Power struggles, tunneling incentives, and investment efficiency in diversified business groups

Abstract

Unlike conglomerates in the U.S., where investment flows may be distorted due to power struggles (Rajan, Servaes, and Zingales (2000)), we find that diversified business groups in India, on average, invest efficiently. Our analysis controls for the possibility of tunneling (Bertrand, Mehta, and Mullainathan (2002)) and examines firm level as well as group level investment flows. At the firm level, we find that investment flows are consistent with the Efficient Internal Capital Markets Hypothesis and incentives for investment distortion due to power struggles do not exist. We also find that investment flow (in the “right direction”) increases with diversity in resource-weighted opportunities among those group-firms that have high resources attached to them, suggesting that the allocation of resources is consistent with the Efficient Internal Capital Markets Hypothesis where it matters more.

At the firm level, we also find that investments flow from group-firms where the controlling family holds low cash flow rights to firms where the controlling family holds high cash flow rights suggesting tunneling. However, we find that it is only in the group-firms with low growth opportunities that investment flows are related to diversity in cash flow rights, as predicted by the Tunneling Hypothesis. Again, where it matters more (group-firms with high growth opportunities), investment decision making in business groups is consistent with the Efficient Internal Capital Markets Hypothesis. We also find that the presence of relational contracts in business groups mitigates the adverse effects of tunneling incentives, consistent with the internal governance argument in Acharya, Myers, and Rajan (2011).

Overall at the group level, our results suggest that investment distortions due to power struggles and tunneling are swamped by efficiency considerations, and investment decisions in diversified business groups are largely consistent with Efficient Internal Capital Markets Hypothesis.