Financial Constraints and the Costs and Benefits of Vertical Integration

1
Financial Constraints and the Costs and Benefits
of Vertical Integration

• Rocco Macchiavello
• Nuffield College (Oxford) and CEPR
• Gerzensee, July 5th, 2007

E-Mail rocco.macchiavello_at_nuffield.ox.ac.uk
2
Financial Constraints and the Costs and Benefits
of Vertical Integration
Preliminary Comments Very Welcome !!

• Rocco Macchiavello
• Nuffield College (Oxford) and CEPR
• Gerzensee, July 5th, 2007

E-Mail rocco.macchiavello_at_nuffield.ox.ac.uk
3
Plan of the Talk

• Motivation / Question / Preview
• Related Literature
• Outline of the Model
• Main Predictions
• Discussion Concluding Remarks

4
Plan of the Talk

• Motivation / Question / Preview
• Related Literature
• Outline of the Model
• Main Predictions
• Discussion Concluding Remarks

5
Motivation

• 1. Firms are often financially constrained in
  poor as well as rich countries
• (e.g. Banerjee and Duflo (2005), World Bank, )
• Countries differ in their level of financial
  development. These differences have been shown to
  be important determinants of industrial growth
  and dynamic as well as trade patterns
• ((Rajan and Zingales (1998), Levine (2004), )
• 3. There is evidence that, in the same
  industries, supply chains are organized
  differently across countries
• - importance of items reflecting interactions
  among firms in corporate balance sheets (Rajan
  and Zingales (1995), Shin (2007))
• - role of business groups in LDC (Khanna and
  Palepu (2002),
• - institutional determinants of vertical
  integration (Acemoglu et al. (2007), Macchiavello
  (2007))
• - 19th Century textile industry (Temin (1987))
• 4. Research Agenda Relationship between
  Financial Institutions and Industrial Structure

6
Question and Preview

• Is there any motive for vertical integration
  purely driven by financial constraints?
• This paper identifies a trade-off
• 1. A consolidated balance sheet is good
  because it is insensitive to uncertainty in
  ex-post surplus allocation,
• 2. However, market transactions impose
  discipline

7
Determinants of Vertical Integration

• Intuition is captured in a very simple model.
• Preliminary Comparative Statics Results
• Vertical integration is more likely to be chosen
  if
• assets are more specific,
• there is higher uncertainty in input markets,
• more unequal distribution of ex-post bargaining
  power

8
Related Literature

• Modern theories of the firm
• - PR approach, Grossman-Hart-Moore (1986, 1990,
  1995),
• - TC approach, Williamson (1971, 1975, 1985)),
• - Holmstrom (1999), Holmstrom and Tirole (1987,
  1991) approach,
• Conglomerates and internal organization of firms
• - Inderst-Mueller (2003), Faure-Grimaud and
  Inderst (2005), Almeida-Wolfenzon (2006), Stein
  (2004)s survey
• Control Rights with no cash
• - Legros and Newman (2000/2004), Aghion and
  Tirole (1994), Aghion and Bolton (1992),
• 4. Legal theories of the firm
• - Hausmann and Kraakman (2001) and Cheung (1983)

9

• Model Set Up

10
Model Outline t 0

• There are 3 risk neutral agents an upstream
  manager (u), a downstream manager (d) and an
  investor (I). No discount.
• The two managers have no cash and are unable to
  finance the fixed costs to engage in production
• The investor has deep pockets and has all the
  bargaining power at the ex-ante contracting stage
  
• Ex-ante parties agree on an initial contract (a
  vertical structure and debt contracts) that
  maximizes the expected repayments to the investor
  (pledgeable income)

11
Model Outline t 0

• The model allows for
• 1. Two vertical structures (non-integration and
  vertical integration)
• 2. Simple debt contracts in which the owner(s)
  commit to repay back a fixed amount

12
Input Trade Configurations
Internal Trade
d/u
d/u
output
input
Vertical Integration
Market Trade
Sell input at price p
d/u
d/u
output
Procure input at price p
13
Input Trade Configurations
Internal Trade
input
d
u
output
negotiated price P
Non Integration
Market Trade
Sell input at price p
d
u
output
Procure input at price p
14
Model Outline t 1/2

• State of the world is realized and observed by
  the two managers
• States of the World
• two (independent) events
• 1. w.p. p internal trade yields high cash flows
• w.p. (1- p) internal trade yields low cash
  flows
• market trade always yields cash flows
• The price at which the input can be sold /
  purchased on the market is a uniform random
  variable

15
Model Outline t 1

• Managers take actions
• Under Vertical Integration
• the owner of the firm decides trade action,
• Under Non Integration
• - to trade internally, d makes a TIOLI offer P
  to u for the intermediate good,
• - no bargaining to trade on the market
• Outside Option in the bargaining is given by
  market price p

16
Model Outline t 2

• Profits are realized
• Owners can hide and keep a fraction f of profits.
  If she does, investors get nothing.
• Contingent on verifiable profits, debt claims are
  executed

17
Model Outline Initial Contract and Timing of
Events
t 0
t 1
t 2
t 1/2
18
Model Outline Initial Contract and Timing of
Events
t 0
t 1
t 2
t 1/2

• Contracts between the two managers
• and the external investor are signed.
• - Vertical structure
• Financial contract(s)

19
Model Outline Initial Contract and Timing of
Events
t 0
t 1
t 2
t 1/2
State of nature is realized and observed by
managers
20
Model Outline Initial Contract and Timing of
Events
t 0
t 1
t 2
t 1/2
Under Vertical Integration Buyer decides trade
configuration. Under Non-Integration Given
debts, firms bargain over input transaction.
21
Model Outline Initial Contract and Timing of
Events
t 0
t 1
t 2
t 1/2
Profits are realized. Owner(s) decide whether
to hide the profits of the firm(s)
22
Parametric Assumptions

• Assumptions
• A1
• A2

23

• Vertical Integration

24
Vertical Integration

• The vertically integrated structure looks very
  similar to the textbook model of entrepreneurial
  firm
• Let B denote the debt level
• Conditional on profits , the possibility of
  hiding profits implies that B is repaid if and
  only if
• Since
• the efficient action is always taken, regardless
  of B

25
Vertical Integration

• Investor trade-off higher debt, with higher
  probability of being repaid
• If debt is repaid for sure,
• If debt is repaid with probability p,
• Proposition 1
• The pledgeable income under vertical integration
  is
• Pledgeable income under integration is
• Increasing in investors' protection (? f)
• Increasing in V

26

• Non Integration

27
Non Integration

• Game has to be solved backward,
• (With a mild abuse of notation) denote with
• the probability of
• where if in state s, j repays debt
• I() is given by a set of IC constraints imposed
  by possibility of hiding profits and bargaining
  outcome

28
Non Integration

• analyze all possible bargaining scenarios as a
  function of debt levels Bu and Bd
• Lemma 1
• i) d always offers P p
• ii) the chosen action is always the efficient
  one
• Lemma 2
• Lemma 2 implies

29
Non Integration

• Investor trade-off higher debt, with higher
  probability of being repaid
• If debt is repaid for sure,
• If debt is repaid with probability s,
• Proposition 2
• The pledgeable income of the upstream firm is
• Pledgeable income of upstream firm is
• Increasing in investors' protection (? f)
• Increasing in upstream expected profits p
• Non monotonic in uncertainty e

30
Non Integration

• If debt is repaid for sure,
• and so on. There are now 4 candidate solutions.
  
• Proposition 3
• Assume A1 and A2
• The pledgeable income of the upstream firm is
• Pledgeable income of upstream firm is
• Increasing in investors' protection (? f)
• decreasing in upstream expected profits p
• Non monotonic in uncertainty e

31

• Determinants of
• Vertical Integration

32
The Costs and Benefits of Vertical Integration

• Vertical integration presents a trade-off in
  terms of pledgeable income
• A. () consolidation effect
• With a consolidated balance sheet investors do
  not need to worry about uncertainty in the
  ex-post allocation of surplus.
• VI centrally organizes the nexus of contracts
  ? contractual externalities
• CE arise because investors are not sitting at the
  input transaction bargaining table
• ? i) cash-pooling (Inderst and Mueller (2003)),
  ii) diversification (Diamond (1984), Fluck et al.
  (1999)), iii) winner picking (e.g. Stein (1997))
• B. () market discipline effect
• - vertical integration suppress the bargaining
  process typical of market transactions a larger
  organization is less transparent and harder to
  monitor,
• - Market bargaining generates information for
  third parties

33
The Costs and Benefits of Vertical Integration

• Consolidation effect is intuitive
• Remarks on market discipline effect
• - Williamson (1971) " (...) unable to monitor
  the performance of large, complex organizations
  in any but the crudest way (...) investors demand
  larger returns as finance requirements become
  progressively greater, ceteris paribus".
• Some evidence that banks base their
  credit-granting decisions on information about
  the trade credit relationships between the firm
  and its input suppliers (Garcia-Appendini
  (2006)).
• Information on trade credit can be obtained from
  credit information brokers such as DB (hard
  information), more often banks can still check
  with the firm's suppliers (soft information).
• This information, becomes unavailable if the firm
  is integrated, and the supplier is an employee of
  the firm.

34
Determinants of Integration

• Highly specific assets should be jointly managed
  and financed
• - Bargaining between firms generates information
  for investors. The higher p, the lower the
  benefits of the discipline effect
• - Implications for Do firms boundaries
  matter?
• - vertically integrated firms are more likely to
  trade internally a selection effect

35
Determinants of Integration

• Highly specific assets should be jointly managed
  and financed
• - Bargaining between firms generates information
  for investors. The higher p, the lower the
  benefits of the discipline effect
• - Implications for Do firms boundaries
  matter?
• - vertically integrated firms are more likely to
  trade internally a selection effect
• 2. Non integration is more likely if e is small
• - lower uncertainty over division of the surplus
• - input market thickness

36
p
1
Integration
1/2
Uncertainty over appropriate action
Non Integration
e
p / 3
Uncertainty over surplus allocation
37
Determinants of Integration

• Highly specific assets should be jointly managed
  and financed
• - Bargaining between firms generates information
  for investors. The higher p, the lower the
  benefits of the discipline effect
• - Implications for Do firms boundaries
  matter?
• - vertically integrated firms are more likely to
  trade internally a selection effect
• 2. Non integration is more likely if input
  markets are thicker
• - lower uncertainty over division of the surplus
• 3. Non integration is more likely if is
  high
• - Caveat result is reversed if seller makes
  TIOLI offer
• - Market is useful only if power is somewhat
  symmetric

38
Determinants of Integration

• 4. The model fails to deliver two comparative
  statics
• Investors protection has no effect on
  integration
• (if not through industry equilibrium effects)
• Scale has not effect on the integration decision
• Linearity

39

• Discussion

40
Related Literature

• Modern theories of the firm
• - PR approach, Grossman-Hart-Moore (1986, 1990,
  1995),
• - TC approach, Williamson (1971, 1975, 1985)),
• - Holmstrom (1999), Holmstrom and Tirole (1987,
  1991) approach,
• Conglomerates and internal organization of firms
• - Inderst-Mueller (2003), Faure-Grimaud and
  Inderst (2005), Almeida-Wolfenzon (2006), Stein
  (2004)s survey
• Control Rights with no cash
• - Legros and Newman (2000/2004), Aghion and
  Tirole (1994), Aghion and Bolton (1992),
• 4. Legal theories of the firm
• - Hausmann and Kraakman (2001) and Cheung (1983)

41
Discussion

• Previous Draft uncertainty over private benefits
  from wrong action
• - efficient action is not always chosen,
• - selection governance effect w.r.t. p
• - markets ? monitoring effect
• - comparative statics on f
• b

42
(No Transcript)
43
(No Transcript)
44
Discussion

• The model defines a firm as an organization with
  centralized allocation of control rights and
  centralized (i.e. joint) financial liabilities
• 2. Legal Scholars
• "To serve effectively as a nexus of contracts, a
  firm must generally have two attributes. The
  first is well defined decision-making authority.
  More particularly, there must be one or more
  persons who have ultimate authority to commit the
  firm to contracts" ... "The second attribute a
  firm must have, ... is the ability to bond its
  contracts credibly .... Bonding commonly requires
  that there exist a pool of assets that the firm's
  managers can offer as satisfaction for the firm
  obligations Hausmann and Kraakman (2001)
• Business Historians
• "no clear economic boundary distinguished
  ordinary contracts from those considered by the
  law to be firm (...) business people could choose
  from a range of contractual forms that offered
  varying degrees of firmness". Lamoreaux (1998)
• Firmness is defined along two dimensions
  liability and firm's autonomy

45
(No Transcript)
46
Discussion

• Centralization in ownership and financial
  liabilities markets vs. hierarchies
• - What about hybrids?
• - Joint liability contracts between two separate
  firms
• - Guess because of f gt 0 JL contracts do not
  make non integration always optimal
• - Moreover, JL contracts might have important
  incentive costs
• (Contractual) externalities at the financing
  stage (common destiny)

47
Discussion

• Centralization in ownership and financial
  liabilities markets vs. hierarchies
• - What about hybrids?
• - Joint liability contracts between two separate
  firms
• - Guess because of f gt 0 JL contracts do not
  make non integration always optimal
• - Moreover, JL contracts might have important
  incentive costs
• (Contractual) externalities at the financing
  stage (common destiny)
• Mechanism Design and Optimal Contract

48

• Thanks !!