Revisiting The Bright and Dark Sides of Capital Flows in Business Groups Joseph P. H. Fan The Chinese University of Hong Kong Li Jin Harvard Business School Guojian Zheng Sun Yat-sen University

Business Group Structure v.s. Conglomerate Structure  Complex group-like organizations are commonplace in the world.  Comparing with the conglomerate organization  Similarity: complex internal resource flows  Difference: legal boundaries, top down control as oppose to horizontal control, complex ownership structure  Because divisions are legally separate entities in a business group, intra-group capital flow becomes an issue to outside minority owners

OwnershipJoseph Fan3 Fusun Group (Shanghai, China) 20 ％ Iron&Steel 25 ％ (2) Commerce Medicine ％ Estate 10% 22% 5% 11.95%(2) 10 ％ 58% 95% ％ 90.3% 20 ％ 90 ％ 1.94 ％ 10 ％ 49 ％ (2) ％ (2) ％ (1) ％ ％ 8.81 ％ ％ ％ (2) 30 ％ 3.77 ％ 30 ％ ％ ％ (1) 48 ％ (2) 20 ％ 21 ％ Shanghai Guangxin Technology Development Co. Ltd. Shanghai Fusun High Technology (Group) Co. Ltd. NISC (600282) FORTE (HK2337) YYTM (600655) ％ Nanjing Iron &Steel United Co.,Ltd. Shanghai Fusun Pharmaceutical Development Co. Ltd. Shanghai Fusun I.T. Development Co. Ltd. (Subsidiary) LRGF (600285) Tianjin Pharmaceutical Holdings, Ltd. TJPC (600488) 中国医药控股有限公 司. ACCORD PHARM (000028) Shanghai Friendship- Fusun (holding) Co. Ltd. SFGIC (600827) Tangshan Jianlong Steel Co. Ltd. Lianhua Supermarket (HK0980) Fusun Pharm (600196) Zhaojin Mining Co. Ltd. JianMin Pharm (600976) Shanghai Fusun High Technology Co. Ltd. Shanghai Fusun Business Investment Co. Ltd. Liang Xinjun GUO Guangchang Wang QunbinFan Wei

Separation between Control and Ownership in a Pyramidal Group Structure Joseph P.H. FanOrganization and Value4 X X V=50% Y V=20% Z V=C=10% Z V=C=50% Y V = 20%, weakest link in the chain, C = 10%. Pyramid structure allows leveraging up in control

Costs of the Group Structure  A body of literature focuses on expropriation of minority shareholders by the controlling parent, e.g., tunneling(Johnson et al.,2000)  Even from the perspective of the whole group, such “tunneling” might not be a zero-sum game.  additional resources to cover up tunneling, potential legal penalties, ex ante distortion of incentives on investments  Investors not systematically fooled, the insider of the business group ultimately bears the welfare loss from tunneling.  Cost of the tunneling is reflected in lower security prices (Claessens et al., 2002; La Porta et al., 2002).

Firms controlled by Pyramids are traded with a discount across all public traded East Asian Firms (Claessens, Djankov, Fan, Lang, Journal of Finance 2002; Based on 3000 East Asian Firms) OwnershipJoseph Fan6

Motivation  Given the costly group structure, what explains the persistent existence and wide prevalence of business groups?  For the whole group in under-developed financial markets: tunneling may be a constrained optimum even if not the first-best outcome, if it  alleviates severe financing constraints of member firms, and  enables the undertaking of positive NPV projects.  Morck, Wolfenzon, Yeung, 2005; Almeida and Wolfenzon, 2006, 2010; Khanna and Yafeh, 2007; Gopalan et al., 2007; Masulis et al., 2010

Empirical Challenge  A key challenge to empirical research demonstrating this tradeoff:  to disentangle the resources diverted to facilitate group efficiency from those diverted to satisfy the private benefits of the controlling shareholder  For minority shareholders: both are tunneling!  But from the business group perspective, sacrificing a division may benefit the whole group  Parent firms typically not observable because of non- listed status

Our attempt  In this paper, we make a modest attempt to bypass the above difficulties by  focusing on transfers of financial resources within business groups, and  testing the hypothesis that intra-group capital flow may be motivated by both group capital allocation efficiency and pure expropriation of minority shareholders.

Business Group and Pyramidal Control Structure in China SAMB Parent Co. (Parent)Parent SOE (Parent) Listed Firm (Listed sub) Private Owner

A Model of Financial Tunneling  Suppose an owner of a business group carves out a subsidiary and lists it, which results in  pair of a publicly listed sub (listed sub) and a non-listed parent company (parent).  Control is one-directional in the firm pair  The public listing allows the owner to raise external capital and create a class of minority shareholders in the listed subsidiary.

Assumptions of the Model  Financial transactions between the pair serve to  fund investment projects in parent or subsidiary  or be consumed by the controlling owner as private benefits.  Legal environment is unable to fully prevent such tunneling activities (Johnson et al., 2000).  The parent company cannot effectively commit to refraining from tunneling because of  the opportunity losses from private benefits and investment opportunities, or  the costs of self-imposed corporate governance constraints.  The non-listed parent is much more financially constrained than the listed subsidiary.

Predictions  Cash flowing in the group is almost one- directional :  from the listed sub to the parent.  We should observe more intra-group cash flow activity (tunneling) if the parent and the listed sub are more severely misaligned in incentives, or if parent faces more financing constraints.

Predictions on magnitude and efficiency of intra- group capital flow activity (tunneling)  D1: High parent ownership stake in sub, less severe fin constraint  D2: High parent ownership stake in sub, severe fin constraint  D3: Low parent ownership stake in sub, less severe fin constraint  D4: Low parent ownership stake in sub, severe fin constraint  Magnitude of capital flow: D4 > D2 & D3 > D1  Efficiency of tunneled capital: D2 > D1 & D4 > D3

Sample and Data  624 firm-year observations from in China  Each obs. includes a pair of firms (Listed sub and Parent).  Financial information from both the listed subs and the non-listed parents  Parent sample comes originally from National Bureau of Statistics’ (NBS) Annual Industrial Survey Database.  Exclude :  “Shell” or holding companies  With missing data  Can’t be indentified in NBS  Less than 20% shares of the listed sub  Parent and the listed sub has the same 3-digit industry code  Negative cash flow 15

Regression Model  Measure of ICF activities: investment of group member firm A out of cash flow of member firm B, controlling for cash flow of firm A ( Shin and Stulz,QJE,1998 ).  Adding firm fixed effects and year dummies.  Run regression for both Listed sub and Parent, compare the results:  ICF exists when β 2 is positive and significant.  For parent, the financing tunneling is efficient when β 4 is positive and significant. 16

Relative investment opportunity  Relative Q = difference in industry Tobin’s q between the parent and the sub  Use industry average q because parent is not listed and to mitigate measurement bias if firm level q is otherwise used

Cash flow measures in the literature  Cash flow=income after tax+ depreciation – dividend payments  Hoshi, Kashyap and Scharfstein (QJE,1991 )  Cash flow=earnings before extraordinary items+ depreciation  Kaplan and Zingales (QJE,1997)  Cash flow=earnings before interest and tax +depreciation + amortization (EBITDA)  Kaplan and Zingales (QJE,1997)  Cash flow=operating profit+ depreciation  Shin and Stulz (QJE,1998); Shin and Park(JCF,1999)

Cash flow measures in our paper  Traditional cash flow measure: EBIT + depreciation  Three adjusted cash flow measures  Adjusted Cash Flow Measure 1: (EBIT)+ depreciation - net change in trade credits  net change in trade credits =increase in accounts receivables - increase in payables  We do not have amortization data.  Rationale:  (EBIT+ depreciation) is the accounting profit.  Reasonable in conglomerates  (EBIT + depreciation - net change in trade credits ) is the amount of cash that is available for use by either own firm or the other firm.  A large fraction of EBIT take the form of trade credits.

Cash flow measures in our paper  Example:  Suppose a listed sub has a total EBIT of $100,of which $30 is the increase of trade credits, then available CF is $70.  Two possibilities of this $30 trade credits :  naturally arise due to normal transactions  only $70 available for tunneling, adjusted measures is appropriate  implicit loans from one firm to the other  $100 available for tunneling, traditional measures is appropriate 20

Cash flow measures in our paper  Which one more closely resembles the reality is an empirical question.  If adjusted CF measure underestimates tunneling relative to the traditional CF measure, investment should be less sensitive to the adjusted CF measure than to the traditional CF measure.  we found stronger sensitivity between investment of the parent and the adjusted CF of the listed sub, suggesting that  the adjusted CF measure does not underestimate tunneling.  Traditional CF measure may be noisy.  It appears that tunneling in China takes less obvious forms than through the extension of trade credit 21

22 Cash flow measures in our paper  Adjusted Cash Flow Measure 2: EBIT + depreciation -net change in trade credits- income tax  Adjusted Cash Flow Measure 3: EBIT + depreciation -net change in trade credits - income tax + net increase of bank debts and equities.  For adjusted cash flow measure1, we have data from both Parent and Listed sub  For adjusted cash flow measure 2 and 3, we only have data from Listed sub.

Summary Statistics 23 VariableObs.MeanMedianMeanMedian Listed SubParent Capital Expenditure Net Trade Credits Traditional Cash Flow Measure Adjusted Cash Flow Measure Adjusted Cash Flow Measure —— Adjusted Cash Flow Measure —— Industry Q Relative Q Industry Growth Cash Flow Right of Parent —— Bank Ownership Dummy —— Size (thousand Yuan)

24 Panel AListed Sub Regression Cash Flow Measure Traditional CF MeasureAdjusted CF Measure 1 Own Cash Flow (0.1154)***(0.1261)***(0.0547)***(0.0603)*** Other Cash Flow (0.0301)(0.0357)(0.0178)(0.0189) Relative Q (0.0126)*(0.0138)*(0.0112)*(0.0119)* Other Cash Flow * Relative Q (0.0176)(0.0210) Adj_R2604 Panel BParent Regression Cash Flow MeasureTraditional CF MeasureAdjusted CF Measure 1Adjusted CF Measure2Adjusted CF Measure 3 Own Cash Flow (0.0565)***(0.0579)***(0.0654)***(0.0689)***(0.0502)***(0.0511)***(0.0534)***(0.0541)*** Other Cash Flow (0.0445) **(0.0466) *(0.0564)***(0.0576)***(0.0413)***(0.0389)***(0.0367)***(0.0278)*** Relative Q (0.0081)**(0.0102)(0.0068)**(0.0087)*(0.0101)*(0.0113)(0.0122)(0.0112) Other Cash Flow * Relative Q (0.0551)(0.0750)**(0.0682)*(0.0449)** Adj_R2 604

25 Impact of corporate governance and financing constraint on ICF  Ownership is fundamental to – and cash flow rights theoretically at the core of – corporate governance.  Empirically strongly related to the incentives of large shareholders to tunnel the listed firms that they control (Bertrand,et.al, 2002; Claessens,et.al, 2002).Especially when legal protection for outside investors is weak (La Porta,et.al, 1997, 1998, 1999)  Bank ownership has been argued to be important to firms for raising external finance(e.g, Hoshi, et.al,1991)  Bank ownership in this paper: A dummy variable whether listed sub(under Parent’s control ) owns shares of local financial banks.

Cash Flow MeasureAdjusted CF Measure 1 Own Cash Flow (0.0434)***(0.0483)*** Other Cash Flow (0.0972)(0.0884)* Relative Q (0.0093)(0.0089)* Other Cash Flow * Relative Q (0.0622)**(0.0618)* Low Cash Flow Right (0.0322) No Bank Ownership (0.0297) Low Cash Flow Right * Other Cash Flow (0.0676)** Low Cash Flow Right * Other Cash Flow* Relative Q (0.0303)** No Bank Ownership * Other Cash Flow (0.0483)** No Bank Ownership * Other Cash Flow* Relative Q (0.0401)** Obs.604 Adj_R20.24

27 Putting the two effects together  We next examine the joint effects of corporate governance and financing constraints.  Consider four types of interactions of corporate governance and financing constraints:  D1: high cash flow right and with bank ownership;  D2: high cash flow right and without bank ownership;  D3: low cash flow right and with bank ownership;  D4: low cash flow right and without bank ownership  D 1 as the benchmark

28 Cash Flow MeasureAdjusted CF Measure 1 (1) (2) Own Cash Flow (0.0412)***(0.0475)*** Other Cash Flow (0.0698)(0.0657) Relative Q (0.0084)**(0.0091) Other Cash Flow* Relative Q (0.0693) D (0.0347)(0.0384) D (0.0691)(0.0754) D (0.0287)(0.0332) D2* Other Cash Flow (0.0621)**(0.0642)* D3* Other Cash Flow (0.0558)**(0.0527)* D4* Other Cash Flow (0.0726)***(0.0825)** D2* Other Cash Flow* Relative Q (0.0728)** D3* Other Cash Flow* Relative Q (0.0358)*** D4* Other Cash Flow* Relative Q (0.0452) Obs.604 Adj_R

Robust Tests Using Alternative Measure of Intra-group Cash Flows  Conventional measure of investment-cash flow sensitivity still comes as an estimate of the true capital flows  Two more direct measures for intra-group capital flow :  ORECTA : Other Receivables deflated by total assets  Jiang et al (2010)  GORECTA ： Other Receivables provided to controlling shareholder deflated by total assets

Dep. VariableORECTAGORECTA_Parent (1)(2)(3)(4) Low Cash Flow Right (0.0040)*(0.0034)*** No Bank Ownership (0.0019)*(0.0021)** Low Cash Flow Right * Relative Q (0.0094)**(0.0024)*** No Bank Ownership * Relative Q (0.0120)**(0.0042)** Relative Q (0.0056)(0.0111)(0.0032)(0.0066) ROA (0.0344)***(0.0341)***(0.0234)***(0.0231)*** Size (0.0012)*(0.0012)(0.0009)*** State (0.0066)*** (0.0045) Marketization (0.0014)*(0.0016)(0.0011)*** Layer (0.0035)**(0.0036)**(0.0024)** Obs.604 Adj_R

Dep. VariableORECTAORECTA_Parent (1)(2)(3)(4) D (0.0021)(0.0022)(0.0028)**(0.0027)** D (0.0051)*(0.0052)(0.0031)**(0.0033)** D (0.0040)***(0.0042)*(0.0036)***(0.0049)** D2* Relative Q (0.0200)**(0.0105)** D3* Relative Q (0.0193)***(0.0126)*** D4*Relative Q (0.0161)(0.0130) Relative Q (0.0047)(0.0284)(0.0032)(0.0124)* ROA (0.0345)*** (0.0234)***(0.0235)*** Size (0.0012) (0.0009)*** State (0.0067)** (0.0045)(0.0046) Marketization (0.0016) (0.0011)*** Layer (0.0036)** (0.0024)** Obs.604 Adj_R

32 Other Robust Tests  Alternative proxy for investment opportunities:  Industry Q: industry average Q matched from listed firms in China’s stock market.  Industry Growth: Industry average sale growth calculated from NBS  Event of corporate governance change:  Capital market regulation against expropriation by controlling shareholder from  Alternative proxy for financing constraints:  Firm size (Almeida and Campello, 2007; Erickson and Whited, 2000)

Industry Q and Industry Growth D2* Other Cash Flow (0.0512)** D3* Other Cash Flow (0.0486)* D4* Other Cash Flow (0.0684)** D2* Other Cash Flow* Industry Q (0.0714)** D3* Other Cash Flow* Industry Q (0.0701)*** D4* Other Cash Flow* Industry Q (0.0357) Obs. 604 Adj_R D2* Other Cash Flow (0.0516)** D3* Other Cash Flow (0.0486) D4* Other Cash Flow (0.0791)** D2* Other Cash Flow* Industry Growth (0.0472)*** D3* Other Cash Flow* Industry Growth (0.0273)** D4* Other Cash Flow* Industry Growth (0.0619) Obs. 604 Adj_R2 0.26

Capital Market Regulation Dep. VariableORECTAORECTA_Parent (1)(2) Regulation (0.0078)***(0.0054)*** Regulation * Relative Q (0.0053)*(0.0020)** Relative Q (0.0076)(0.0048) ROA (0.0341)***(0.0231)*** Size (0.0012)(0.0009)*** State (0.0066)***(0.0044) Marketization (0.0016)(0.0011)*** Layer (0.0036)**(0.0024)** Obs. 604 Adj_R Regulation =1 if sample year is Cash Flow MeasureAdjusted CF Measure 1 (1)(2) Own Cash Flow (0.0446)***(0.0425)*** Other Cash Flow (0.0655)***(0.0754)** Relative Q (0.0084)*(0.0099) Other Cash Flow * Relative Q (0.0665)* Regulation (0.0226)***(0.0266)** Regulation * Other Cash Flow (0.0356)*(0.0288)* Regulation * Other Cash Flow* Relative Q (0.0658)* Obs.604 Adj_R Panel A: Investment-Cash Flow Sensitivity ModelPanel B: Capital Flow Determinant Model

Firm Size Dep. VariableORECTA ORECTA_Paren t (1)(2) Small Size (0.0044)***(0.0021)** Small Size * Relative Q (0.0020)**(0.0050)* Relative Q (0.0041)(0.0048)* ROA (0.0343)***(0.0233)*** Size (0.0012)(0.0009)*** State (0.0066)**(0.0044) Marketization (0.0016)(0.0011)*** Layer (0.0036)**(0.0024)** Obs. 604 Adj_R Small Size=1 when parent firm size is below the median of sample. Cash Flow MeasureAdjusted CF Measure 1 (1)(2) Own Cash Flow (0.0528)***(0.0513)*** Other Cash Flow (0.0755)**(0.0822)** Relative Q (0.0084)**(0.0086) Other Cash Flow * Relative Q (0.0725)* Small Size (0.0286)***(0.0301)*** Small Size * Other Cash Flow (0.0486)**(0.0496)* Small Size * Other Cash Flow* Relative Q (0.0391)** Obs.604 Adj_R Panel A: Investment-Cash Flow Sensitivity Model Panel B: Capital Flow Determinant Model

36 Conclusion  We document the existence of two aspects of intra- group financing using 604 pair-years of Chinese listed firms and their non-listed parents :  cross-financing to mitigate severe financing constraints, and  the exploitation of minority shareholders due to weak corporate governance.  Both can account for the rise of intra-group financing, but they have opposite impacts on group capital allocation efficiency:  highest when the motivation is purely the mitigation of financial constraints, and  lowest when it is purely expropriation of outside investors.

Thank You!