Business Groups: Between Market and Firm

October 14, 2005

"Business Groups in Emerging Markets: Paragons or Parasites?" (PDF), Khanna & Yafeh, ECGI, Aug 2005

A business group is a cluster of legally distinct firms with a managerial relationship. The most obvious example is the Japanese keiretsu, although business groups dominate the corporate landscape outside of the English-speaking world. Until 2000, for example, the Italian economy was dominated by the IRI & ENI groups of massively telescoped holding companies; the Swedish economy likewise is dominated by very old groups.¹ In India, the Tata Group is reponsible for a very large share of that country's domestic industry; in Malaysia, Thailand, and Indonesia, it seems as if most foreign capital flows are channelled through business groups with close ties to the armed forces or the ruling party.

THE VARIETIES OF BUSINESS GROUPS

THere are basically three types of business groups. Khanna & Yafeh focus on the two fundamental ways, vertical versus horizontal, but promptly elaborate on that to remind us that the picture is far more complex. In a horizontally organized group, there exists a holding company at the top whose assets are dominated by a single family. The holding company owns a controling interesting in other holding companies, many of which may be disguised as conventional productive firms. In the above-mentioned IRI group, this was the Italian State. In a horizontally-organized group, the member firms own shares in each other. Khanna & Yafeh use the example of privatized state industries in the Czech Republic (p.90), in which voucher privatization led to mutual ownership.

Khanna & Yafeh classify the modern Japanese keiretsu as an example of a horizontal business group since most of the control is mutual (p.62). However, I would argue, based on Iwao and Ballon (The Financial Behavior of Japanese Corporations, 1988) that the keiretsu represents a special case of business group, one in which the relationship does not merely involve mutual ownership and affinity, but the massive integration of business functions in a group. For example, each of the old six keiretsu were endowed with a commercial bank, an investment bank, a trading house, an insurance company, a construction firm, a brewery, and a very tightly-integrated system of suppliers, shippers, retailers, and so on. Interestingly enough, the member firms would avail themselves of services from each of the other five component firms, but overwhelmingly relied on the in-house firms.

The reason I mention this is that, in the typical horizontal business group, the different firms are not unified to achieve conventional monopoly power (since they are, by definition, in different markets), nor to ensure streams of supplies at fixed prices (which can be achieved contractually), but to (a) reduce risk by accumulating "cash" in the related firms, or (b) tunnelling. I might hasten to add that, in the US business magazines I have read, (a) is regarded as a form of administrative tunnelling since it reduces the return on equity (because the managers are playing the stock market to fortify their position as managers, rather than cranking out better widgets at lower costs). In other words, it's difficult to imagine a reasonable justification to shareholders for a horizontal grouping, whereas it is easy to imagine a reasonable justification for a keiretsu: the latter offers industrial services in synch with the partners' industrial procedures.³ Likewise, the kaisha (the prevailing form of Japanese corporation) is responsible for inculcating a comprehensive corporate Weltanschaung, one that is compatible with the rest of the keiretsu. Hence, a middle manager who leaves one kaisha for another in the same keiretsu will have the appropriate skill set. Finally, the keiretsu combines horizontal and vertical business group forms to achieve complex administrative objectives. Incorporating all the member firms into the same entity would result in an entity that had no market pricing mechanism.

Needless to say, there are also business groups that are neither strictly vertical nor horizontal. In Chile, for example, it's common for businesses to lack any unambiguous classification (p.33).

Other distinctions among business group ties involve how the firms are tied together: cross-holding of shares is one method, but so is shared patronage by the same politician, or dynastic ties. In the computer industry, "consortiums" are extremely common; they are united by a common format. Finally, there are varieties of business groups in which the relationships are contractual rather than financial (Bianchi-Bianco-Enriques, p.39; they focus on Italian industry, where control is accompanied by a huge concentration of ownership. So the Italian industry furnishes few examples of control minus ownership).

THE CONTROVERSY OF BUSINESS GROUPS

Business groups are commonly looked upon by Western observers as a prime example of "crony capitalism." While corruption is encountered everywhere, in the business world it is usually held in check by the urgent prudential motives of financial analysts, shareholders, regulators, and banks. Some forms of business groups, such as commercial banks owning construction companies, are absolutely forbidden by national laws. In the US "Gilded Age," business groups were formed by the existence of trustees who were allowed to vote on behalf of large numbers of shareholders. The trustees naturally used their trustee status to control many related firms as a single monopoly. In 1890, this was outlawed under the Sherman Antitrust Act, but seldom enforced until the Theordore Roosevelt Administration (1901-1909). Likewise, the Glass-Steagal Act of 1933 banned certain types of business associations in financial services in order to act as "firewalls" between certain financial functions. The object was to prevent banks from replacing financial markets with money laundering scams.

But in the rest of the world, a primary concern has been the use of the business group to expropriate wealth from minority shareholders. For example, the object of a holding company is to use the corporate organization to raise capital from small investors, but still allow a single bloc of investors to retain a controlling interest. The controlling interests can "water the stocks" (reducing the value of the minority shareholder) and then have the management buy the company's own stock (retaining control of the company at company expense). Another technique is called "tunnelling."² In this method, control of the board translates to the ability to buy assets from the family at a premium. A third method, obviously, is nepotism (for some reason, "tunnelling" does not include the tactic of hiring one's relatives as decorative corporate officers at high salaries.)

These methods of expropriation are specific to business groups because they are much harder to use, or less effective, in wholly autonomous firms. In a single firm, for example, the controlling shareholder doesn't have a holding company capable of owning shares of greater value than the liquid assets of that particular shareholder; the holding company, in contrast, can triple the financial leverage of the shareholder, and of course multiple holding cpompanies can triple it again. Likewise, tunnelling is harder if one does not control a firm that can launder one's swag.

PERFORMANCE OF BUSINESS GROUPS

I would expect business groups to differ from strictly autonomous firms in the same economy in that they (a) are older; (b) more profitable; (c) pay lower taxes and enjoy more political influence; (d) less efficient; (e) more corrupt, i.e., they are more likely to expropriate value from minority shareholders; (f) they are a drag on the economy, i.e., they systematically misallocate resources. I would expect these things because business groups direct resources from productive capital investment to capture of control by management. Managers are not suppose to control their employers; they are suppose to control the productive processes of the firm.

Bianchi-Bianco-Enriques (cited below), like most business journalists, recognizes these as drags on the Italian economy; Högfeldt (also cited below) likewise recognizes the inherently self-endangering aspects of the group as the foundations of union between the state and employer-investor. In the corporatist-syndicate model, the state attempts to buy off both employer and worker by allowing guarantees to both; since somebody has to pay, the deal depends on either nobody noticing the hidden costs, or inflicting them on someone who can neither escape them nor challenge them. Khanna & Yafeh, however, examine a cross section of different legal and developmental regimes (p.15ff), and observe that business groups may, or may not, exist to expropriate rents.

Their research on profitability is inconclusive; while firms in groups range from more profitable, to equally profitable, and from more volatile, to less volatile, in their profits, it turns out this may have more to do with the functions of the group; if the group exists to manipulate earnins for tax purposes, it will exploit its control over other firms to convert profits into tax-free capital gains.

Likewise, Khanna & Yafeh challenge the conventional wisdom against unrestrained diversification. "Theoretically, corporate diversification could be beneficial to shareholders if a firm has some resources that can be profitably deployed outside the industry in which it operates, such as entrepreneurial skills, technology, etc." (p.19). Pardon me, but this is like saying "unrelated diversification could be a good thing if the industries are related." If selling airline tickets is the same skill as selling move tickets, then by all means, let United Artists merge with United Airlines. Conglomerates in the USA boomed in the 1960's and '70's as managers adopted the "management of industrial resources = portfolio management" theory en bloc. A startling corollary of this was the death of training in American firms, since employees were assumed to be either competent or not.⁴ It should come as no surprise that, as business enterprises become larger and larger, the conglomerate structure would have an obvious natural appeal: since firms are too big to manage, the managers justify their role in the bureaucracy of production by equating investment decisions with actual management.

In the USA, the conglomerate imploded; Khanna & Yafeh correctly, in my opinion, minimize the applicability of this experience to non-US countries. That diversification in US firms accompanied deterioration in profitability, does not mean diversification led to deterioration in profitability. More likely, the real problem was that, as individual sectors of the US economy became dominated by larger and larger firms, the conglomerate simply suffered from controlled many business units with a comparatively smaller market share than the winners. Likewise, a conglomerate is not the same as a business group (which is rare in the USA anyway). Khanna & Yafeh mention (p.21) that conglomerates actually perform better iin countries where financial markets are not deepened, but perform at a discount where they are developed. In a business group, though, the main distinction is legal distinction from controlling entities; the business group operates in a twilight zone between the open market and the command economy inside a large firm. In the latter, the conglomerate suffers from the comparative political influences of the operating units, much of which may be felt through a theoretical business plan (the managers may believe the x sector is crucial to mastery of the y industry, regardless of the profitability or efficiency of the x-division of the conglomerate).

However, what the business group suffers in comparison to the conglomerate, or to the big automomous firm, is contol without legal accountability. In a rare example of an American business group, the northern Californian utility company Pacific Gas and Electric (PG&E) was required to spin off its electricity generation division, its nuclear power division, its transmission network, and its distribution network. These became effectively four different operating units. In 2001, as the transmission network tottered on the brink of bankruptcy, Gov. Davis negotiated an agreement to bail out PG&E. Subsequently, the transmission network declared bankruptcy, aborgating the agreement and costing the state billions. PG&E's holding economy, meanwhile, made billions that year. Many Californians were flabbergasted that the holding company could make record profits even as a company it owned went bankrupt and defaulted on gigantic debts. Most Californians assumed this was the Governor's fault, and of course voted in the cabal of perpetrators.

This is common in countries where business groups are the norm; in the USA, the business group is so rare that vigorous protection against tunnelling is unlikely to develop. In countries such as EU member states, where business groups are common, business groups are regulated more effectively, but tunnelling is still a constant drag on multifactor productivity growth.

NOTE: 1 There are actually five papers on business groups I reviewed for this post. The other four are "State and Economy in Italy before the Economic Miracle" (PDF), Simone Selva (2004); "The History and Politics of Corporate Ownership in Sweden" (PDF), Peter Högfeldt, 2004; "History of Corporate Ownership in Italy" (PDF), Alexander Aganin & Paolo Volpin, 2003. ADDED: "Ownership, Pyramidal Groups and Separation between Ownership and Control in Italy" (PDF), Marcello Bianchi, Magda Bianco, and Luca Enriques, 1997.

2 "Tunnelling" (PDF), Johnson, La Porta, Lopez-de-Silanes, & Shleifer, 2001. Although tunnelling is as old as the corporate form of business organization, it fell to the Czechs (2000) to coin the phrase "tunnelling." The metaphor comes from the idea of the looters using an underground "tunnel" to carry the assets out of the corporation. According the authors, "tunnelling" specifically does not include nepotism, but does include (p.4), "...dilutive share issues, minority freezeouts, insider trading, creeping acquisitions, or other financial transactions that discriminate against minorities." In "The History of Corporate Ownership in Japan" (PDF; Morck & Nakamura, 2003), "tunnelling" is used to refer to the strategy, in a pyramid business group, of concentrating profits in the holding company (p.30).

3 From the point of view of the middle management and the labor force, the idea of plowing earnings into shares of unrelated firms is, if anything, even more offensive: first, because it can be used to tunnel earnings out of view of the unions or labor ministries (in many countries, strikes can be forbidden if they threaten the company with bankruptcy); second, because the managers' objective is no longer confined to increasing sales (and therefore, payrolls), but is dilluted: now, the managers can remain in power by accumulating assets in other companies with better growth performance than their own, thereby allowing them to become less accountable. "Cash" is in quotation marks because, while shares in another company are not cash, they are at least notionally liquid.

4 Too much is made of technically specialized training in US firms, as if this were comparable to the older form of on-the-job training. First, labor unions have contributed somewhat to requiring that senior employees receive training that allows them to be promoted within the firm. If this were not used as a political bargaining chip, then of course firms would have all lower managers be hired from outside, thereby having the lower manager bear all of the costs and risks associated with skills acquisition. Second, training employees to use the custom software is an inescapable cost of custom software (or any other office machinery); it does not substitute for actually training employees at their jobs. As firms acquire more capital equipment, they are typically required to retrain staff they don't sack. They can then tell government surveys, "See, the private sector is investing in workers!" No, the "retraining" is just part of the installation process.