued)

Study

Chang (2003b)

Ferris, Kim, andKitsabunnarat(2003)

Joh (2003)

Kim and Lee(2003)

Baek, Kang, andPark (2004)

Lim and Kim(2005)

Main Argument, Sample Size,Sample Period

Simultaneous nature of relationshipbetween ownership structure andperformance in a sample of groupaffiliated public firms. Performancedetermines ownership structure butnot vice versa: controlling share-holders use insider information toincrease their direct and indirectequity stakes in more profitablefirms and transfer profits to otheraffiliates through intragroup trade.419 chaebol-affiliates, 1986–96

Chaebol-affiliated firms suffer lossof value relative to nonaffiliatedfirms. This may be due to: (1) pur-suit of profit stability rather thanprofit maximization; (2) overinvest-ment in low performing industries;(3) cross-subsidization of weakermembers of their group. 759 chae-bol firm-year observations and1,316 independent firm-year obser-vations, 1990–95.

Tunneling by controlling sharehold-ers when their cash flow rights arelow. 5,829 firms, 1993-1997.

Performance during crisis is relatedto agency problems. 590 firms, May1997–August 1998.

Change in firm value during crisisis a function of firm-level differ-ences in corporate governancemeasures. 644 firms, November1997–December 1998.

Highly leveraged groups with ahigh proportion of nonmanufactur-ing business tend to have directownership. Larger groups with ahigh proportion of nonvoting sharestend to have pyramidal structure.Groups with focused business linestend to have larger family stakes.669 firms, 1995.

Category

Corporate governance/pyramids/tunneling


Corporategovernance/pyramids/tunneling



Groups as diversifiedentities + corporategovernance/pyramids/tunneling

Yes

ListedFirmsOnly?

Yes

Listed orotherwise“registered”Companies

Listed onthe KSE

Listed onthe KSE

Listed andunlisted

Groups asPyramids?

Significantreference tothis issue

No reference

Reference tothis issue


Reference inthe model


Info. aboutFamilies?

Quite a bit ofreference tothe familyissue

Reference tothis issue; nospecificinformation


General ref-erence

Control byfamily mem-bers amongother vars.

Reference tothis issue; nospecificinformation

Notes: This table summarizes many of the English language journal articles on the South Korean chaebol. The litera-ture exhibits a pronounced shift in recent years from a positive (or at least mixed) view of groups as diversified enti-ties to a clear impression that groups are undesirable. The table also illustrates some strong trends in theeconomics–finance profession, as reflected in the recent focus on tunneling and conflicts between controlling andminority shareholders. Features of corporate groups which were praised in some of the early studies when SouthKorea was doing well (e.g., centralized control) have been reinterpreted more recently as potential weaknesses, whichare detrimental to small shareholders. Finally, the table demonstrates the tendency to focus on listed or quasi-listed(audited) firms (because of data constraints), the limited use of information on group structure and on familial andother possible intragroup contracts, and the absence of a dynamic perspective.


the answer is less clear-cut than it should be.La Porta, Lopez-de-Silanes, and Shleifer(1999), who do not focus specifically on busi-ness groups, find that widely held firms arerare outside the United States and theUnited Kingdom. By contrast, concentratedfamily ownership, often exercised throughpyramids and other mechanisms that enablecontrol in excess of cash flow rights are quitecommon around the world. This view is sup-ported by Fabrizio Barca and Marco Becht’s(2001) description of ownership and controlof European firms (see also Mara Faccio andLang 2002), and by the evidence inClaessens, Simeon Djankov, and Lang(2000) and Claessens et al. (2002) on theownership and control of Asian firms. Buteven within this general framework, thereseems to be considerable cross-sectionalvariation. Khanna and Catherine Thomas(2004) study business groups in Chile,where, they argue, pyramidal equity tiescharacterize less than half of all group firms.According to Roberto Barontini andLorenzo Caprio (2005), unlike Claessens etal.’s (2002) description of Asian firms, awedge between cash flow and control rightsin family-dominated firms in ContinentalEurope is far more commonly associatedwith dual shares than with pyramidal struc-tures. By contrast, Chang (2003a) arguesthat in South Korea pyramidal structures arecommon, Piruna Polsiri and YupanaWiwattanakantang (2006) estimate (withoutproviding precise data) that about half of thebusiness groups in Thailand are pyramidal,and Yurtoglu (2000) discusses the preva-lence of pyramids in Turkey. Some pyrami-dal groups can also be found in othercountries such as Indonesia, Malaysia andMexico. Part of the difficulty in mappingpyramidal groups stems from the fact thatbusiness group structures are often morecomplex than textbook pyramids, making adichotomous classification of groups intopyramids and nonpyramids difficult. TheSamsung group, for example, involves bothvertical pyramidal control and horizontal

cross shareholding, making the decisionwhether or not it should be considered apyramid difficult (Chul-Kyu Kang 1997).

Second, in much of the literature, the linkbetween pyramidal groups and the expropria-tion of minority shareholders is an unques-tioned axiom. This is unwarranted: theempirical evidence on the prevalence andseverity of profit tunneling from minorityshareholders within pyramidal groups is farfrom clear-cut, although there is certainlyanecdotal evidence on incidents of tunnelingin Europe (Johnson, La Porta, Lopez-de-Silanes, and Shleifer 2000), and more system-atic evidence from pyramidal Indian businessgroups (Marianne Bertrand, Paras Mehta, andSendhil Mullainathan 2002) and SouthKorean business groups (Kee-Hong Bae, Jun-Koo Kang, and Jin-Mo Kim 2002; Sung WookJoh 2003; Jae-Seung Baek, Kang, and InmooLee 2006). But even these convincing studiesof tunneling raise a number of unansweredquestions. For example, Bertrand, Mehta, andMullainathan (2002) find that Indian firmslocated lower within pyramidal groups are lesssensitive to industry-specific shocks to theirprofitability than are firms located in upperlevels. They interpret this result as evidencethat positive shocks to firms in lower levels ofthe pyramid are siphoned off to firms in upperlevels of the group pyramid, an activity whichserves the interests of controlling sharehold-ers, but not of minority shareholders holdingan equity stake in the tunneled firms only.This interpretation is plausible for positiveshocks (additional profits are taken away bythe controlling shareholders), but it is less self-evident why tunneling would make firmslocated in low levels of the group pyramid lesssensitive to negative shocks.

Bae, Kang, and Kim (2002) examine acqui-sitions of often ailing companies by othergroup firms within the South Korean chaebolgroups and find that within-group takeoversrarely raise the value of the bidder, but doraise the value of other group members.They also provide some examples (from theLG group, for instance) showing how such



takeovers benefited controlling shareholdersat the expense of minority shareholders. Veryclosely related methodologically is a study byBaek, Kang, and Lee (2006) whose focus ison private securities offerings within SouthKorean groups, rather than on takeovers.They find that some of these securities areoffered to other group members at pricesthat are very far off from their true values,and document negative stock price responsesto such deals. But the tunneling interpreta-tion favored in these studies is not the onlypossible one; some intragroup takeovers andsecurities placements may also constituteefficient mutual insurance or risk sharing, asKhanna and Yafeh (2005) document forSouth Korea. Furthermore, An Buysschaert,Marc Deloof, and Marc Jegers (2004) reporta positive price response to within-groupequity sales in a small sample of pyramidalBelgian groups, suggesting that these trans-actions are not always interpreted as harmfulto minority shareholders.

Moving to historical evidence from theJapanese prewar zaibatsu groups, Morck andMasao Nakamura (2005) argue that thegrowth patterns of some of the Japanese pre-war zaibatsu reflected the importance attrib-uted to private benefits of control by somelarge shareholders. Julian Franks, ColinMayer, and Hideaki Miyajima (2006) disagreeand do not find much evidence of tunnelingin the major zaibatsu groups; instead, theyargue that small shareholders were happy toinvest in their shares in the stock marketdominated financial system of prewar Japan.

Another proxy used in the literature tomeasure tunneling is control premia, whichare generally higher in countries whereminority shareholder protection is poor(Tatiana Nenova 2003; Alexander Dyck andZingales 2004). Yet the relation between con-trol premia, minority shareholder rights andpyramidal business groups is less thanstraightforward. South Korea, for example, isfound to have a high control premium inboth studies, yet in certain other countrieswhere business groups are dominant (e.g.,

Indonesia) control premia are low.Furthermore, in some European countries(e.g., Austria or the Czech Republic) thevalue of controlling blocks is much higherthan in the chaebol-dominated South Koreaneconomy (see Dyck and Zingales 2004).

Beside the caveat that not all groups arepyramids and the fact that some of theempirical results on tunneling are open tomore than one interpretation, even wheregroups are pyramidal in structure, reputationand other safeguards might preclude minori-ty shareholder exploitation. Martin Holmenand Peter Högfeldt (2005), for example, dis-pute the equation of pyramids and tunnelingin present-day Sweden, where there is ade-quate investor protection. Historically, tun-neling did not seem to be a major concern forBritish investors in the early twentieth centu-ry, who were eager to invest money in multi-national trading groups with certainpyramidal characteristics; affiliation with oneof the family-controlled British merchanthouses was apparently viewed as a stamp ofcertification, rather than as a reason for fearof expropriation (Jones 2000, chapter 6).23

More recent evidence in Yan-Leung Cheung,P. Raghavendra Rau, and Aris Stouraitis(2006), who document tunneling in HongKong (often through “connected transac-tions” between related parties), suggests thattunneling is not especially common inpyramidal groups. Morton Bennedsen andKasper Meisner Nielsen (2006) provide evi-dence that in Europe dual class sharesdestroy more value than pyramids. In otherwords, not all pyramids are associated withtunneling, and tunneling is not restricted topyramidal organizations.

Finally, much of the literature pays onlyscant attention to the participation constraintsof investors in these pyramidal schemes.24


23 It is interesting to note that these pyramidal businessgroups did not operate within the United Kingdom, onlyoverseas. This may support the view that business groupsmake up for underdeveloped institutions.

24 Shleifer and Wolfenzon (2002) is a notable exception.See also Morck, David A. Stangeland, and Yeung (2000).


Why, on a routine basis, do investors continueto invest in situations where their investmentis likely to be expropriated? It is, perhaps,possible to argue that naïve investors inemerging markets invest in business groupsprone to tunneling because of inexperience orinadequate human capital; we find thisimplausible. Another possibility is that thefeasible alternatives available to investors areextremely limited, although this claim proba-bly did not apply historically to Britishinvestors in merchant houses. An explanationthat we find more plausible is that group rep-utation for fair treatment of minority share-holders is an important consideration (seeArmando Gomes 2000 for a related theoreti-cal model). This could be group reputationfor risk sharing (or assistance to poorly per-forming companies) which reduces thedefault risk of group-affiliated companies, afeature which investors may find attractiveeven if they know that they are exposed to acertain risk of expropriation by controllingshareholders. A more formal mechanism isproposed by Faccio, Lang, and Leslie Young(2001) who find that some groups, especiallyin Europe, are known to pay higher dividendsand thus compensate investors for the risk ofexpropriation. Finally, it is possible that atleast some part of the alleged tunneling mayin fact represent returns to some core asset,with the investing public’s participation con-straints being satisfied. This asset can be asocially productive one, such as some coreentrepreneurial ability, or a socially detrimen-tal lobbying capability (e.g., Faccio 2006). Atpresent, the literature provides very fewanswers to these questions.25

3.2 Family versus Nonfamily Groups

Another dimension related to ownershipand control in the taxonomy of businessgroups around the world has to do with roleof family considerations in the presence,evolution and performance of groups:

Hypothesis 4: (a) Family-controlledgroups are likely to be more common incountries with inadequate rule of law, wheretransactions with outsiders are costly. (b)Family considerations influence the forma-tion, structure and performance of family-controlled groups; in some cases, groupsmay continue to exist for family-related soci-etal reasons, even when they no longerenhance economic efficiency.

3.2.1 Evidence on Groups and Families

Evidence on the relation between fami-lies, the prevalence of business groups andeconomic institutions is provided by LaPorta, Lopez-de-Silanes, and Shleifer(1999) who document higher presence offamily firms (not necessarily groups) in envi-ronments where contracting is difficult.Kathy Fogel (2006), using data on thelargest business groups and individual com-panies in over forty countries, also suggeststhat family ownership is more common ineconomies with poor institutions. One read-ing of these findings is that kinship andother social ties facilitate economic transac-tions (Granovetter 2005) and, more general-ly, that business groups are networks whoseprevalence facilitate the creation of “trust,”which makes up for incomplete contracts andimperfect rule of law. Fogel (2006), by con-trast, claims that family ownership and con-trol is the cause of economic and institutionalunderdevelopment.26

In addition to these two internationalcomparisons, there are a number of studiesdocumenting the prevalence of family-controlled business groups in specific


25 Somewhat related to this discussion is the phenome-non of foreign investors who are reluctant to invest inIndian groups (Khanna and Palepu 2000a) or, more gener-ally, in firms with concentrated family ownership in emerg-ing markets with poor investor protection (Christian Leuz,Karl V. Lins, and Francis E. Warnock 2006). This could beconstrued as evidence of tunneling which is, for some rea-son, more acceptable to domestic investors than to foreign-ers (see also Susan Perkins, Morck, and Yeung 2006).However, these studies do not measure the extent to whichpyramidal structures in particular deter foreign investment.

26 Morck, Stangeland, and Yeung (2000) make a similarpoint.


countries. For Taiwan, Chung andMahmood (2006) document considerablefamily equity stakes and involvement inmanagement in 1988, followed by a rapiddecline in the 1990s, which was accompa-nied by an increase in the use of pyramids inorder to maintain family control.27 InSingapore, Lai Si Tsui-Auch (2006) suggeststhat about a third of the top business groupsare family controlled (the rest are govern-ment linked). Family equity stakes are oftenabove 50 percent, (without much changebetween 1996 and 2002), and family involve-ment in management is extremely high: innine of the top ten business groups thechairman is a family member; in all but oneof these firms, so is the CEO. In Malaysia,Edmund Terence Gomez (2006) estimatesthat thirty-five of the top fifty businessgroups in 1997 were family owned, but thenumber has declined since the East Asianfinancial crisis; as in Singapore, other largegroups are typically government linked.Claessens, Djankov, and Lang (2000) dis-cuss family firms as an important feature ofAsian companies more generally, and Jones(2000) regards historical British tradinghouses operating in Asia as well-functioningfamily-controlled groups.

Not only is the evidence on the preva-lence of family controlled groups limited,there is also very little research on theextent to which considerations affectingfamily firms influence the growth andbehavior of business groups. Some researchon this question originates from an exten-sive literature within (economic) sociology,which views business groups as a familyorganization, whose objective is tied to thesocial milieu (Orrù, Biggart, and Hamilton1997). Diversification, for example, may beinterpreted as a way to manage familyassets—firms are merely asset holders forlineage interests (Hamilton 1997), although

it is not clear from these studies why familyassets cannot be divided into independentcompanies without the group structure.There is also no clear evidence in this liter-ature—much of which is centered on EastAsia—on whether or not family orientedgroups are more prevalent in East Asia(where there is a special cultural emphasison the family) than in other regions; thereare certainly non-Asian countries withextensive family involvement in businessgroups: in Mexico, for instance, there is con-siderable family influence in all of the eightlargest groups.

Beyond pure family ties, the sociology lit-erature regards groups as network struc-tures serving primarily social and culturalpurposes, rather than seeking to achieveeconomic objectives. Granovetter (2005)uses the mixed evidence on the perform-ance of group firms to suggest that consid-erations other than economic efficiency maybe at play. The importance of noneconomicfunctions of business groups is reinforced,he argues, by the enormous variation instructure of business groups around theworld, which is likely to reflect societal, cul-tural, institutional, and other norms goingbeyond standard economics. Factors such asinheritance customs (e.g., primogeniture orother), kinship structure, and even nationalideology and pride, may all play a role inshaping corporate groups in different envi-ronments. Cultural edicts on how economicexchange should be arranged, rather than arational response to missing markets or eco-nomic institutions, may account for differ-ences in the structure of groups between,for example, South Korea and Taiwan(Hamilton and Feenstra 1997; Hamilton1997).

Moving from sociology to economics,issues raised by the literature on familyfirms (primarily in the United States) suchas succession, differences between founder-controlled firms and successor-controlledones, the importance of family control ver-sus family management, the tendency to use


27 See also Xiaowei Luo and Chung (forthcoming) onfamily and other social ties and group performance inTaiwan.


debt finance and the link between all theseand performance28 seem highly relevant forunderstanding the link between familiesand business groups. A recent workingpaper by Bertrand et al. (2004) is the first toexamine these issues systematically in thecontext of Thai business groups dominatedby ethnic Chinese families. Using elaboratedata on seventy groups, they show that thegroup structure is related to family historyand evolution, for example, to the numberof male sons of the founder or to the num-ber of brothers he had. Bertrand et al.(2004) also attempt to relate diversificationand growth to family considerations, and tolink group performance to intrafamilyfeuds.29

The relation between family considera-tions and business group structure isapparently not specific to Thailand.Piramal (1998), for example, providesanecdotes describing how intergenera-tional considerations influence the struc-ture of business groups in India.30 InIsrael, where contracting institutions andthe rule of law are considered highly devel-oped, two tycoons, controlling two of thelargest business groups, admitted recentlythat family considerations affected thenumber of companies in their groups and

the appointment of senior officers (TheMarker, August 17, 2006). Commonwealthof Australia (1995) emphasizes family-related issues as determinants of groupstructure in Indonesia, and describes fam-ily ties and inheritance customs in ethnicChinese business groups in several otherEast Asian countries. There is also consid-erable evidence on the link between fami-lies in business group structure andperformance in South Korea. Chang(2006) documents the rapidly decliningequity stakes of the founding families ofHyundai and SK, whereas in other largegroups family stakes were historicallysmaller but have remained stable. Changand Shin (2005) show that group firmswith large family stakes in South Korea donot outperform other members of thesame group, in contrast with what onewould expect if extensive tunneling tookplace on behalf of the controlling families.Euysung Kim (2006) studies the relationbetween family ownership and total factorproductivity and finds a positive relationfor group firms.31

In addition to the influence of familyconsiderations on group structure and per-formance, the tendency of many groups touse debt rather than equity finance may berelated to family ownership, reflecting adesire not to dilute control (Chang 2003adiscusses this in the context of the SouthKorean chaebol). Thus, in contrast with thepossible negative effects of business groupson equity markets, many groups are largeborrowers and important bank clients. It isnot clear, however, if this tendency is more


28 See Morck, Wolfenzon, and Yeung (2005) for furtherdiscussion of this literature.

29 See also Polsiri and Wiwattanakantang (2006) forinformation on the extensive involvement of families inthe ownership and management of business groups inThailand.

30 The decision of Williamson Magor Group toacquire Union Carbide India in 1994 was apparentlyprompted by the Khaitan family’s worry about its off-spring’s habits. “Worried that their son . . . was spendingtoo much time in their stable of three hundred horses,Shanti (Khaitan) persuaded her husband to make anoffer. . . . Deepak (Khatian) needed to settle down, andshe was convinced that a big company like UnionCarbide would be just the right ticket.” Similarly,Kasturbhai Lalbhai, a cotton textile magnate, made fourlarge investments the period 1929–35, of which threewere designed to sustain his nephews’ careers, and thefourth was to avoid disgracing the family name by bailingout an errant family member.

31 On the relation between performance of SouthKorean groups and the equity stakes of insiders or familymembers, see also Chang (2003b), Woochan Kim,Youngjae Lim, and Taeyoon Sung (2004), and Ungki Limand Chang-Soo Kim (2005). Keister (2004) comparesfamily and business group structure in South Korea andChina, and Amsden (1989) and Eun Mee Kim (1997) dis-cuss the importance of families in South Korea businessgroups more generally.


pronounced in family-controlled groupsthan in stand alone family firms.32

We regard the family-firms line of researchon groups as highly promising, both withrespect to the prevalence of family-controlledgroups in different environments, and withrespect to the interaction between familyconsiderations and group performance andefficiency. Contrasts between business groupsthat are single-family controlled and thosethat are either government controlled (inSingapore or in China) or are controlled bymultiple families (e.g., LG in South Korea forat least part of its history or some joint ven-tures between the Koc and Sabanci groups inTurkey) would be particularly interesting.

Analyzing groups from this perspective is,however, difficult for two main reasons.First, while all of the studies discussed in thissection focus on the link between familiesand firm performance, performance mightalso affect the stability of the familial contractand thereby the structure of families.Bertrand et al. (2004) take a first step inaddressing this issue when they treat thenumber of male offsprings as an endogenousoutcome. Second, in many cultures, it is notat all clear that “what one sees is what onegets” with regard to the family assets. In otherwords, the best assets of the family might notbe the publicly listed parts (Bertrand et al.2004 and Khanna and Palepu 1999a attempt

to address this issue). Furthermore, the equi-ty contracts that are visible to the publicobserver and the social scientist might not bethe most meaningful contracts in systemswhere relationship contracting predominates(Khanna and Thomas 2004).

4. Interactions Between Business Groupsand Society

4.1 Business Groups, Politics, andGovernments

This part of the taxonomy focuses on thenature of the interaction between businessgroups, governments, and politics.33

Because business groups have enjoyed closeties to their governments in many countries,it is not surprising that the political economyliterature on groups has often viewed gov-ernment-supported business groups as rentseeking “parasites.” Influential papers suchas Jagdish N. Bhagwati (1982) or Anne O.Krueger (1974), while not directly studyinggroups, have been used in support of argu-ments on rent-seeking through the powerexercised by incumbent businesses, typicallyfamily-based business groups. Indeed, theinteraction between groups and the state hasreceived much attention over the past fewdecades, to the extent that an impressionthat all groups are deeply politically involvedhas been generated:


32 On various other aspects of debt finance in businessgroups, see Bianco and Nicodano (2006) or Ronny Manos,Victor Murinde, and Christopher J. Green (2004). Notealso that leveraged business groups share some attributeswith leveraged buyout (LBO) organizations in the UnitedStates (we are grateful to George P. Baker and KrishnaPalepu for suggesting the analogy; George P. Baker andMontgomery 1994 compare LBOs with American con-glomerates). As in LBOs, each business group affiliate isorganized as a separate legal entity, with its own fiduciaryresponsibilities, its own board, and its own disclosureregime. Just like LBO associations that finance individualpurchases with heavy leverage, business groups oftenlaunch new ventures with financial support from financialintermediaries. In India, for example, a typical new ven-ture of the past few decades was launched with very littleequity capital from the entrepreneur (just as in an LBO)and a lot of (equity and) debt from domestic institutionalinvestors. There is also extensive evidence that the South

Korean chaebol were extremely heavily leveraged (MarkL. Clifford 1994; Chang 2003a), a feature that made themespecially vulnerable during the Asian crisis of 1997–98.But the parallel between business groups in emergingmarkets and American LBO organizations should not betaken too far. Debt from Indian institutional investors orfrom government-controlled financial institutions in SouthKorea would hardly have the disciplining character of debtfrom American capital markets in the heyday of LBOs.Another striking difference is that LBO organizations inthe United States were forced to liquidate their invest-ments within a defined time period. This led to an inde-pendent measure of the value of each business (in order tosell it), and to a powerful incentive structure, quite differ-ent from that prevailing in the case of a business group inan emerging market.

33 See a related discussion in Morck, Wolfenzon, andYeung (2005).


Hypothesis 5: Business groups areformed with government support, expandand diversify with government nurturing,and their performance is a function of theirrent-seeking ability and opportunities.

In general, there is substantial evidencesupporting the first part of the hypothesis—business groups in emerging markets arevery often, though not always, formed withgovernment support. But as the groupsevolve and (some of) the countries develop,the relations between groups and govern-ments become far more complex so thatthere is considerable variation in this dimen-sion across groups and countries.

4.1.1 Evidence on the Origins of Groups:The Role of Governments

In many countries, the very appearance ofthe business group phenomenon wasstrongly influenced by government policies.The Japanese prewar zaibatsu groupsemerged as a result of a government privati-zation program in the early 1880s, andexpanded and diversified their activities inresponse to government contracts awardedunder preferential terms (Eleanor M.Hadley 1970). The South Korean businessgroups, the chaebol, enjoyed close ties tothe government of General Park; the gov-ernment controlled the allocation of creditand foreign currency, and the chaebolenjoyed preferential access to these andother resources (e.g., Clifford 1994; Kim1997; Chang 2003a). The privatization poli-cies of Prime Minister Mahathir’s govern-ment in Malaysia enriched certain ethnicMalay-owned business groups dramatically(Gomez and K. S. Jomo 1999). The Salimgroup in Indonesia had family ties withPresident Suharto and expanded, as didother Indonesian groups, with the assistanceof government-granted monopolies andlicenses. Keister (1998 and 2004) describeshow the government actively encouragedthe formation of business groups in Chinaand protected them from foreign competi-tion. In Israel, family-owned groups

emerged as an outcome of certain govern-ment economic policies (Daniel Maman2002), and the rise of the “oligarchs” inRussia is yet another recent (and veryextreme) example of the emergence ofgroups under the auspices of the govern-ment (Sergei Guriev and Andrei Rachinsky2005).

Tables 4 through 7 present a comparativeperspective on the origins of business groupsaround the world. Table 4 confirms that gov-ernment support is an important factor inthe formation of business groups in manyenvironments. Nevertheless, even withincountries where groups generally enjoyedgovernment support some groups emergedwith little or no government favors (e.g.,Samsung, see table 5 on prewar Japan andtable 6 on South Korea).34 Table 7 suggeststhat the vast majority of business groupsbegan as family dominated corporations,often with close ties to the government.35

4.1.2 Evidence on the Relations betweenMature Groups and Governments

While in most countries groups emergedwith at least some degree of government sup-port, often in the context of development-oriented mercantilist policies, the relationsbetween mature groups and the state canvary considerably. In some circumstances,groups continue to enjoy close ties with theauthorities. Raymond Fisman (2001) pro-vides convincing econometric estimates ofthe value of political connections enjoyed bybusiness groups in Indonesia during theSuharto regime (see also Leuz and FelixOberholzer-Gee 2006). Gomez (2006,Appendix table 6.1) delineates the extensive


34 Nevertheless, Kang (1997) argues that Samsung’sdiversification was, at least partially, driven by an attemptto maximize rents from the government’s preferentialinterest rate policies.

35 Table 7 is based on detailed web-based and archivalresearch by Hyunjee Kim for which we are very grateful.Examples of groups that were not family controlled evenearly in their development exist in Chile (Nicolás Majlufet al. 1995) and in China (Keister 1998).



TABLE 4THE COMPARATIVE ORIGINS OF BUSINESS GROUPS: HISTORICAL COMPARISONS BY COUNTRY

Family ties have always been atthe center of groups and groupstoday are still owned and some-times run by the families that cre-ated them decades ago.

Family groups evolved, typically asa result of the success of specificfirms, especially in commodities.

Clusters of business groupsformed around ethnic, religiousand social communities, for exam-ple, the Marwaris of Rajasthanformed businesses in Bengal andelsewhere; the Gujeratis in theWest, the Chettiars in the South,etc.

Some groups benefitedfrom privatization dur-ing the Pinochet regime.

Voucher privatizationled to the creation oflarge, diversified invest-ment funds, often indi-rectly run by banks,which control linkedenterprises.

Some entrepreneurswho formed groupsbenefited from thetransfer of assets for-merly held by theBritish to Indians dur-ing the Independencemovement (de factoprivatization).

Brazil

China(since the1980s)

Chile

CostaRica

CzechRepublic

India

State-backing (general) Privatization-related Ethnic Policies and Family issues

(continued)

State protection (through tariffs andnon-tariff barriers and through target-ing of priority sectors) benefitedgroups, as did extensive state financ-ing. In the 1990s protection decreased(although there is still some statebacking in the form of technology andresearch grants and support).

Government encouraged the forma-tion of many business groups and pro-tected them from foreign competitionbecause they were regarded as essen-tial for development. However, gov-ernment sentiment waxed and waneddepending on the fortune of businessgroups in neighboring countries, par-ticularly South Korea. In addition, thePeople’s Liberation Army has histori-cally been involved in several businessventures, many of which are organ-ized as business groups.

Some groups benefited from the con-solidation policies following the crisesof 1970s and 1980s.

A limited role of the state combinedwith a historically homogeneous dis-tribution of land and coffee plants.However, government protection ofsome sectors (e.g., sugar, meat, rice)led to the growth of certain groups.

Industrial holding companiesemerged out of former Communistplanning units, sometimes with 15–30horizontally and vertically linkedplants and subsidiaries. These compa-nies were voucher-privatized andrestructured using government subsi-dies. The remaining shares werebought at discount by the new man-agement team and consortia of Czechbanks.

Favored entrepreneurs formedgroups during the License Raj of the1960s and 1970s (although othergroups date back to the early twenti-eth century). This was despite theexistence of de jure legislation thatwas anti-big business (e.g., theMonopolies and Restrictive TradePractices Act).



TABLE 4 (continued)


Suharto viewed the involvementof his children in business groupsas a way of righting the Pribumi-Chinese imbalance in the topranks of the business community(although most groups are identi-fied as ethnic-Chinese, includingthe state-supported Salim group).

Prime Minister Mahathir supportsBumiputeras (indigenous Malay)entrepreneurs in the privatizationprocesses. Some ethnic Chinesegroups operate in Malaysia andacross its borders (to diversifypolitical risks).

Family ties are crucial for busi-ness groups in Mexico. Thelargest industrial conglomerates incertain regions are still run by thefamilies who started the business-es in the mid-nineteenth century,often with very strong ties to thegovernment.

The Salim groupreceived assets seized bythe army.

Privatization—transferof some governmentassets to families andnew groups in the 1990s.

Sale of assets formerlycontrolled by theJapanese and of stateassets to some favoredgroups and entrepre-neurs.

Privatization (of colonialassets and of failed gov-ernment investments)—buyers have politicalcontacts and statepatronage.

The privatization period(mostly 1988 to 1994)benefited many businessgroups which bought thenational phone company(and was granted amonopoly for five years)and banks. Some newgroups were created fol-lowing the privatizationof the 1990s.

Indonesia(underSuharto)

Israel

Italy

SouthKorea(1960–90)

Malaysia(underMahathir)

Mexico

(continued)

Some groups run by members of theSuharto family. Others, such as theSalim group, were granted monopolyover mills. Close governmentinvolvement in business. State-spon-sored cement and other monopoliesbenefited groups.

State backing of preferred groups inthe early decades after independence.

Government credit and protection ofsome groups in early postwar years(e.g., the Pesenti family who ownedPirelli). Some government-controlledgroups as well.

Preferential credit and protectionfrom foreign competition to entrepre-neurs following government guide-lines, especially with political contactsto General Park. The government,through its control of the financialsystem, often encouraged groupdiversification, mergers and consolida-tion (acquisition of ailing firms andgroups), and investment in certainindustries.

Preferential credit to businessmenwith close ties, including members ofMahathir’s family. Political partiesexplicitly involved in business.Consolidation has often been used asa remedy to salvage distressed firms,particularly by grouping companiesunder favored Malay entrepreneurs.

Until the mid 1980s, the governmentsupported business groups by pro-tecting many sectors through tariffsand trade restrictions, as well as bygranting discretionary concessions(for example, in media, mining, andother sectors), as well direct and indi-rect subsidies to certain goods andindustries (e.g., sugar). Groups alsoenjoyed monopolies, state-inducedconsolidation and certain protectionfrom FDI. Since 1973, groups andconglomerates have enjoyed certainspecial tax incentives.



TABLE 4 (continued)


Concentration in family groups,inherited from colonial times.

Ethnic Chinese, who felt threat-ened by the government formedprivate, family controlled groups,diversifying across industries andborders to reduce risk.

During Apartheid, major groupswere associated with the whites;In the postapartheid period, theadoption of Black EconomicEmpowerment policies induced atransfer of assets from whites toblacks, and the formation of con-glomerates by select black entre-preneurs, some of whom hadpolitical contacts to the ANC.

Groups are often dominated byethnic Chinese, some of whomoperate in neighboring countriesas well.

Industry-led financial-industrial groups (FIGs)emerged early in the pri-vatization process. Bank-led FIGs emerged later,in relation to auctionsinitiated by PresidentYeltsin favoring (some)buyers; state assets soldat low prices to“Oligarchs.”

Nicaragua

Pakistan(startingaround1960)

Russia

Singapore

SouthAfrica

Taiwan

Thailand

Not much government support andencouragement; family groups formedendogenously (but benefited fromcertain tax advantages starting in the1960s).

Some groups originated in the 1940s;politicians and military officers ofteninvolved in business groups; restrictedcompetition in many sectors favorsgroups.

(continued)

The government of the Somozas(father and son) controlled directly alarge number of industries. At theend of the Sandinista governmentmany firms were bankrupt and a fewgroups acquired them, leading toconsolidation

Foreign exchange licenses given pri-marily to rich families. Combinedwith restrictions on imports.

Some (limited) government supportof industry-led FIGs which evolvedwith the collapse of Communism;much more support of the bank-ledFIGs which enjoy (enjoyed?) politicalclout, lobbying power for variousprivileges (e.g., restrictions on for-eign investors), and influence themedia.

Government-linked business groupsestablished in the 1960s and 1970s inorder to make economic investmentsjointly with private investors.


and close ties between business groups andthe government in Malaysia (see alsoJohnson and Mitton 2003). In India, somebusiness groups were able to receive favor-able treatment from the “License Raj” in cer-tain periods (Dwijendra Tripathi 2004).There are yet more extreme examples ofsymbiosis between business groups and thegovernment: each of the two major Japanesezaibatsu, Mitsui and Mitsubishi, virtuallycontrolled one of the major parties in theJapanese parliament in the 1910s. Morerecently, some owners of South Korean chae-bol seemed to entertain political aspirations(e.g., Chairman Chung of Hyundai ran for

president in 1993), a Turkish business grouphas launched a political party, allegedly sothat their representation in government canconfer political immunity on them (AndrewMango 2004), and in Malaysia some businessgroups are centered on political parties (e.g.,the Malay political party UMNO or theChinese political party MCA; see Gomezand Jomo 1999 and some discussion inCommonwealth of Australia 1995). PramuanBunkanwanicha and Wiwattanakantang(2005) describe Thai business tycoons whoenter politics in order to win various govern-ment concessions, and in Singapore thereare still some fully government controlled


Sources (in English): Brazil—Leff (1978), Suzingan and Villela (1997), and Musacchio (2004); Chile—Khannaand Palepu (1999a, 2000c); China—Keister (2004); Costa Rica—private communication with A. Condo; CzechRepublic—McDermott (2002); India—Khanna and Palepu (1999a, 2000b, 2005) and Piramal (1998);Indonesia—Commonwealth of Australia, Chapter 8, Schwarz (1994), Kompass Indonesia (1996) and Fisman(2001), Hanani (2006); Israel—Maman (2002); Italy—Aganin and Volpin (2005), Amatori (1997); Malaysia—Gomez and Jomo (1999) and Gomez (2006); Mexico—Gómez-Galvarriato (forthcoming); Nicaragua—Strachan(1976); Pakistan—White (1974); Russia—Johnson (1997) and Guriev and Rachinsky (2005); Singapore—Tsui-Auch (2006); South Africa—McGregor (1998); Taiwan—Hamilton (1997) and Chung (2001); South Korea—Amsden (1989), Clifford (1994) and Chang (2003a); Thailand—Bertrand et al. (2004), Tara Siam (1996-97),Polsiri and Wiwattanakantang (2006); Turkey—Mango (2004), Yaprak et al. (2004), and Karademir et al. (2005);Prewar Japan—Morikawa (1992).(For Latin America, a general Spanish source is America Economica, 1997).

TABLE 4 (continued)


The nineteenth century businesselite was mostly composed of eth-nic minorities and foreigninvestors. With the founding ofthe new Turkish Republic in1923, the economic agendastressed creating an indigenousbusiness class: bureaucrats, mer-chants, and professionals wereencouraged to become entrepre-neurs.

Relatively larger busi-ness groups are thefavored participants inthe privatization of stateowned enterprises, espe-cially those with strongpolitical ties. Smallerfamily groups participatein the privatizationefforts of smaller stateassets.

Turkey

Nine-teenthCenturyJapan

Between 1923 and 1980 some groupswere supported through preferentialinput prices, low-cost credits, taxrebates, foreign exchange licenses,import licenses, government con-tracts, as well as through export-spe-cific measures allowing businessgroups to establish large export com-panies in the1980s. The governmentalso encouraged diversification andinternationalization of business groupsvia various economic incentives. (Butseveral group-owned banks weretaken over by the government afterthe bank crisis in 2001.)

Some “political merchants” receivedstate credit and grants. Ailing govern-ment businesses privatized and sold tothe zaibatsu. Government contractsencouraged group growth aroundmajor wars.


business groups (Temasek, for example,which controls Singapore Airlines).

But governments and business groups donot always operate symbiotically. First,there are a number of historical exampleswhen governments harmed, rather thanassisted, business groups. This has hap-pened both in times of wrenching societal

transformation—e.g., when the ChineseCommunist Party took power in 1949—andin an ongoing sense when groups struggledin the face of an inimical state—e.g., India’ssocialist government in the few decadesfollowing Indian independence; indeedKhanna and Palepu (2005) point out thatthe turnover in leading Indian groups


TABLE 5THE COMPARATIVE ORIGINS OF BUSINESS: GROUP-SPECIFIC ORIGINS IN NINETEENTH CENTURY JAPAN

Origin Growth and Relations with the State

Historically close ties with various governments.Growth and diversification through acquisitions andthrough establishment of new businesses, in partthrough government privatization and contracts.

Initial investment in shipping enjoyed governmentprotection, subsidies, loans etc. Subsequent growthand diversification patterns broadly similar toMitsui’s.

Diversified from mining into trading, finance andindustry. Again, diversification and growth throughboth acquisitions and through the establishment ofnew businesses, with government support.

Less diversified than the other big groups, morefocused on banking and finance. Again, both acqui-sitions and new businesses as mechanisms ofgrowth.

Initial fortune out of various investments. Growththrough cooperation with a separate financial insti-tution.

An internal family feud led to the dissolution of thisgroup and its reorganization as the Kuhara zaibatsuin 1905.

Mostly in mining and utilities, e.g., established thefirst hydroelectric power plant in 1890. Characterizedby more vertical integration (e.g., in copper extrac-tion and production) than diversification.

Growth mainly through acquisitions. Despite sub-stantial operations overseas, government contractsremained a major source of income.

Dates back to 1673 (dry goods); “politicalmerchants”1 who provided financial servicesto the Tokugawa regime since the late seven-teenth century.

Founded by a former Samurai after the MeijiRestoration.

Dates back to the late sixteenth century, withties to the Tokugawa regime.

“Political merchants” from the MeijiRestoration period. Mainly provided finan-cial services (including the establishment ofthe third national bank in 1876).

Around 1870; no previous political ties.

Origin: supplier of goods and engineeringworks to the new government (with contactsto major figures in the Meiji government).

Formed in 1874, related to old wealth fromthe Ono family.

Merchant (groceries) before the MeijiRestoration; converted into gun productionin the 1860s and then into overseas tradingstarting 1873.

Mitsui*

Mitsubishi*

Sumitomo*

Yasuda*

Asano

Fujita

Furukawa

Okura

1 This refers to the Japanese term seisho which is defined by Morikawa (1992, p. 3) as “traders and financierswho used their ties to powerful political figures to obtain government favors, enabling them to earn substantialprofit in return for providing goods and services to the state. Government patronage took the form of subsidies,grants and monopolies or special privileges, favorable credit arrangements, and sales of state enterprises at nomi-nal prices.”

Source: Morikawa (1992). * denotes the big four zaibatsu groups.


across the past sixty years is far too high tobe consistent with entrenchment and closegroup–government ties. In Pinochet’sChile, after the fall of Allende’s Socialistgovernment in 1973, pro-free-market andantiownership concentration policies wereadopted, which were sometimes antibusi-ness groups. In South Korea, Jordan Siegel(2006) shows that political regime changeslead to differences in the particular firmsthat receive government favors according

to social ties between the office holder andsenior managers. Furthermore, even with-in the same group, different affiliates mayeither be favored or punished dependingon their CEO or Chairman’s social ties tothe current political regime. In the UnitedStates, Morck (2005) and Morck andYeung (2005) describe how PresidentRoosevelt took policy measures againstbusiness groups (see table 4 for otherexamples).


TABLE 6THE COMPARATIVE ORIGINS OF BUSINESS GROUPS: GROUP-SPECIFIC ORIGINS IN PRESENT-DAY SOUTH KOREA

Source: Clifford (1994) and Chang (2003a).

Origin Growth and Relations with the State

Hyundai

Daewoo

Samsung

LG

SK

Mr. Chung (the founder) started byproviding mechanical services tothe American army; later estab-lished contacts with the SyngmanRhee regime.

Mr. Kim (the founder) was the sonof General Park’s teacher. Groupestablished in 1967.

Mr. Lee (the founder) establishedthe company in 1938, using someinherited wealth. Acquisition ofassets left by the Japanese in 1945.

Founded as a trading company in1947.

Founded in 1957; close ties withthe government since inception.

Together with Daewoo, one of General Park’s favored groupsin the 1970s, when Hyundai cooperated with the government’spolicy of investment in heavy and chemical industries.Obtained licenses and government finance as well as preferen-tial tax treatment and protection from imports. Growththrough both acquisitions and entry into new industries.Allegedly, Hyundai and other big groups used governmentcontacts to improve their competitive positions, occasionallyby acquiring assets of ailing groups and by winning major gov-ernment contracts. Mr. Chung was General Park’s “informalconstruction minister” and a personal friend.

Close relations with the government, which transferred toDaewoo the Okpo shipyard and some assets in the autoindustry previously owned by GM. Government-inducedinvestments in heavy industry. Expansion mainly throughacquisitions. Strong international orientation (overseas invest-ments).

Samsung was relatively large already in the 1950s; made polit-ical “donations” and established contacts in government. Butrelations with the state were turbulent in comparison with theother major groups: General Park forced Samsung to“donate” some of its assets soon after taking power, and for awhile the group was virtually excluded from most governmentcontracts. Instead, growth fostered through cooperation withforeign firms; relative focus on electronics. Growth and diver-sification in 1960s through both acquisitions and establish-ment of new businesses.

Growth mostly in electronics and chemicals; benefited fromgovernment development plans in the 1960s; related diversifi-cation strategy.

Much of its growth driven by acquisition of privatized stateassets (including property left by the Japanese), through closeties to the government, including the marriage of thefounder’s son to the daughter of President Roh.


Even where governments were not hostiletoward business groups, the relationshipbetween them often changed over time, asgroups became stronger and more inde-pendent. This seems to have been the casein Japan in the 1930s (Franks, Mayer, andMiyajima 2006) and in South Korea startingin the 1980s (Amsden 1989; Clifford 1994;Kim 1997; Chang 2003a; Chung H. Lee,Lee, and Kangkook Lee 2002), where theexpression the “Republic of Samsung” issometimes used. In post-1997 South Korea,the government has actively tried to weakenthe chaebol albeit with limited success inview of their power and influence (althoughEduardo Borensztein and Jong-Wha Lee2002 provide evidence that group firms losttheir preferential access to capital followingthe crisis). The overall conclusion from thisevidence is that as business groups accumu-late political and economic influence, thenature of their relations with governmenttends to change—from government pro-tégés to a strong lobby with often capturedregulators (in line with phenomenon of“entrenchment” emphasized by Morck,Wolfenzon, and Yeung 2005) or to a sector

that loses favor with the authorities becauseof its excessive influence.36

4.1.3 The Welfare Implications of Close Tiesbetween Groups and Governments

The prevailing assumption in much of theliterature is that government support ofgroups is socially harmful. Despite the nega-tive implications of government favors of thetype described above, there may also be abright side: business groups may havehelped governments orchestrate a “bigpush” in several sectors simultaneously(arguably in prewar Japan, see, for example,Kazushi Ohkawa and Henry Rosovsky 1973).In other cases, governmental favoritismtowards business groups controlled by anethnic minority may have helped preserve


36 The changing relations between groups and govern-ment may be related also to changes in the ownershipstructure of business groups over time. For example, inIndonesia or Mexico, foreigners often hold very signifi-cant equity stakes in business groups firms—many groupfirms among the largest business groups in Indonesia,Mexico, and South Africa have foreign ownership of 20percent or more. This may affect the nature of tiesbetween groups and politicians.

TABLE 7THE COMPARATIVE ORIGINS OF BUSINESS GROUPS: INITIAL CONTROL STRUCTURE OF BUSINESS GROUPS

Family Others

Indonesia Nearly Complete Some state involvement

Malaysia High (90+ percent) State involvement andsome foreign investment

Thailand High (80 percent) Some state involvement

Turkey Nearly Complete N/A

Mexico High (90 percent) Some state involvement

Sources: The table is based on detailed archival, web-based, and interviews by Hyunjee Kim. ISIEmerging Markets Database, One Source Database, Hoover’s Database, Datamonitor CompanyReport, websites and annual reports. Data refer to the largest firms within the largest groups in eachcountry. Family control is defined as having the founding family holding at least 20 percent of theequity during the first decade after the group was founded. In Malaysia, for example, over 90 percentof the group firms examined satisfy this criterion.


social equilibrium, as in Malaysia. Theappropriate counterfactual against whichthis government policy should be judgedmay well be race riots and chaos. Similargovernment-directed transfers are currentlybeing attempted in South Africa, under thelabel of Black Economic Empowerment,with groups forming around emergent suc-cessful black entrepreneurs in the post-Apartheid regime—again, the overalleconomic value of such a policy is not easy togauge.37

Social welfare might be enhanced by group-government liaisons if, for instance, the rela-tion between groups and governmentssupports tax collection and fiscal policy. Dogovernments favor groups because it is easy tocollect taxes from them? If so, this would bereminiscent of medieval rulers who parti-tioned their territories into fiefdoms con-trolled by quasi-independent lords who couldrule them as they saw fit as long as they paidtheir taxes to the government. This issue hasrarely been addressed in the literature.Hidemasa Morikawa (1992) notes that taxescollected from the Japanese zaibatsu duringWorld War II were substantial. By contrast,Morck (2005) describes how the U.S. taxauthorities felt that collecting taxes from busi-ness groups was especially difficult because oftunneling, and so supported (perhaps eveninitiated) President Roosevelt’s attack on busi-ness groups. Chang (2003a) suggests thatSouth Korean groups shift funds so as toreduce their tax liability. Mihir A. Desai, Dyck,and Zingales (forthcoming) argue that ineffi-cient corporate governance structures associ-ated with the expropriation of the rights ofminority shareholders are likely to be associat-ed also with tax evasion (expropriation of thegovernment’s rights). Clearly, more systematicevidence on this issue from various countrieswould be of interest.

Analytically, it might not always be sensi-ble to study just the interaction between the

private sector and the government, withoutconsidering additional constituencies. Forexample, Aldo Musacchio (2004) argues thatthe rise of business groups (and concentrat-ed ownership) in Brazil coincided with therising power of organized labor, with thegovernment playing only a background role.Yasheng Huang (2003) discusses the generalsuppression of the indigenous private sectorin China. This analysis, along with Keister’s(2004) study of the forced formation of busi-ness groups in China, suggests that the gov-ernment favors business groups formed bythe state but discriminates against businessgroups formed by private entities.

In some countries, the government mightitself be in transition, affecting the formationand evolution of business groups. InCzechoslovakia, for example, newly formedgroups reflected new networks of compa-nies, as power shifted from the Communistgovernment to the regime that replaced it(Gerald A. McDermott 2002; see also DavidStark 1996 on post-Communist corporatenetworks in Hungary).38

4.1.4 Evidence on the Political Ability ofGroups to Shape their Environment

Can business groups use their politicalclout to shape their business environment?This central question has no systematicanswer in the existing literature. Historically,groups have often invested in market-supporting infrastructure and launched newindustries—the Japanese zaibatsu are a goodexample. There are also claims that businessgroups in Mexico exerted influence in favorof free trade with the United States fromwhich the groups were hoping to benefit.Kim (1997) argues that the South Koreangroups lobbied for liberalization in the1980s, and Anusha Chari and Nandini Gupta(2006) show that in India industries with


37 The relevant legislation is the broad-based BlackEconomic Empowerment Bill, no. 53, of 2003.

38 Somewhat related is a historical anecdote from earlytwentieth century British India, when the Birla group sup-ported and financed indigenous Indian businesses andentrepreneurs as an alternative to the British-dominatedbusiness scene (Piramal 1998; Tripathi 2004).


high presence of group-affiliated firms weremore likely to be associated with liberaliza-tion of foreign entry in the early 1990s thanindustries dominated by state ownedfirms.39 By contrast, groups may resist cer-tain political reforms, improvements inminority shareholder protection or antitrustlegislation—this seems to be the case inSouth Korea in recent years (Chang 2003a).Morck, Wolfenzon, and Yeung (2005) arguethat “entrenchment” through political cloutis often used by business groups to restrictentry and competition. Rajan and Zingales(2003) also express concern about the abilityof business incumbents (not specificallygroups) to curtail competition and freefinancial markets. The ability of groups toshape their environment may also be relatedto attempts by business groups in manycountries to gain influence on the media(Bhattin Karademir and Ali Danisman 2006describe this for the case of Turkey).

Two conclusions emerge from this discus-sion. First, political economy explanationsfor the formation and effectiveness ofgroups, beyond the traditional focus on gov-ernment favors, should receive more atten-tion. Second, it might be fruitful to view therelations between groups and the state as theequilibrium outcome of a game, in the spiritof work by Aoki (2001) and Greif (2006).These games are typically complex, and theirapplication to a particular context is notalways straightforward. Nevertheless, con-ceptually, the result of such a government-business group game might well be rentseeking and cohabitation, but it might alsobe an uneasy coexistence, quite distinct fromthe outcome of groups currying favor withthe state.40

4.2 Business Groups and Monopoly Power

There are good theoretical reasons to sus-pect that business groups may wield consid-erable market power. They may, under somecircumstances, drive their rivals out of mar-kets, or prevent entry, due to their “deeppockets,” “first mover advantage,” and ties tothe government. “Multimarket contact” (B.Douglas Bernheim and Michael D.Whinston 1990) between diversified busi-ness groups competing with each otherrepeatedly in many sectors may facilitate col-lusion. And business groups may bundletogether different group products in order toextract more rents from distributors andultimate buyers. It is not clear, however, ifthese considerations are the rationalebehind the formation of business groups.

Hypothesis 6: (a) Business group forma-tion should involve horizontal mergers, ver-tical foreclosure, entry deterrence, and othermechanisms designed to increase marketpower. (b) Monopoly power should bereflected in high profit rates. (c) Group pres-ence should be especially pronounced inenvironments where monopoly rents can beextracted such as industries and countrieswith trade barriers and weak antitrustenforcement.

4.2.1 Evidence on Business Groups andMonopoly Power

The theoretical conjectures associatingbusiness groups with monopoly powerenjoyed popular support in the past, albeitwithout rigorous empirical tests. The viewthat business groups harm competition datesback to the Great Depression in the UnitedStates. Morck (2005) argues that PresidentRoosevelt sought to dissolve America’s groups(by taxing intercorporate dividends) partly onthese grounds. One of the primary objectivesof the postwar American occupation reformsin Japan was the dissolution of the prewar zai-batsu, which was driven by strong views ontheir anticompetitive effects and the resultingsocial tension that may have contributed to


39 This is in some contradiction to Tripathi (2004),who argues that the Bombay Club (of Indian industrial-ists) lobbied for restricted entry of foreign multinationals.

40 It would be interesting to model the relationbetween ties with the government and the business groupstructure, in contrast with politically connected firmsoperating in one industry.


the rise of militarism in Japan (Hadley 1970;Yafeh 1995). Ginette Kurgan-Van Hentenryk(1997) suggests the Belgian business groupsfacilitated the cartelization of the Belgian coalindustry in the interwar period.

Nevertheless, despite the plausibility ofarguments on groups and monopoly power,the literature on the industrial organizationeffects of business groups has not developedmuch. The theoretical relation between groupaffiliation and entry deterrence is exploredformally in an interesting recent study byGiacinta Cestone and Chiara Fumagalli(2005). They show that internal capital mar-kets are not always advantageous to groupaffiliated firms when they try to deter entry;under certain conditions they may actually be“softer” than stand-alone firms.41 Thereseems to be scope for many more theoreticalanalyses of groups and industrial organization.

Empirical evidence on the hypothesis thatbusiness groups restrict competition is sur-prisingly scarce. Casual observation suggeststhat not all groups enjoy high profit rates andmonopoly rents (table 1). The few studiesdirectly testing the monopoly power of busi-ness groups use not very recent data fromdeveloped economies: David Encaoua andAlexis Jacquemin (1982) investigate Frenchindustrial groups and find little evidence oftheir having any market power (although theeconometric techniques used in empiricalindustrial organization have evolved signifi-cantly since then); David E. Weinstein andYafeh (1995) argue that (in the 1980s) Japan’sbank-centered groups competed aggressivelyagainst each other rather than colluded.Although there are no similar studies foremerging markets, there are occasionaldescriptions of the intense rivalry betweenthe South Korean chaebol. These are not for-mally substantiated, and even if true, do notnecessarily preclude anticompetitive entry

deterrence. Other anecdotes refer to collu-sion across ethnic Chinese business groups inEast Asia (Commonwealth of Australia1995). Ahmed Mushfiq Mobarak andPurbasari (2005) provide more systematicevidence—they show how politically con-nected Indonesian business groups used theirinfluence during Suharto’s reign to win exclu-sive import licenses conferring protectionfrom imports, market power, and competitiveadvantage relative to their rivals, leading toincreased concentration. There is also fairlysystematic evidence on changes in the relativesize and rankings of business groups overtime, which could be interpreted as evidenceof competition or erosion of monopolypower—the list of top ten business groups haschanged dramatically over the past threedecades in India and Taiwan, but hasremained very stable in South Korea andThailand.42 It is not clear, however, whygroups in some countries wield less power torestrict entry than groups in other countries.Overall it is surprising that no attempts havebeen made to use modern NEIO (NewEmpirical Industrial Organization) tech-niques to assess the market power of businessgroups in emerging markets.

5. Directions for Future Research

This final section outlines general directionsfor future research in view of what we believewe know, and what we would like to know,about business groups in emerging markets.

5.1 Origin and Formation of BusinessGroups

The formation of business groups remainslargely unexplained. Because of this lacuna,


41 See also Antoine Faure-Grimaud and RomanInderst (2005) who discuss related issues in the context ofconglomerates with internal capital markets. Feenstra andHamilton (2006) also discuss monopoly power of businessgroups in a different context.

42 In India, only three of the top ten groups in 1969were included in the list of top ten groups in 1997.Taiwan is similar to India in this respect: only three of thetop ten groups of 1973 appear on the list for 2002. Bycontrast, in South Korea, six of the top groups in 1972were among the top ten groups in 1996, and in Thailandtoo, six of the top ten groups in 1979 appeared on the listof top ten business groups in 1997 (Khanna and Palepu2005; Chung and Mahmood 2006; Chang 2003a; Polsiriand Wiwattanakantang 2006, respectively).


selection effects may render comparisons ofgroups and nongroup firms invalid. We viewthis as an important direction for both theo-retical and empirical future research.

The existing theoretical literature on theformation of business groups consists of nomore than a handful of models. Raja Kali(1999) studies the endogenous formation ofbusiness networks in response to limitedcontract enforcement by the legal system;Maurer and Sharma (2001) also focus onimperfect property rights. Maitreesh Ghatakand Kali (2001) and Kali (2003) emphasizeimperfect information in capital markets asanother possible motive. Almeida andWolfenzon (forthcoming) offer a theoreticalexplanation for the formation of pyramidalgroups which is based on the ability of con-trolling shareholders to access the cash flowsof all group firms so as not to rely on under-developed external financial markets. A par-ticularly intriguing theoretical direction (alsorelated to underdeveloped financial mar-kets) would relate the formation of groups torisk attitudes: are groups a mutual insurancearrangement attracting risk-averse economicagents? Se-Jik Kim (2004) is the only existingmodel along these lines.43

Existing empirical studies of the formationof groups are often based on small data setsand employ empirical techniques that are notfully convincing. For example, Chung (2001,2006) examines the origin and evolution ofgroups in Taiwan, distinguishing betweenreasons related to market forces, culture, andsocietal institutions, but the relative empiri-cal importance of these factors is hard to dis-entangle. Tsui-Auch (2005) documents atendency among ethnic Chinese entrepre-neurs in Singapore to form diversified busi-ness organizations (in comparison withethnic Indian entrepreneurs), and attributesthis interesting observation to the cultural

heterogeneity of the Chinese community.The empirical support for this claim, howev-er, is suspect because of other systematic dif-ferences in the background of Chinese andIndian entrepreneurs in Singapore. Moresophisticated empirical analyses of the differ-ential origins of business groups are likely tobe valuable.

Somewhat related conceptually is the ideato use within-country variation in the struc-ture and development of business groups todraw some conclusions on the forces that leadto their formation. For example, it appearsthat the Chinese government pursued liberal-ization primarily in regions where it was weak(the south), and not in the northeast (e.g.,Beijing) where the Communist Party had itspre-1949 stronghold. Is it the case then thatstate-sponsored groups created by fiat aredeveloping primarily in the northeast?Variation in group presence across Indianprovinces might shed light on the relationbetween the formation of business groupsand issues related to ethnic identity and per-haps also to “trust.” For example, is it possibleto map the presence of certain ethnic groupsin certain regions (e.g., Marwaris in Rajasthanand, by migration, in Bengal; Chettiars in thesouth) to the formation and development ofgroups along similar ethnic lines? Indian busi-ness groups offer an opportunity to takeadvantage of the variation over time in theprocesses that led to the formation—somegroups, like the Tatas and Birlas were createdby indigenous entrepreneurs during the timeof the British Empire; a second wave, like theGoenkas and the Khaitans, were the productof the postindependence (1947) transfer ofassets from the British to Indians; a third setoriginated during India’s “License Raj” of the1960s and 1970s. Can these different circum-stances be related to group structure?

5.2 Evolution and Dynamics of BusinessGroups

Historical and dynamic (over a long periodof time) perspectives of business groups canenrich our understanding of this institution


43 The empirical evidence in Kaivan Munshi and MarkRosenzweig (2005) on informal mutual insurance institu-tions in India, and in Ran Abramitzky (2005) on the IsraeliKibbutz may offer some useful related insights.


in several ways. First, it would be interestingto compare the validity of cross-sectionalexplanations for the ubiquity and perform-ance of business groups with time-seriesbased perspectives (Jones and Khanna2006)—do groups evolve in a fashion that isconsistent with missing institutions, risk shar-ing, tunneling, use of a scarce resource, etc.?The Japanese prewar zaibatsu provide anobvious opportunity to carry out such ananalysis because of the wealth of informationabout their activities and development, pro-viding over five decades of data.44 Anotherpossibility is the shorter, but more recent his-tory of the South Korean chaebol.45 Thereare other interesting examples: Maurer andSharma (2001) study the evolution of nine-teenth century Mexican business groups(which, in their view, was a response to limit-ed contract enforcement); Khanna andPalepu (2005) study the evolution of businessgroups in India (which, they argue, fits theview of groups as a substitute for underde-veloped institutions; see also Jones 2000 onhistorical British groups); and AlexanderAganin and Paolo Volpin (2005) study theevolution of Italian groups (focusing oninvestor protection and political issues).

Many more historical studies with explicithypotheses in mind, especially with compet-ing hypotheses whose testable implicationscan be contrasted in time-series data, couldshed further light on the evolution ofgroups, on path dependence (ways in which

“history matters”), and on the raison d’êtreof group formation and development.

5.3 Longevity of Business Groups

Although there is no systematic evidenceon the question whether or not the longevi-ty of group affiliates exceeds that of other-wise comparable, unaffiliated firms, in manycountries, very long-lived groups can befound. In some cases, groups have survived,without a substantial change in structure,over a long period, starting in an era whenthe country was poor, all the way to prosper-ity (e.g., Sweden).46 This is related to theimpression that, if groups ever dissolve, thistends to conincide with dramatic changes ingovernment policy.47 Can groups ever diepeacefully? We are not sure. One of the fewexamples of such a process is provided byJones (2000), who describes the demise (orrefocus) of British trading houses duringrecent decades in response to a changingenvironment (rise of diversified institutionalinvestors in London, decolonization abroad,decline in trade in raw materials, etc.).Morck et al. (2005) show that Canadian pyr-amids died peacefully in the mid twentiethcentury due to market crashes, inheritancetaxes, and other factors, but new groupsarose to replace them in the later decades ofthe century. There is also some recent evi-dence on the on-going, gradual decline ofcross shareholding in Japanese corporategroups (Mitsuaki Okabe 2002; Yafeh 2003;Miyajima and Furniaki Kuroki forthcoming).By contrast, recent evidence suggests thatthe business group phenomenon in much of


44 Morikawa (1992) is the most detailed English-lan-guage study of these groups with a plethora of informationon their origins, evolving relations with the government,growth and diversification patterns, controlling families,human resource management, and more. He tends tointerpret the zaibatsu growth and diversification history ina Chandlerian tradition of efficient management and useof internal resources. The evidence he provides, however,is not really set up in a way that enables testing competinghypotheses about the reasons for the existence and growthof these groups.

45 Chang (2003a) argues that, much like the Japanesezaibatsu in the late nineteenth century, South Korea’sbusiness groups developed under the auspices of a devel-opment-oriented government, but gradually becameindependent and pursued a growth strategy that reflectedtheir resources and competitive advantages.

46 For a brief discussion of the history and survival ofthe Wallenberg group, the largest in Sweden, over thepast 150 years, see the Economist, Oct. 14, 2006, p. 94.

47 For example, President Roosevelt deliberatelyattempted to dismantle American big businesses duringthe Great Depression (Morck 2005; Morck and Yeung2005), which may explain why he could muster the neces-sary political will. The American occupation authoritiesforcefully dissolved the Japanese zaibatsu after World WarII (Yafeh 1995). The South Korean government attempt-ed to curb the power of the major chaebol following theAsian financial crisis of 1997–98 (Khanna and Palepu1999b; Chang 2003a) with limited success.


East Asia did not disappear following the1997 crisis, although some groups did col-lapse and others were forced to restructure.For example, Chung and Mahmood (2006)show that Taiwanese groups became morediversified both across industries and acrosscountries following the crisis; they alsobecame more pyramidal in structure. Tsui-Auch (2006) examines both government-owned and privately owned groupscontrolled by ethnic Chinese in Singapore,finding certain gradual changes towardincreased focus but much continuity. Gomez(2006) documents significant weakening ofMalaysian groups with the demise of theirpatrons, Prime Minister Mahathir and otherpoliticians in Malaysia, like Daim and Anwar.Polsiri and Wiwattanakantang (2006)describe the restructuring of Thai businessgroups and Alberto Hanani (2006) ofIndonesian groups. None of these studiessuggests that, despite the crisis and the ensu-ing changes, the dissolution of businessgroups in any of these countries is imminent.

Are there cultural or societal reasons thatwould prevent corporate structure in emerg-ing markets from self-evolving into a morefocused structure as the country develops?What is the role of government in thisprocess? Is it advisable, or even possible, forthe state to forcibly dismantle groups, as hasbeen attempted in South Korea? Even ifgroups have run their course, is it clear thatthe desired policy is to try and dissolve them(Khanna and Palepu 1999b)? Is a policy ofbenign neglect more desirable (as in India)?Is it clear that when the social costs of cor-porate groups exceed their social benefits,private costs to group owners will alsoexceed private benefits? Can groups involv-ing substantial inefficiencies persist for along time? If so, is it because of a weak cor-porate control environment? Because ofsocial reasons (e.g., families who diversify toaccommodate disparate interests of the nextgeneration)? These are complex theoreticalissues. At present, we are aware of only onestudy that tries to address them: Almeida

and Wolfenzon (2006) argue that because ofnegative externalities (on the ability of non-group firms to raise finance) business groupsdo not realize the full cost of their presence(and presumably will not dissolve on theirown even when it is optimal to do so).

5.4 Counterfactuals to Business Groups

When considering the welfare conse-quences of groups, it is unclear what theappropriate counterfactual should be:against what alternative should groups beevaluated? The ideal is a well functioningmarket economy, but in reality the worldconsists of distant second-bests. In theabsence of groups, would there be otherforms of networks? Would market-support-ing institutions emerge spontaneously? Isthere a way to infer the appropriate counter-factual from recent policy interventions(e.g., in South Korea or China)? Almeidaand Wolfenzon (2006), who evaluate thewelfare implications of business groups as afunction of measures of efficiency of exter-nal financial markets, provide an interestingstarting point for addressing this issue. Alsorelevant is the model of Vojislav Maksimovicand Gordon Phillips (2002), who suggestthat conglomerates are an efficient equilibri-um outcome to certain business opportuni-ties, whereas for others standalone firms arebetter suited. The equivalent for businessgroups would be that groups are an efficientoutcome for certain situations in which theappropriate counterfactual is not necessarilystand alone firms but some other, not wellspecified, outcome. Also related is the obser-vation in Maurer and Haber (2006) that,when restrictions were imposed on relatedlending within Mexican business groups in1997, the result was a large decline in thesize of the credit market, not the emergenceof a competitive equilibrium in which allfirms could access loans on equal footing.

Conceivably, the relevant counterfactualto business groups may change with eco-nomic development—in early stages, in theabsence of groups, the plausible feasible



alternative may well be underdevelopmentand limited market institutions. In moreadvanced economies, in the absence of busi-ness groups, perhaps superior capital, labor,and other market institutions would develop;this conjecture has never been tested.

5.5 Groups and Macroeconomic Crises

Some studies relate corporate governancein business groups to the financial crisis inEast Asia (e.g., Giancarlo Corsetti, PaoloPesenti, and Nouriel Roubini 1999; Johnson,Peter Boone, Alasdair Breach, and EricFriedman 2000; Mitton 2002; Byungmo Kimand Lee 2003; Baek, Kang, and Kyung SuhPark 2004).48 Somewhat related is the argu-ment that crony capitalism enabled groups toborrow particularly easily, and moral hazardproblems associated with this may have pre-cipitated the crisis (Chutatong Charumilind,Kali, and Wiwattanakantang 2006). The pop-ular press, especially in South Korea, echoesthese concerns. But are countries whoseeconomies are dominated by business groupsmore crisis prone than countries character-ized by stand alone companies? Is it the casethat, if a few families control a large fractionof an economy through business groups,microeconomic governance or managementdifficulties may turn into macroeconomicproblems? On theoretical grounds, this isuncertain—links between group firms maypropagate adverse shocks, but mutual insur-ance within groups can sometimes dampenthem (Khanna and Yafeh 2005). Empirically,the ubiquity of business groups may rendersuch an exercise difficult, but this line ofresearch has potentially important welfareand policy implications.

To conclude, we believe that any blanketcharacterization of business groups as eitherparagons or parasites would be unwarrant-ed, both because of the nature of the exist-ing evidence and because of the continued

existence of unanswered puzzles. Part of thedifficulty stems from the vast differencesacross countries, groups, and time periods,and part from the multiple effects thatgroups tend to have. Progress is likely toresult from casting a broader net for relevantdata; this includes paying attention to histor-ical data and evidence, using group origin asa relevant variable, and exploiting time-series variation. To us, business groups con-tinue to be a fascinating topic for research,still posing many interesting questions withimplications for a variety of important issuesin economics and finance.

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Business Groups in Emerging Markets: Paragons or …...2007/05/11 · Chile to about two-thirds in Indonesia. The table also indicates that, in virtually all emerging markets, group