Internal capital market in emerging markets: expropriation and mitigating financing constraints

1
Internal capital market in emerging markets
expropriation and mitigatingfinancing constraints

• July 8, 2008
• SUFE School of Accounting
• Joseph P.H. Fan Chinese University of Hong
  Kong
• Li Jin Harvard Business School
• Guojian Zheng Chinese University of Hong Kong

2
Motivation

• Considerable literature on functioning of
  internal capital markets (ICM) in developed
  markets.
• The literature largely focuses on internal versus
  external resource allocation efficiency.
• The implicit assumption is that both external
  financing and internal financing are feasible,
  although in some circumstances one is preferable
  to the other due to agency problems and
  informational asymmetry.
• Cross-subsidization of divisions (Rajan, Servaes,
  and Zingales 2000, Scharfstein and Stein 2000).
• Headquarter allocation efficiencies (Williamson,
  1985, Stein 1997).

3
Motivation

• In emerging markets, all the above arguments
  apply.
• However, the emerging nature of the market leads
  to two distinct features
• Severe and chronic financial constraints
• Rampant expropriation of minority shareholders
  (tunnelling)
• Understanding how internal capital market in
  emerging market reflects both the need to
  mitigate severe financing constraints and the
  desire of controlling shareholders to expropriate
  minority investors will help shed light on the
  functioning and roles of internal capital markets
  in general.

4
Unique Setting of China

• In China, firm IPOs are subject to a quota
  system.
• Big companies often spin off subsidiaries, and
  list subs.
• Result pairs of publicly listed firms (LFs) and
  their non-listed parent companies (HQs).
• HQs typically retain controlling stake in LFs,
  but have dispersed outside equity investors
  taking rest of shares.
• Compare to Business Groups
• Legally independent entities with close
  relationship financially and operationally.
• But control is one-directional (HQs controlling
  LFs).
• Most comparable to a pyramid structure.

5
Asymmetric Pattern of the Flow of Internal
Financing

• Since HQ is not a public company, it typically
  has higher liquidity/financing constraint than
  the LF.
• In addition, the pyramid structure of control
  might give HQ some incentive to expropriate the
  minority investors in LF, through its controlling
  position. This could happen particularly if the
  corporate governance of the LF is weak.
• Both of these might a priori lead to the
  prediction that Cash Flows generated in the firm
  pair is more likely to flow from LF to HQ, if ICM
  is at work.

6
Magnitude and Efficiency of ICM

• Two possibilities
• ICM can arise due to expropriation of minority
  outside shareholders (tunnelling).
• More prevalent if HQ has less cash flow stake in
  LF (but still control), or if other corp.
  governance mechanisms are weak
• The cash flows expropriated might not be put into
  very productive use. Efficiency of HQ investment
  out of LF cash flow could be low.
• ICM can also arise to mitigate severe financing
  constraint.
• More likely when HQs are severely financially
  constrained.
• Cash is flowing into HQs in pursuit of better
  investment opportunities. Efficiency could be
  higher.

7
Preview of Results (1)

• Measure the ICM activities using the conventional
  measure how responsive is the investment
  activity of one firm (division) to the cash flow
  of another firm (division), controlling for own
  firm cash flows and firm and year fixed effects.
• Document a strong presence of ICM in the overall
  sample.
• Furthermore, the effect is asymmetric
• HQ investment is MUCH MORE responsive to LF cash
  flows than vice versa.
• HQ investment is also much more responsive to own
  firm cash flows, suggesting HQs are more
  financially constrained.

8
Preview of Results (2)

• When separately estimated, for LFs with weak
  corporate governance measures, the pair has
  bigger ICM activities. Furthermore, the
  investment efficiency of such ICM is low
• When separately estimated, for HQs with more
  severe financing constraints, the pair has bigger
  ICM activities. Moreover, the efficiency of such
  ICMs tend to be not lower.
• When putting both together, we see that weak
  corporate governance encourages the ICM and the
  efficiency of such ICM is lower, whereas severe
  financing constraint of HQs also encourage ICM
  but the efficiency of such activities is not
  lower (could be even higher).

9
Preview of Results (3)

• Taken together, our results suggest that in
  emerging markets, the existence and efficiency of
  ICMs reflect a trade-off of two contributing
  factors the need to mitigate severe financing
  constraints and the desire by controlling
  shareholders to expropriate minority outside
  shareholders.

10
Data and Measure

• 1324 firm-year observations spanning six years
  2000-2005, each obs. consists of one year and one
  pair of firms (LF and HQ).
• Financial information from both the public
  companies (LFs) and the private companies (HQs).
• Measure of ICM activities investment of firm A
  out of cash flow of firm B, controlling for cash
  flow of firm A.
• Cash flow EBIT adjusted by the changes in Net
  Working Capital.
• Rationale EBIT is the accounting profit. (EBIT
  change in NWC) is the amount of cash that is
  AVAILABLE for use by either own firm or the other
  firm.

11
Data and Measure

• E.g., EBIT100, AR increased by 30 and nothing
  else changes, so 100-3070 available for
  investing by either own firm or other firm.
• This is a conservative estimate of the true
  inter-firm cash flows. Presumably, some ICM
  activities could take place through extending
  trade credits.
• However, for the Chinese firm pairs, many LFs are
  artificially spun off from HQ for the IPO, so
  they are likely highly interdependent
  operationally after the spin-off.
• For example, LF might be a production unit that
  sells its intermediate goods to the HQ. So it
  will have a large AR.
• We do not want to attribute trade credits arising
  naturally from business interdependences to ICMs.
• We might be conservative in our estimates.

12
Data and Measure
13
Data and Measure
14
Regression Results

• Table 4
• Run regression for both LF and HQ, compare the
  results.
• Adding firm fixed effects and year dummies.

15
Table 4
16
Regression Results

• ICM exists for both LFs and HQs, but much
  stronger financial constraints for HQs (own cash
  flow coefficients are 5 times larger), and also
  much stronger effect of ICM (other cash flow
  coefficient 10 times larger).
• Overall, there is indication that HQ investment
  out of LF cash flows are inefficient the
  interaction term on other cash flow sales
  growth rate in the HQ regression is negative.

17
Regression Results

• How does corporate governance affect the
  intensity and efficiency of ICM activities?
• Table 5 Run regression separately for firms with
  above or below median level of corporate
  governance measures.
• A variety of different proxies for corporate
  governance levels.

18
Table 5, Panel A
19
Regression Results

• Table 5 Panel A split the sample into above or
  below median cash flow rights of HQ in LF (higher
  cash flow rights indicate better alignment of HQ
  and LF interest).
• While there are ICM activities in the HQ
  regressions for both subsamples, the magnitude of
  ICM is bigger (coefficient on other cash flow
  twice as large) for the subsample with
  below-median HQ cash flow rights in LF.
• Also, the investment is inefficient for that
  subsample the coefficient on the other cash
  flowsales growth is significantly negative.
• Other panels show consistent results when
  measuring corporate governance strength using
  ownership type (SOE vs. non-SOE), CEO
  entrenchment (same CEO for both firms), and a
  measure of external governance strength.

20
Financing Constraints

• Table 6 Run regression separately for firms with
  above average or below median financing
  constraint measures.
• Measures of financing constraints Existing
  leverage, working capital ratio, size, and
  financial constraint score.
• According to the existing literature, in general,
  firms face more financing constraints when
  existing leverage is higher (Cleary, 1999 2006),
  working capital ratio ((current assets-current
  liabilities )/total assets) are lower (Cleary,
  1999 2006) and size is smaller (Cleary,2006
  Hubbard, 1998) and FC Score is higher (Cleary,
  1999 2006).

21
Table 6, Panel A (higher leverage is more
constrained)
22
Regression Results

• Table 6 Panel A run regression for subsamples
  with above and below median level of leverage.
• While there are ICM activities in the HQ
  regressions for both subsamples, the magnitude is
  bigger (coefficient on other cash flow twice as
  large) for the subsample with higher leverage.
• Also, the investment is less inefficient for that
  subsample the coefficient on the other cash
  flowsales growth term is insignificantly
  negative and much smaller in magnitude compared
  to the other subsample, by both measures of sales
  growth.
• Other panels show consistent results when
  measuring financing constraints using working
  capital ratio, size and financing constraint
  score.

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Putting the two together

• Table 7-10 Run regression with various
  combinations of the corporate governance measures
  and the financing constraint measures.
• Four possible combinations
• Corporate governance above median or below
  median.
• Financing constraints above median or below
  median.
• If both are operative, we would expect to see ICM
  being the least efficient when corporate
  governance is bad, and the firms dont face
  severe financing constraint.

24
Table 7, Panel A (Cash Flow Right and Firm
Leverage)
25
Regression Results

• Table 7-10 Run regression with various
  combinations of the corporate governance measures
  and the financing constraint measures.
• Table 7, Panel A when corporate governance is
  bad (lower cash flow rights) and financing
  constraint for HQ is not severe (lower leverage
  ratio), the efficiency of ICM is the lowest
  (corresponding to the negative and significant
  coefficients on the interaction term other cash
  flow sales growth in columns (4) and (8).
• Results are largely consistent across a variety
  of measures of corporate governance/financing
  constraints.

26
Conclusion

• We focus on two aspects of the internal capital
  market that are less commonly seen in the
  developed markets a cross-financing to get over
  severe financing constraints that are often
  prevalent in emerging market economies, and the
  rampant expropriation of minority shareholders
  due to weak corporate governance. We document the
  existence of both.
• Our results suggest that internal capital market
  in emerging market economies might serve two
  distinct roles it helps mitigate severe
  financial constraints, while at the same time can
  be used to expropriate outside investors,
  particularly when the corporate governance
  mechanism is bad.