Editor's Note: The following post comes to us from Ronald Masulis, Peter Pham, and Jason Zein, all of the School of Banking & Finance at the University of New South Wales.

Across the world, difficulties in accessing external equity capital create a serious barrier to the development of new firms. In developed economies, this funding gap is bridged by angel investors and venture capitalists. In emerging economies however, contracting mechanisms and property rights protections are often insufficiently developed to support substantial venture capital activity. As a consequence, little is known about new venture funding in such economies and how external financing constraints are overcome.

In our paper titled “Does Group Affiliation Facilitate Access to External Financing? Evidence from IPOs by Family Business Groups,” which was recently made publicly available on SSRN, we investigate a major source of funding support for new firms—namely, internal equity investments by business groups, especially those controlled by families, and how this facilitates access to external equity markets. Our study is motivated by the pervasive nature of business group participation in international initial public offering (IPO) markets around the world: on average, 29 percent of new issue proceeds in each country is attributable to group-affiliated firms. This raises an important question regarding the role that business groups play in assisting new firms seeking to tap public equity markets. It also raises important questions about whether ignoring the existence of business groups creates serious biases in studies of international IPO activity.

Click here to read the complete post...

" /> Editor's Note: The following post comes to us from Ronald Masulis, Peter Pham, and Jason Zein, all of the School of Banking & Finance at the University of New South Wales.

Across the world, difficulties in accessing external equity capital create a serious barrier to the development of new firms. In developed economies, this funding gap is bridged by angel investors and venture capitalists. In emerging economies however, contracting mechanisms and property rights protections are often insufficiently developed to support substantial venture capital activity. As a consequence, little is known about new venture funding in such economies and how external financing constraints are overcome.

In our paper titled “Does Group Affiliation Facilitate Access to External Financing? Evidence from IPOs by Family Business Groups,” which was recently made publicly available on SSRN, we investigate a major source of funding support for new firms—namely, internal equity investments by business groups, especially those controlled by families, and how this facilitates access to external equity markets. Our study is motivated by the pervasive nature of business group participation in international initial public offering (IPO) markets around the world: on average, 29 percent of new issue proceeds in each country is attributable to group-affiliated firms. This raises an important question regarding the role that business groups play in assisting new firms seeking to tap public equity markets. It also raises important questions about whether ignoring the existence of business groups creates serious biases in studies of international IPO activity.

Click here to read the complete post...

" />

Does Group Affiliation Facilitate Access to External Financing?

The following post comes to us from Ronald Masulis, Peter Pham, and Jason Zein, all of the School of Banking & Finance at the University of New South Wales.

Across the world, difficulties in accessing external equity capital create a serious barrier to the development of new firms. In developed economies, this funding gap is bridged by angel investors and venture capitalists. In emerging economies however, contracting mechanisms and property rights protections are often insufficiently developed to support substantial venture capital activity. As a consequence, little is known about new venture funding in such economies and how external financing constraints are overcome.

In our paper titled “Does Group Affiliation Facilitate Access to External Financing? Evidence from IPOs by Family Business Groups,” which was recently made publicly available on SSRN, we investigate a major source of funding support for new firms—namely, internal equity investments by business groups, especially those controlled by families, and how this facilitates access to external equity markets. Our study is motivated by the pervasive nature of business group participation in international initial public offering (IPO) markets around the world: on average, 29 percent of new issue proceeds in each country is attributable to group-affiliated firms. This raises an important question regarding the role that business groups play in assisting new firms seeking to tap public equity markets. It also raises important questions about whether ignoring the existence of business groups creates serious biases in studies of international IPO activity.

Prior literature on family business groups focuses disproportionately on minority shareholder concerns around investing in these groups, namely the risk of being expropriated by controlling shareholders. This risk is particular pronounced when pyramidal ownership structures are used. Here, a family can use a public firm which it controls through a 50% ownership state (Firm A), to set up and control a second Firm B, which itself owns 50 percent of another public Firm C. While these ownership chains ensure that a group has uncontested control of all three firms, the family only holds 25% and 12.5% of the cash flow rights in Firms B and C, respectively. This effectively creates a wedge between cash flow and control rights, increasing the family’s incentives to extract private benefits from lower layers of the pyramid (Firm C and to a lesser degree Firm B). This cash flow-control rights wedge can be further increased through the use of dual class shares. Moreover, multiple chains involving additional firms are common. For example, Firm A can also own 50% of Firm D shares and which can in turn hold 50% of Firm E shares. Finally, there can be additional chains of control going from other higher layer firms to lower layer firms (e.g. Firm D to Firm C) as well as cross holdings of shares at the same pyramid layer (e.g. Firms B and D).

While such risks undoubtedly exist, business groups can also serve an important economic function that justifies their global prevalence and durability. The literature to date has been relatively silent on the specific channels through which groups support their member firms. By analyzing IPO transactions of privately held group firms, our study provides new insights into a potentially valuable support channel arising from a group’s ability to utilize its internal capital to help new firms tap external equity markets.

In general, young firms’ access to new equity is constrained by large price discounts that public investors require as compensation for adverse selection and moral hazard risks associated with investing in relatively new ventures. This can excessively dilute an entrepreneur’s shareholding, which can deter a firm from raising sufficient capital, thus delaying its profitable investments. Business groups possess significant advantages over independent entrepreneurs in overcoming such external financing constraints because they can utilize large amounts of internal capital from other group firms to provide “seed capital” for a new firm. This is feasible as business groups can set up new firms in a pyramidal ownership structure, where an existing affiliate owns effective or actual voting control in other public affiliates of the same group. Under this structure, a group effectively channels internal resources raised in part from minority investments in the shares of its existing affiliates, into its new firm. As a result, the new firm can minimize the need for costly external equity capital, and find it easier to go public.

Using a sample of 12,683 IPOs and 1,895 business groups from 44 countries, we investigate whether groups exploit their distinct internal capital advantages to facilitate IPOs for their affiliates. We argue that these advantages should manifest themselves more strongly in family controlled business groups because these families are controlling shareholders who have stronger ownership incentives and tighter control over affiliates, allowing them to internalize the financing benefits of group structures and more effectively coordinate the group’s internal capital market to support to new affiliates. Consistent with the existence of an internal capital support mechanism, we find that across family groups, high rates of group-level internal capital accumulation strongly predict which groups subsequently conduct an IPO. In terms of timing, an IPO event is also more likely to occur after a large increase in a group’s internal capital accumulation. Looking more closely within a group, we find that an IPO firm tends to be sponsored and to receive intra-group investments from group affiliates having the greatest internal capital accumulation. Our results are driven by both variations in groups’ profitability and by their dividend decisions. Group IPO events are more likely when family groups deliberately retain internal capital by limiting dividend payments, which only rebound after the IPO is completed.

We also examine the effect of pre-IPO internal group support on reducing an IPO’s offer size. Here, the role of pre-listing internal investments should be reflected in the IPO firm’s need to raise relatively less new capital. Consistent with this prediction, we observe that family group IPOs firms on average raise a relatively smaller proportion of new shares compared to non-group IPO firms. Among family business groups, we show that this proportion falls with the pre-IPO internal capital accumulation rates of both the sponsoring group as a whole and the IPO parent firm in particular.

Next, we examine whether group support translates into other observable benefits for new firms tapping the IPO market. We find that a group’s internal capital advantages allows them to float difficult-to-finance IPO issues, to do so under less favorable IPO market conditions, to reduce flotation costs, and to maintain robust post-listing access to further external equity from public investors. This support appears to translate into a positive post-listing valuation effect for group IPO firms. Specifically, after controlling a potential selection effect regarding the different characteristics observed for group and non-group IPO firms, our evidence suggests that group affiliation enhances an IPO firm’s value relative to the counter-factual case in which the same firm raises funds independently.

Overall, our study highlights a critical channel through which family groups provide important benefits to both existing group affiliates and the capital market: that is, through facilitating the initial round of public equity fundraising by new firms and by providing continuing support in the early post-IPO years. In this sense, family groups appear to play an important economic function akin to that of venture capitalists and private equity investors in developed economies. However, unlike venture capitalists who rely on enforceability of financial contracts to alleviate the risks associated with funding risky growth opportunities, family groups often operate in underdeveloped capital markets with weak governance and legal institutions. In such environments, our evidence indicates that a group’s ability to leverage the internal capital of its affiliates to build up large controlling ownership stakes in new firms, often within a pyramidal structure, is a very attractive means of overcoming the external financing challenges faced by new ventures.

The full paper is available for download here.

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