As the Ambani brothers? feud over KG gas embroils the country and the government, it brings to fore, once again, the centrality of business groups, with their complex relationships, to India Inc. With about two thirds of top 500 Indian firms belonging to business groups?mostly family-controlled?understanding their modes of functioning is crucial to understanding the Indian corporate sector itself. And yet there are many basic things that we do not clearly understand about them. For instance, why do they exist in the first place? I mean, why not diversified firms, like Wipro and ITC? Why do they keep creating new companies for each venture? Or do they? Equally puzzlingly, when and why do they merge them like RIL and RPL recently did? How come value gets created in some brotherly splits? Hypotheses abound, ranging from protecting individual businesses from risks of one another to the ability to create pyramid structures, but little is known conclusively about the motivations and behaviours on the expansion and diversification of Indian business groups.
A recent research paper* sheds some light on the ways of business groups organise themselves, or more specifically, when they choose to float new firms to house a project and when they ?integrate? it, i.e. house it in existing group firms. At first glance this may appear to be obvious. ?One firm per industry? seems logical; so diversification projects in new industries should be housed in new firms, right? Wrong. Close to three-quarters of the diversification projects undertaken by Indian business groups are actually housed in existing group firms. The statistics looks even starker when we compare it with stand-alone firms where the relationship is exactly the opposite?that is, nearly three-quarters of new industry projects are implemented by floating a new firm.
What would you expect to be the drivers of the decision to integrate as opposed to floating a new firm? Integrating has the advantages of ?synergy? where the value of the new business and an existing business together is greater than the sum of their individual values. This is particularly likely when the two are in the same industry. Another driver can be ?subsidisation?, where the cash flows of an existing profitable business sustains the new business. In both cases, the new business is benefited?it is only the question of whether the relationship with the existing firm is symbiotic or parasitic. Finally there may be the ?expropriation? motive, whereby insiders gain by selectively implementing profitable projects in firms where they have larger shareholding.
In India, the synergy effect is certainly there. A project is very likely to be integrated if there is already a group firm in the industry. But as we noted, the converse is not true. All forays into new industries are not housed in new firms. In fact, larger and more profitable business groups seem more likely to integrate projects and that too, projects that seem to come from less profitable industries. This smacks of a need for subsidisation from the cash flows of existing firms.
Furthermore, even when integrated within the business group, the projects are typically housed in larger and more profitable firms. However, the exact channel of subsidisation remains elusive to researchers. Past research has shown that intra-group loans are frequently used by Indian business firms to bail out weak group businesses particularly close to a collapse. Integration within a firm just makes such subsidisation even more opaque.
The expropriation story is not without support either. The more profitable projects are generally housed in group firms where the insider or the family has high shareholding. Surprised, anyone?
Interestingly, none of this is news to the stock markets. On average, markets dislike diversification announcements?market participants already know there is going to be some subsidisation from existing firms. However, for firms with higher insider shareholding announcing a diversification project, the reaction is opposite?they are, in fact, rewarded. The markets already know that these projects are likely to be the more profitable ones.
While the broad statistics presented and analysed in the paper shed some light on the systematic biases of group businesses in India, it only opens a discussion on these issues rather than provide the final word on the subject. The biases clearly exist but there is no smoking gun of any systematic tunnelling or expropriation. Whether such a weapon is truly non-existent or just very well disguised, we have no way of knowing, at least for now.
The author teaches Finance at the Indian School of Business, Hyderabad
*Meghana Ayyagari , Radhakrishnan Gopalan, and Vijay Yerramilli, ?Investment decisions of business groups: The choice between integration and non-integration?
