Faculty of law blogs / UNIVERSITY OF OXFORD

Capital Allocation Efficiency of Firms Outside the Business Group


Yunxiao Liu
Woochan Kim
Taeyoon Sung

Studies on business groups have increased significantly in the past two decades, and the specific research questions motivating them have broadened over time. However, the existing literature scarcely investigates the influence that business groups exert on other economic sectors. Business groups do not exist in a vacuum; they coexist with other types of firms and compete against one another in product and input markets. Business group firms’ successful input mobilization may actually imply a lack of necessary input for non-affiliated firms and the disruption of their investments in a country with scarce capital and labor input. Efficient capital allocation within business groups, in other words, may not guarantee economy-wide capital allocation efficiency. However, existing literature on business groups is virtually silent on this subject.

This study fills this gap in literature by investigating the association between business groups’ influence and the capital allocation efficiency of firms outside the business group. We specifically ask the following questions: Can firms without group affiliations efficiently allocate capital in industries with dominant group-affiliated firms? If not, is this due to the group-affiliated firm’s ability to mobilize capital from its internal capital market? If the financial constraint is what matters, can a country’s financial market development or stronger investor protection alleviate such a negative spillover effect from business groups? Would non-affiliated firms in industries without collateral or internal equity capital suffer more?

We answer these questions by sampling Korean firms from 1987 to 2010, as Korea provides an ideal setting to investigate our research questions for many reasons. Our empirical analyses begin with the construction of an index that captures the influence of Large Business Groups (‘LGBs’) in each industry. We name this index the Business Group Strength and Dominance Index (‘BSDI’). As its name suggests, the index captures two distinct features: the collective size of the LBGs’ internal capital market (‘strength’) and their collective market share (‘dominance’) in a particular industry. Using this index, we find a number of noteworthy results.

First, we discover evidence consistent with the perception that large business groups can harm capital allocation efficiency outside the LBG, and that this is primarily accomplished by imposing greater financial constraints upon non-LBG firms. Specifically, we find that the industry-level capital allocation efficiency of non-LBG firms is negatively associated with the BSDI during a period characterized by an underdeveloped financial market and weak investor protection (ie, before the 1997–1998 Asian financial crisis), but not during a later period.

Second, to see if BSDI causes non-LBG firms’ capital allocation inefficiency and not vice versa, we limit our analyses to the component of BSDI that is exogenous to non-LBG firms’ capital expenditure, and find that the negative association strengthens. We believe that the collective size of LBGs’ strength is exogenous to non-LBG firms’ capital expenditures. It is difficult to imagine that non-LBG firms’ underinvestment in a particular industry would trigger LBGs to increase their internal capital markets – measured as the sum of the book assets of member firms (excluding the firm in the industry under investigation) – by acquiring firms in other industries or increasing the asset size of existing group firms in other industries.

Third, to further emphasize that our finding comes from greater financial constraint, we conduct many subsample tests to discover that the negative association between BSDI and non-LBG firms’ capital allocation efficiency is stronger in industries that may lack collateral (ie, low asset tangibility) or internal equity capital (low cash flows).

Fourth, we observe evidence that low capital allocation efficiency translates into lower profitability. Specifically, we discover that the BSDI predicted both non-LBG firms’ lower profitability and LBG firms’ higher profitability before the Asian financial crisis – but not so much thereafter.

Yunxiao Liu is Professor at the College of Management and Economics, Tianjin University, Woochan Kim is Professor at the Korea University Business School, and Taeyoon Sung is Professor at the School of Economics, Yonsei University.


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