Elsevier

Journal of Economics and Business

Volume 59, Issue 5, September–October 2007, Pages 443-465
Journal of Economics and Business

Leverage and business groups: Evidence from Indian firms

https://doi.org/10.1016/j.jeconbus.2007.04.006Get rights and content

Abstract

The motivation of this paper is that information problems and other market imperfections, which explain the business group phenomenon of firm ownership structure in emerging markets, also underpin mainstream theories of firm leverage. We draw from elements of theories of business groups as well as capital structure theories to specify a generic model of capital structure, which is then estimated and tested on a sample of 1652 quoted non-financial firms in India, including group-affiliated and independent firms. It is found that the leverage decisions of group-affiliated firms are significantly different from those of non-affiliated firms, suggesting that the business group ownership structure creates virtual (or internal) capital markets. Further evidence indicates that group-affiliated firms enjoy exceptional access to government and foreign loans, as proposed by the market failure and policy distortion theories of business groups.

Introduction

Business groups are an important firm ownership feature of the private sector of many emerging as well as developed markets. La Porta, Lopez-de-Silanes, and Shleifer (1999), investigating firm ownership in 27 economies, find that many firms are typically controlled by families through pyramidal structures. The resultant group of firms, controlled by a single family, is referred to as a family business group by Almeida and Wolfenzon (2006). Other forms of business groups include collections of firms that are linked through a common main bank, interlocking directorships, cross holdings of equity, or other non-family social ties (see Khanna & Rivkin, 2006).

Since the seminal works of Leff, 1976, Leff, 1978, there has been an increasing research interest into the question of why firms constitute themselves into business groups.1 Among other reasons, it is argued that firms form business groups in order to influence the way they are governed and the means by which they raise capital (Khanna, 2000). Overall, the pivotal argument is Leff's market failure theory. Accordingly, groups are dominant in emerging markets because of the prevalence of market imperfections and information problems.

It is interesting to note that information problems and other market imperfections, which underpin the main theories on business groups, also underpin the theories on the determinants of capital structure. Hence, the paper synthesizes two strands of the literature by investigating the effect of group affiliation on the firm's leverage decision. The investigation is conducted in the context of emerging markets and focuses on India for the reasons outlined in Khanna and Palepu (2000a). First, there are many business groups in India (around 400), which vary greatly in terms of size and the level of diversification. Second, it is not cumbersome to establish the affiliation status of firms in India, unlike the case in other markets.2 Third, business groups in India are representative of business groups in many emerging markets in at least two ways: they are often linked to a particular family; control is typically achieved either through appointing family members and friends to directorship and top managerial positions, or through direct and indirect ownership.

In India business groups are referred to as Business Houses and their origin dates back to the Managing Agency System during colonial times. The system had begun to evolve in the late 18th century and when the English East India Company lost its monopoly over trade. At that time employees of the company and some locals from the trading communities started to trade on their own account as free merchants. Through trade the free merchants accumulated wealth and started to diversify their activities.3 The way these entrepreneurs organized themselves is what later became known as Agency Houses. Particularly the managing agent – be it a partnership, a firm, or an individual – would set up a new business using his and his family's wealth. Once the business was up and running he would sell it off, usually leaving a fraction of shares in his name, and enter a managing agency contract with the new owners. The capital gains from the sell of the business would be used to set up another business and to repeat the process.4

Following Indian independence in 1947 the Agency House had evolved into a Business House (business group). The Indian business group, like many other business groups around the world, is typically a collection of legally independent firms in a wide variety of industries. The group is often associated with a particular family and the firms in the group are linked through interlocking directorships and financial ties that include cross holding of equity, internal loans, and debt guarantees (Bandyopadhyay & Das, 2005). La Porta et al. (1999) and Almeida and Wolfenzon (2006) find that the controlling families typically maintain control by building pyramid ownership structure rather than by the issuance of multiple classes of shares.5

The main argument of this study is that information asymmetries, agency conflicts, tax and risk considerations, as well as other distortions that influence the firm's capital structure decision, are also central to understanding the business groups’ phenomenon. Firms organise themselves into business groups in order to mitigate market distortions. To the extent that they succeed, their capital structure decision should be driven by factors other than those that determine the capital structure decision of non-affiliated firms. To assess this assertion, the paper investigates firms’ capital structure decisions, comparing group-affiliated firms with independent firms.6

The remainder of the paper is organised as follows. Section 2 reviews the current literature on the capital structure decision, on business groups, and on the interaction thereof. In Section 3, drawing from the literature review, a generic model is specified to capture the impact of group affiliation on firms’ capital structure decisions. Section 4 discusses data and measurement issues. The empirical procedures and results are presented in Section 5. Section 6 concludes.

Section snippets

Capital structure and business groups: theoretical considerations

The three main theories of capital structure include pecking order theory, the trade-off theory and agency theory. Empirical testing of these theories typically involves variants of models in which the firm's debt level is regressed on a number of explanatory variables that underpin the theories (for a review of empirical studies, see Prasad, Green, & Murinde, 2001).

One of the main three capital structure theories, the pecking order theory, is due to Myers (1984). Pecking order theory is based

The empirical model

On the basis of the capital structure strand of the corporate finance literature, we specify a standard model to underpin the firm's capital structure decisions. The model is a cross-sectional regression of leverage on variables that are predicted to be important in explaining the capital structure decision. Hence, the explanatory variables encompass the trade-off theory, agency theory and pecking order theory:Li=j=08αjTVji+j=08βjTVjiGPi+j=16ωjGVji+j=111κjINDUSTRYji+εiwhere L is the debt

Data

The data are retrieved from the PROWESS database provided by CMIE and updated to 22 March 2001. The initial data set includes the universe of all quoted and unquoted Indian Private Sector firms available on PROWESS, totalling 6548 firms, and comprising 4506 independent firms and 2042 group-affiliated firms.18 The data for the 2042 group-affiliated firms are used to construct group diversification and other

Estimation and testing results

The empirical procedure includes two stages. In the first stage ordinary least squares (OLSQ) regressions are used to investigate the capital structure decisions of group-affiliated and independent firms. The second stage uses a binary choice (Probit) model to investigate differences between group-affiliated and independent firms in terms of access to government and foreign loans.

Concluding remarks

Inspired by a synthesis of two strands of the literature on business groups theories and capital structure theories, this paper investigates the effect of group affiliation on the firm's capital structure decision. The basis for the synthesis is the notion that information asymmetries, agency conflicts, tax and risk considerations, as well as other market distortions, underpin both business groups theories and capital structure theories. The paper argues that firms organise themselves into

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