Why Do Family Business Groups Expand by Creating New Public Firms? The Role of Internal Capital Markets
In public equity markets around the world, corporations pursue distinctly different approaches to funding investment opportunities with external equity capital. In developed capital markets, publicly listed firms generally raise capital with seasoned equity offerings (SEOs), whereas in emerging markets, investment opportunities are frequently financed through initial public offerings (IPOs) of divisions or private affiliates of closely held public firms. Such IPOs result in the creation or expansion of business groups, which are prevalent in many parts of the world.
Our study examines the conditions under which business groups form or expand by raising capital through IPOs for their private entities. We construct a novel international dataset that identifies the pre-IPO controlling owners of 12,793 newly listed firms in 44 countries. Our data also provide detailed time-varying ownership structures of business groups around the world. This allows us to show for the first time a comprehensive picture of the sources of capital that helps incubate emerging investment projects and facilitate their tapping local equity capital market. This activity is economoically significant. In emerging markets, IPOs associated with business groups account for more than a quarter of all equity capital raised. Family-controlled business groups are dominant in this process. In some markets, these groups raise over 40% of the total IPO issue proceeds.
Why do family business groups prefer IPOs rather than SEOs in some financing circumstances? Consistent with the business group literature, we show that one important motive for this funding choice is that it reconciles the conflict between raising external equity capital and retaining control. Funding a new investment project as a private division of an existing public listed firm can require a large offering of voting shares that critically dilutes a family’s control rights in the issuing firm, whereas creating a separate publicly listed firm allows a family to raise substantial amount of new equity, while leaving their control rights in existing public affiliates untouched.
However, undertaking an IPO can be difficult given the high financing barriers that the stock market imposes on new firms. We show that in this situation, family business groups can utilize their internal capital to incubate difficult-to-finance investment projects, making it feasible for them to access outside equity to further support these projects through a subsequent IPO. Such support is most observable when an IPO resolves the family’s trade-off between raising external equity and maintaining control and when new-firm financing barriers are high. Our analysis is robust to an identification strategy exploiting exogenous internal capital variations generated by changes to corporate dividend tax rates in different countries.
We also explore additional channels of internal capital support. We find that future IPO firms tend to be incorporated as subsidiaries of existing publicly listed affiliates with abundant cash flows. Before going public, these subsidiaries also tend to receive additional investments from other internal-capital-rich affiliates beyond their direct parents. Overall, our study provides evidence in support of a number of important theories on the financing advantage of business groups and shows that family business groups play an important economic function akin to that of venture capitalists and private equity investors in many emerging markets.