Essay: Essay on the business group as a common business form

Business group as a common business form has played an important role in East Asian countries. Chang and Hong (2000) mentioned that, in Korea, there are top 30 business group contributing 40 per cent of the total country output. In China, near 60% of the national industrial output is contributed by the business group (China statistic yearbook, 2000). That information has showed the importance of business group to the development of East Asian economy.
Although there are many researches on business group, there is no accepted definition in the literature. Generally, two perspectives appeal in the literature: one is mainly based on sociology; the other tends to be more based on economics (Cuervo-Cazurra, 2006). Based on the definitions provided by different authors including Leff (1978), Granovetter, (1994) and Yiu et al (2005), the sociology perspective emphases a multiplicity of relationship which can create a sense of identity based on common social bound. Those firms are grouped in a formal or informal way and there are some key factors such as ownership, financial and commercial relationship, family, and friendship serving as the economic and social ties. However, those definitions cannot always distinguish business group from other firm network.
Turn to economic perspective, it has provided a definition that better distinguish the business group from other firms??? network through emphasizing the diversification of business group and common control. In addition, the family ownership of business group has also been discussed as the second feature of business group (Ghemawat and Khanna ,1998; Chang & Hong, 2002; Fisman & Khanna,2004). However, family ownership is still a Controversy characteristic in order to define business group because many other diversified firms with non-family ownership have been discussed as business group (Hoshi & Kashyap, 2001; Keister, 2004).
Nevertheless, Cuervo-Cazurra (2006) reviewed those definitions and defined business group as ???a set of legally-separate firms operating in strategically-unrelated activities that are under common ownership and control???. Moreover, as a type of firm network, there are different types of business group classified by the ownership.
There are many reasons for the popularity of business group in East Asian country. Firstly, in terms of the conditions of some East Asian countries such as China, the early period of Korea and Japan, it is in an emerging market where the product markets, labor markets as well as financial markets are inefficient or absent, combined with the lack of completely law and regulation system as well as contract enforcement (Khanna and Palepu, 1997). Furthermore, Hoskisson et al (2000) argued that the institutional environment can affect company in terms of generating strategic initiatives. Therefore, in order to deal with such environment, companies would use unrelated diversification strategy to generate necessary support which has been provided in advanced economy (Scott, 1995). Besides, Lins and Servaes (2000) carried the research in seven emerging market including Hongkong, South Korea, and Thailand, and compared the research results between diversified companies with focus ones. The results show that through developing internal capital market within business group the performance of business group are better than individual companies.
An example of internalization can be showed with Haier Group, an electronics group headquartered in China. It founded its own university named Haier University in 1999 to provide human resource and employee training for the group. The university sets modules based on the need of the group and provide valuable elites in order to promote the group???s development (Haier, 2013). Also, Haier Group builds its internal financial institution to control and organize the cash flows among affiliations. The internal financial institution will provide financial support for the innovation and promotion of new products. It also provides loans to the affiliated companies. It has been predicted that the internal financial institution will be updated into internal bank for further development (China Finance News, 2013).
Chong and Hong (2000) collected data from Korean business groups and examined the group-affiliated companies. The research indicated that business groups have a positive impact on the company???s performance. Moreover, the evidence showed that there are large amount of debt guarantee, equity investment and internal trade within groups and such transaction improve both the group and affiliated companies performance. Manikandan and Ramachandran (2011) also confirmed that business group could improve affiliated firms through providing access to the opportunities hidden in the imperfect market.
For example, in 2009, PetroChina Company Limited, a state owned company, acquired a local bank, Kelamayi Bank in Xinjiang province and changed its name to Kunlun Bank. The evidence showed that PetroChina has monopolized China???s oil business because of its strong political connections as a state owned company. As a branch of PetroChina Company Limited, Kunlun Bank becomes the only bank that is able to settlement on Iran for oil business in China (Luo, 2013). Such internal trade has dramatically increased the performance of Kunlun Bank and, consequently, improve the total performance of the group.
Additionally, reducing transaction cost under market imperfection is also an important argument for institutional theory. Those costs may contain identification of possible partners, negotiation for the contracts, enforcement of contracts as well as the cost on resolving potential conflict (Khanna and Palepu, 1999). It is believed that in the emerging market, the market failure will generally push companies to internalize the important activities especially when the internal cost will be lower than the external cost. That is because there is usually an absence of comparable market-supporting institutions in order to maintain regular operations. Also, although governments often intervene development of economy and create regulations for business, it may neglect the regulations on governing corporate disclosures, accounting standards and other aspect that may negatively affect the development of the capital market (Carney, 2008). Mishra and Akbar (2007) proved that diversified group will benefit from the structure in emerging markets since the transaction costs will be lower and hence they will be more competitive in advanced economy with the lower transaction costs. Moreover, Collis and Montgomery (2005) stressed that the market cannot be perfect even in advanced economy. Therefore, internalization can reduce such market-related transaction cost generated by market failure and benefit affiliations within business group (Carney, 2008).
In the former example that PetroChina acquired Kelamayi Bank, the main purpose for such acquisition is to complete its internal financial function since it can be showed that after the acquisition, Kunlun Bank become the main source to provide loans for PetroChina Company Limited. Moreover, based on the research (Luo, 2013), the financial cost for loan also become relative low, compared with the market interest rate which is around 3.25%, the interest rate for the company is only 1.86%. Therefore, such diversification not only completes the internalization but reduces the cost for the business. However, the rapid growth created by such diversification also brings high risk for the company since the ability of control risk for the financial branch, Kunlun Bank, is quite limited because of the small size and limited experience of the local bank.
However, such benefit can only be obtained by the affiliations that are within the corporation. Those affiliated companies that are independent legally, such as collection based business group, cannot take advantage of the reduced transaction cost since transactions between them are not internal (Chung, 2004).
Nevertheless, it should be noticed that the market imperfection argument and institutional inefficient can explain the initial development of business group in underdeveloped economy. With the development of economy, the benefit created by taking advantage of market imperfection and institutional inefficient in some areas is fading off. Fauver et al (2003) believed that in high income country with developed institutional environment there is a diversification discount. And Lee (2001) examines Korean business group and found that trade premium starts to discount from 1994.
Technology acquisition could be another important reason for forming business group especially in late industrialization especially for Korea. Because of high competition and the advanced technology captured by the existing large companies, it is difficult for individual firms to employ foreign technology with limited financial resources. Moreover, the fact that large companies in USA and German in 19th century achieved Schumpeterian technological and organizational breakthroughs also impeded the development of latecomers in terms of first-mover advantage in capital intensive industry even if those individual firms can borrow foreign technology (Amsden, 1989; Chandler, 1990). Forming business group not only provide access to financial support to acquire advanced technology, but allow firms to accumulate experience on project execution skills through the large amount technology acquisition transactions. Such skill will ultimately become competitive advantage for business group compared with other competitors in industry (Amsden, 1994). In addition, because of lack of technology proprietary and high profit rates in ???pre-modernized??? industry, business groups are forced to be unrelated- diversified (Amsden, 1994). Malerba (2003) mentioned that unrelated diversified technology has also provided a boarder knowledge base to support further innovation for business group.
However, such unrelated diversification reduced. Firstly, the development of market has reduced the institutional voids. The transaction and organizational cost will not decrease after optimal point as the diversification increasing. More importantly, Asian currency crisis happened in 1997 lead to revolution in corporate governance and the competition has been fiercer because of the globalization. Those facts coupled with other events increased the pressure for business group in East Asian countries such as Korea and Japan. Therefore, business group began to change their strategy and refocus to their core capabilities.
Take Hyundai, a Korean business group as an example, the business group used to be a diversified group operating in automobile, tourism, finance, logistics and other businesses. After the financial crisis in 1998 in South Korea, Hyundai started to restructure the business and force on five core business including automobile, shipbuilding, finance, retailing and electronics. In 2001, Hyundai was further disintegrated into separate groups, and now Hyundai is more famous for automobile and shipbuilding.
It should be noticed that the main assumption of resource based perspective is that firms will form business group if the political condition allow them to acquire asymmetry resource. Therefore, the support from state is also important for forming business group in East Asian countries. Kim (1997) has stressed the necessity of government intervention in a country???s economy development. DiMaggio and Powell (1983) mentioned that because of the lack of managerial capital and capital formation, government in countries such as Korea and Japan will distort the market in order to support the selected business group, including financial and administrative help. Hence, those business groups can be easier to accumulate valuable resources and develop more quickly. There is also a mutual beneficial relationship exists between government and business groups. Such relationship has played a crucial role in the initial development of business group in Korea and Japan. With the global economy and post industry policy era, it will disappear (Chuang, 2004).
Nevertheless, the political power used for protecting domestic firms and infant industry, which still exists in underdeveloped economy such as China, also result in problems. The protection has made business group pay more attention on the ???rent-seeking??? rather than on improving their managerial and technological capabilities in order to pursuing the success of the group (Kock and Guillen, 2001). Furthermore, Bebchuk and Roe (1999) mentioned that in spite of relative high cost of maintaining relationship between government and business group since that could make sure that the firm???s profit will not shrink.
Nevertheless, although the business group in common in East Asian, it does not mean that it is a perfect form for the company???s development. Some problems cannot be neglected. Chakrabarti (2007) examined the aspects that may influence the result of diversification. It has been found that institutional environment, coupled with economic stability and affiliation with business groups will affect the result of diversification, and it will lead to improved performance only in the least developed environment. More importantly, the outcome of the diversification will be different under different developing environment.
Also, it may result in some problems for the organizations. Pyramidal structure is very popular within business group, and it is positive related to the reduction of interventions from local government, consequently reducing the political cost (Fan et al, 2014).On the other hand, the complex ownership and pyramidal structure may result in a greater agency problem and opportunistic earrings management (Claessens and Fan, 2003). Lins (2003) stated that, in terms of using internal market formed by the group members, although the popularity of diversified business group can reduce the transaction cost with limited protection on minority shareholders rights the controlling shareholders may carry the agency cost in the form of share price discount and monitoring cost. Besides, Carney (2008) stated that business group are often organized as pyramids, and it allow the leading owners extend their control right over their cash-flow right, the actual ownership, and therefore chasing their own interest. The strong interest conflict between controlling shareholders and minority investors also takes a significant percentage of earnings management, even though there may be other intensives resulting in such earnings management behaviour (Liu and Lu, 2007). Fan and Wong (2002) examined the companies in East Asian economies with pyramidal structure and concluded that the controlling shareholders are perceived to report accounting information based on their own interest, therefore losing credibility in terms of reported earnings to outside investors.
Furthermore, the divergence between ownership and controlling make it possible for controlling shareholder to transfer the resources out of firm and increase their own wealth, therefore engaging in tunnelling (Johnson et al., 2000). Cheung et al. (2005) conducted research on state-owned listed companies in China and examined the related party transaction within company. The results confirmed that when tunnelling activities such as issuing loans to majority shareholders occurred, the minority shareholders are not typically beneficial from the transaction. Bae et al (2002) also used a Korean Chaebol as a sample to show the evidence of tunnelling and the negative impact it has on stock returns. That is because the Chaebol bidders acquired target with poor performance but in the same group. By making such takeover decisions it will be only beneficial to the controlling owners of the group at the expense of minority shareholders within firms.
Baek et al (2006) empirically showed that in Korean Chaebol, controlling shareholders gain benefit from tunnelling activities at the expense of other shareholders. The research showed that with good historical performance firms tend to sell the securities at a low price for intragroup deals. For example, the Samsung Group was criticized for the sale of Everland???s convertible bonds to Lee Jae-Yong and Everland???s affiliated firm, Cheil Jedang at extremely low price, which is 7700 won, compared with the market price, arranged from 85000 to 230000 won, at that time.
In conclusion, through forming business group, companies could take advantage of the imperfect market to gain better performance, lower transaction and organizational cost. For advanced economy, business group can bring benefit through technology acquisition. The influence and support given by local government is also an important factor in forming business group. The dark side of the business group is also mentioned for more critical understanding.