1. science
2. mathematics
3. geometry

Infant Firms in Emerging Market:
An Analysis of Stand-Alones vs. Subsidiaries
Soo Jin Kim and Woojin Kim *
August, 2013
Abstract
Newly established manufacturing firms in Korea without any corporate shareholder participation –
stand-alones - exhibit significantly higher profitability and smaller asset size compared to those set
up by corporate shareholders – pyramidal subsidiaries. Pyramidal subsidiaries set up by large
business groups or chaebols engage in more related party transactions generating more negative
internal earnings relative to stand-alones. For pyramidal subsidiaries, revenues generated from
affiliated firms are positively correlated with overall profitability, while expenses paid to affiliates
are negatively correlated. Nevertheless, combined related party transactions adversely affect
overall profitability of all infant firms, regardless of their initial ownership structure.
Keywords: Stand alone; Pyramidal subsidiary; Business group; Corporate governance; Related
party transaction; Establishment; Korea
JEL classification: G30; G32; G34
* Respectively, University of Virginia School of Law ([email protected]) and Associate Professor of
Finance, Seoul National University Business School ([email protected]). This paper is an extension of
Soo Jin Kim’s Master’s thesis at Seoul National University. Woojin Kim appreciates support from the
Institute of Management Research at Seoul National University. Financial support from the Institute of
Finance and Banking of Seoul National University is also gratefully acknowledged.
Correspondence to: Woojin Kim, SNU Business School, Seoul National University, Gwanak Ro, Gwanakgu, Seoul 151-916, Korea; Email: [email protected]
Infant Firms in Emerging Market:
An Analysis of Stand-Alones vs. Subsidiaries
August, 2013
Abstract
Newly established manufacturing firms in Korea without any corporate shareholder participation –
stand-alones - exhibit significantly higher profitability and smaller asset size compared to those set
up by corporate shareholders – pyramidal subsidiaries. Pyramidal subsidiaries set up by large
business groups or chaebols engage in more related party transactions generating more negative
internal earnings relative to stand-alones. For pyramidal subsidiaries, revenues generated from
affiliated firms are positively correlated with overall profitability, while expenses paid to affiliates
are negatively correlated. Nevertheless, combined related party transactions adversely affect
overall profitability of all infant firms, regardless of their initial ownership structure.
Keywords: Stand alone; Pyramidal subsidiary; Business group; Corporate governance; Related
party transaction; Establishment; Korea
JEL classification: G30; G32; G34
1. Introduction
A firm in its broadest sense goes through a series of stages during its life cycle. At
the initial stage, a firm is established either as a corporation or a non-corporate entity
which later may become a corporation. A small subset of newly established firms is
successful enough to tab the public equity market for the first time at some point in time.
Most empirical research in corporate finance, however, considers calendar time since
initial public offering (IPO) as the firm's age, implying that IPO date is the firm's birth
date. Such approach is by no means accurate since IPO firms have been there for a while
before they actually become public. To some extent, this tendency is largely due to the
fact that financial and other key information about closely-held private firms is largely
unavailable. Unfortunately, such “emphasis on large companies has led us to ignore (or
study less than necessary) the rest of the universe: the young and small firms, who do not
have access to public markets.” (Zingales, 2000. p. 1629)
Such negligence inherently restricts our understanding of the broader corporate
sector, especially in emerging markets where external capital and labor markets are
relatively less developed. In such economies, lack of appropriate institutional mechanisms
to mitigate agency problems and information asymmetry leads to difficulties in enforcing
contracts. As such, business groups that provide internal capital and labor markets may
naturally arise as a substitute for market mechanism. (Khanna and Palepu, 2000a, 2000b,
2005).
This paper takes a step back and focuses on firms that have just been established in
an emerging market, either within a business group or outside business groups. We refer
to these genuine new firms as infant firms to distinguish them from IPO firms. In most
theoretical models in corporate finance, an investment opportunity of a firm is in general
characterized by an entrepreneur, financier(s), and some output generating technology
2
along with some frictions. Such approach implicitly assumes that new firms are
established by individual entrepreneurs with brilliant ideas. Recent success of Facebook or
more traditional case of Microsoft would fit into such description.
However, an individual entrepreneur is not the only entity that may set up a new
firm. As Almeida and Wolfenzon (2006) appropriately point out, an existing firm may set
up another firm, creating a pyramidal subsidiary. It is well established in the international
corporate finance literature that firms outside U.S. and U.K., especially those in emerging
markets, are typically controlled by families who control a group of firms through
hierarchical chains of equity ownership referred to as pyramids. 1 Under such environment,
existing member firms may well set up a new member firm.
A new firm set up by an entrepreneur, which we will be referring to as a standalone, and one set up by an existing firm, or a pyramidal subsidiary, are fundamentally
different in the following respects. First, the degree of deviation between cash flow rights
and control rights of the ultimate controlling shareholder tends to be higher in the latter
than in the former. This is because entrepreneur controls the former through direct
holdings while she controls the latter with indirect holdings through an existing member
firm. Second, the latter has a financing advantage over the former, since the family can use
all cash flows of an existing firm to set up the latter, while it must use its personal wealth
to create the former. Third, profitability of the former is likely to be higher than the latter
since the family would want to keep good projects within the family while it would prefer
to share losses with other shareholders of the existing firm. 2 Finally, any sale made by a
stand-alone would be a genuine arm’s length transaction made to an external customer
1
La Porta et al.(1999), Claessens, Djankov, and Lang (2000), Faccio and Lang (2000), Barca and Becht
(2001), and Johnson et al. (2000) among many others.
2
Almeida and Wolfenzon (2006)’s theory mostly builds on the second and third point.
3
which generates genuine cash inflow, while those made by a pyramidal subsidiary to an
affiliated party may simply reflect an internal transaction at the business group level. 3
We empirically test whether such predicted differences exist in newly established
infant firms based on a unique dataset of private firms in Korea. Korea has a number of
characteristics that provide an ideal setting for such an analysis. First, Korean regulatory
authorities mandate an external auditing of financial statements even for non-publicly
traded firms as long as they exceed a certain size threshold. The audited financial
statements are filed to the Korean Financial Supervisory Services and are made publicly
available. Given that the constraint on non-public firms research is largely due to a lack of
appropriate data, this is certainly an advantage. Second, Korean financial statements report
items that provide information on revenues generated from and expenses paid to related
parties, including affiliated firms. Considering that Korean corporate sector is plagued
with business groups and internal transaction, disclosure of such related party transactions
(RPTs) provides a minimum protection for minority shareholders. From our perspective,
this allows us to quantify the relative magnitudes of revenues, expenses, and earnings
generated through RPTs. 4 Finally, Korea has many active business groups, particularly the
large business groups or chaebols, who continue to grow by setting up pyramidal
subsidiaries. Thus, our analysis provides an estimate of the chaebols’ influence on newly
established, non-public corporate sector of the economy.
Based on 1,368 newly established manufacturing firms in Korea between 2000 and
2011, we first document that roughly half of our sample firms have group membership
while the remaining half are purely entrepreneurial. Pyramidal subsidiaries directly set up
by large business group members only account for 6.7% of total infant firms, but in terms
3
For example, consider Japanese automobile exports made to a U.S. subsidiary. The transaction would
technically be recorded as an export, but it is not a true export until the subsidiary sells the automobile to a
local customer.
4
For example, La Porta et al. (1999), Claessens, Djankov, and Lang (2000), Faccio and Lang (2000), Barca
and Becht (2001), and Johnson et al. (2000).
4
of combined total assets, they account for 40%. This suggests that the influence of large
business groups in start-up sector is not trivial.
We next compare firm size proxied by total assets and fixed assets between standalones and pyramidal subsidiaries in the spirit of Bena and Ortiz-Molina (2013).
Consistent with their European results and predictions of Almeida and Wolfenzon (2006),
we find that pyramidal subsidiaries are larger than stand-alones. This suggests that
financial advantage of being able to use the existing firms’ cash flows in setting up a new
firm becomes important when the required investment for a given investment opportunity
is large.
We implement a similar comparison of profitability proxied by EBITDA or EBIT
scaled by total assets between stand-alones and pyramidal subsidiaries. Similar to those in
Bena and Ortiz-Molina (2013) and Almeida and Wolfenzon (2006), we find that standalone firms exhibit higher profitability than pyramidal subsidiaries. This suggests that
when a firm’s investment prospect is good, the families prefer to keep it to themselves
rather than to share it with the outside shareholders of an existing firm.
In addition, we compare pyramidal subsidiaries with stand-alones whose
controlling shareholders own other firms. These stand-alone firms are essentially members
of a business group, although they are directly owned by a controlling shareholder. 5 We
implement this exercise because controlling shareholders of these stand-alones could have
chosen a pyramid structure instead since they already own an existing firm, while for pure
entrepreneurs, pyramid structure is not a feasible alternative. The results indicate that
pyramidal subsidiaries still exhibit lower profitability compared to stand-alones in
horizontal groups. We also implement a series of robustness checks based on matched
firm and matched period analyses, and find that our results are unaffected.
5
Almeida and Wolfenzon (2006) refer to this structure as ‘horizontal’ business group to distinguish it from
standard pyramids where one firm owns another. Bena and Ortiz-Molina (2013) do not distinguish between
pure entrepreneurial and horizontal group structure within stand-alones.
5
Our key set of analyses focuses on the implications of RPTs on the profitability of
infant firms. We find that the proportion of RPT-based revenues and expenses relative to
total revenues and expenses is the highest among pyramidal subsidiaries set up by large
business group members. This proportion is the lowest among pure entrepreneurial standalones whose controlling shareholders do not own other firms. For all infant firms,
earnings from RPTs are negative in general, indicating that resources being transferred out
of the infant firms to other affiliates are larger than incoming transfers. This imbalance in
RPT-based revenues and expenses is the largest in pyramidal subsidiaries set up by large
business group members.
When we regress overall profitability on RPTs, we find that within pyramidal
subsidiaries, revenues generated through RPTs are significantly positively correlated with
overall profitability while expenses paid through RPTs are negatively correlated. As a
result, RPT earnings are positively correlated with overall profitability. These results
suggest that reported profitability of newly set up pyramidal subsidiaries largely depends
on resource transfers to and from other existing affiliated firms, and as such may have
been inflated by the amount of internal sales. Such positive (negative) relationship
between profitability and RPT revenues (expenses) is also observed among stand-alones
whose shareholders own other firms, but not among pure entrepreneurial firms.
Overall, the findings in this paper suggest that profitability and size well predict
the initial ownership structure of a newly established firm. Profitable firms tend to be set
up directly by individual shareholders as a stand-alone, while large firms tend to be set-up
by corporate shareholders as a pyramidal subsidiary. In addition, RPTs among group
member firms have substantial influence on the profitability of newly set up member firms.
Our findings suggest that combined effect of RPT-based revenues and expenses on overall
6
profitability of infant firms is negative rather than positive, regardless of the initial
ownership structure.
The remainder of the paper proceeds as follows. Section 2 reviews the related
literature. Section 3 describes the data and sample. Section 4 provides the main empirical
results. Section 5 provides a brief conclusion.
2. Literature Review
It is fairly well established by now in international corporate finance literature that
firms outside U.S. are tightly controlled by individuals or families through chains of intercorporate shareholdings or pyramids. Such chain of ownership allows the controlling
shareholders to control not just a single firm, but a number of firms along the control chain
which constitute a larger entity referred to as a business group. 6 Researchers have
examined various consequences of such distinct corporate control structure. 7 However,
despite their ubiquitous nature, formal theory outlining why and how they might arise is
still very scant. 8
Traditional understanding of pyramidal business groups is that pyramids allow
controlling shareholders to control a large amount of assets with relatively small amount
of their own personal capital, thereby creating a wedge or deviation between cash flow or
dividend rights and control or voting rights. (Bebchuk, Kraakman, and Triantis, 2000).
This deviations provides the controlling shareholders the ability and the incentive to
expropriate or tunnel corporate resources out of the firms in the bottom layers of the
pyramid structures to those in the top layers or to the controlling shareholders themselves.
6
Morck, Wolfenzon and Yeung (2005) and Kim (2013) provide comprehensive surveys.
Claessens, Dijankov, Fan, and Lang (2002), Lins (2003), Bertrand, Mehta, and Mullainathan (2002), Joh
(2003), Bae, Kang, and Kim (2002), Baek, Kang, and Park (2004), and Baek, Kang, and Lee (2006) among
many others.
8
Kim (2012) suggests that prevalence of partial acquisitions in low investor protection countries may lead to
pyramidal business groups.
7
7
Almeida and Wolfenzon (2006) challenge this perspective and argue that the
direction of causality is reversed. They emphasize that under poor investor protection
where diversion of corporate resources is possible to some extent, pyramids provide the
controlling shareholders both financing advantage and payoff advantage compared against
a horizontal structure where controlling shareholders directly set up firms on their own.
Financing advantage arises since all retained cash flows in an existing firm may be used to
set up a new subsidiary whereas in a horizontal structure the family can only use their
proportional claims from the existing firm. Payoff advantage arises under diversion since
one diverts away more of other people’s money in a pyramid than in a horizontal
structure. 9
Our empirical work is broadly motivated by both Bebchuk et al. (2000) and
Almeida and Wolfenzon (2006). But since both theories require at least some outside
investors to exist from the very beginning of pyramid creation, they implicitly imply that a
firm becomes public as soon as it is established, which is quite unlikely in the real world.
Moreover, investment opportunities of the parent and the subsidiary are assumed to be
independent. Specifically, neither study considers related party transaction as an important
channel through which the cash flows in the parent and the subsidiary could well be
correlated, which is the key focus in our study. 10
There are only few exiting studies up to date that empirically test the implications
provided in Almeida and Wolfenzon (2006). One is Almeida, Park, Subrahmanyam, and
Wolfenzon (2011), who use detailed ownership data for large business groups or chaebols
in Korea designated by the Korea Fair Trade Commission (KFTC). They examine the
dynamics or evolution of business groups by examining additions of group members and
9
There are some subtle semantic issues. Although the concept of diversion in Almeida and Wolfenzon
(2006)’s original theory is essentially tunneling, Almeida et al. (2011) refer to their theory as ‘selection’
hypothesis while ‘tunneling’ is used to refer to the traditional perspective by Bebchuk et al.(2000), which is
somewhat confusing.
10
Cheung, Rau, and Stouraitis (2006) study implications of related party transactions in Hong Kong.
8
show that chaebols create pyramids by acquiring firms with low pledgeable income. 11
They do not directly examine new establishments, but instead focus on acquisitions as the
main channel of new member firm addition. This is presumably due to the fact that the
theory critically depends on existence of outside investors when the new firm is set up and
this is more likely in acquisitions than in new establishments.
Our study is similar to theirs in that we examine ownership structures in Korean
firms. But, the approaches in the two studies are fundamentally different in the following
respects. First, their study exclusively focuses only on chaebols or large business groups
designated by KFTC while we focus on all newly established firms regardless of their size
or business group membership. In fact, chaebol subsidiaries only account for 6.7% of our
sample of new firms. As such, the key focus of their paper is the evolution of business
groups while ours is the initial shareholder structure of newly set up firms regardless of
chaebol membership. Second, they identify new membership in a business group through
acquisitions only and ignore new establishments. To the contrary, our focus is specifically
on newly established firms. In addition, we examine the implications of related party
transactions within business groups which has not been analyzed in Almeida and
Wolfenzon (2006).
The other one is Bena and Ortiz-Molina (2013) who resort to a large sample of
newly established firms in Europe and compare firm size and profitability between
pyramidal subsidiaries and stand-alones. The first part of our empirical analysis largely
follows this approach and confirms their findings for our sample of Korean firms. Our key
contribution above and beyond what they find is that we directly examine how the
intensity of related party transactions among member firms may affect the level of
profitability in newly established firms. Specifically, we measure the extent to which intra11
Masulis, Pham, and Zein (2011) examine business groups around the world and argue that financing
advantage is key driver of pyramidal structures in countries and firms with financing constraints.
9
business group deals are correlated with the overall profitability and further test whether
existing member firms are more likely to subsidize the new firms or expropriate them. In
doing so, we also carefully distinguish stand-alone firms into those whose controlling
shareholders own other exiting firms which imply a horizontal form of a business group,
and those whose controlling shareholders do not own any other firms which are more
likely to reflect a pure entrepreneurial start up. 12 This distinction allows us to effectively
compare pyramidal subsidiaries with those stand-alones that could have been set up as a
pyramidal subsidiary through another existing firm owned by the controlling shareholder.
3. Data and Sample Construction
To construct a sample of newly established corporations, we first resort to the
universe of firms that are subject to mandatory external auditing. Korean accounting
regulations require all corporations, including privately held firms, with total assets in
excess of KRW 10 billion (roughly USD 10 million) to hire an external accounting firm,
have their financial statements audited, and file the audited statements with the Korea
Financial Supervisory Services (FSS). KIS-VALUE, a database maintained by the
National Information and Credit Evaluation (NICE) Inc., a local data vendor, compiles the
filings made by these externally audited firms into electronic format. The information
provided in KIS-VALUE includes the date of initial incorporation, the identity of the
business group to which the firm belongs if applicable, names and proportional ownership
of the top five largest shareholders, as well as standard financial accounting items. We
augment ownership data with manually collected information from Data Analysis,
Retrieval and Transfer (DART) System, an electronic disclosure platform similar to
EDGAR in U.S.
12
Bena and Ortiz-Molina (2013) do not make such a distinction among their stand-alone firms.
10
We initially start out with around 9,000 manufacturing firms that are subject to
external auditing as of 2012. Many of these firms, however, initially started out as a
smaller corporation that was not subject to external auditing, but eventually grew large
enough to be covered by KIS-VALUE through external auditing. In addition, ownership
information for largest shareholders is available only after 1999. To filter out these old
firms, we restrict our sample to those firms that were newly established between 2000 and
2012. This initial cut-off leaves us with 3,266 firms.
We further filter out the following cases from the sample; those without any
shareholder information within 4 years of establishment, firms that are newly formed as a
result of spin-offs or split-ups as these do not reflect a genuine new set up, firms without
original filing documents available at FSS, firms incorporated in 2012 as financial reports
from those firms are not yet available, and firms with foreign shareholders. 13
It is often the case that financial statements are unavailable until 2 or 3 years after
incorporation. To utilize as much information as possible, we keep the firm in the sample
as a newly established firm as long as it was established within 1 to 3 years of the first
available financial data. 14 After this filtering, we end up with our final sample of 1,368
new manufacturing firms established between 2000 and 2011 in Korea.
For these firms, we identify their top five shareholders. If any of the top five
shareholders include a corporation, we classify this firm as a pyramidal subsidiary,
following Bena and Ortiz-Molina (2013). Otherwise, i.e. if all top five shareholders are
individuals, we classify it as a stand-alone. 15 For pyramidal subsidiaries, we further
classify them as members of large business groups, or chaebols, if any of the corporate
13
Firms with foreign shareholders are excluded mainly because information on their ownership of other
firms or business group affiliation is unavailable.
14
Bena and Ortiz-Molina (2013) and Klapper, Laeven, and Rajan (2006) also resort to a similar approach.
15
Technically, a pyramidal subsidiary requires a non-zero outside ownership which implies less than 100%
ownership by the parent firm. With this caveat in mind, but given that business groups are generally reported
to be in pyramidal structure and for lack of a better yet simple antonym of a ‘stand-alone’, we chose to retain
this expression. Bena and Ortiz-Molina (2013) refer to these firms as ‘firms with parent companies.’
11
shareholders is a member of a large business group designated by the Korea Fair Trade
Commission (KFTC). For stand-alone firms, we further classify them as pure
entrepreneurial stand-alones if none of the individual shareholders own and control
another exiting firm at the time of initial incorporation. 16 Otherwise, i.e. if some individual
shareholders own and control other existing firms, we classify them as horizontal group
stand-alones. As a result, our sample of newly established firms is classified into four
distinct groups; pyramidal subsidiaries of chaebols, pyramidal subsidiaries of nonchaebols, pure entrepreneurial stand-alones, and horizontal group stand-alones. 17
4. Empirical Results
4.1. Distribution of newly established firms: stand-alones vs. pyramidal subsidiaries
Table 1 presents the distribution of the four groups of new established infant firms
based on the number of firms and also combined total assets. The numbers indicate that
stand-alones account for around 2/3 of the sample, while pyramidal subsidiaries make up
the remaining 1/3. Among the four groups, pure entrepreneurial stand-alones account for
the largest portion, 48.6%, followed by non-chaebol subsidiaries (27.6%), horizontal
group stand-alones (17%), and chaebol subsidiaries (6.7%).
In terms of combined total assets, however, the ordering is somewhat reversed. For
example, combined total assets of chaebol subsidiaries account for 39.5%, which is the
largest among the four groups, followed by non-chaebol subsidiaries (29%), pure
entrepreneurial stand-alones (20.1%), and horizontal group stand-alones (11.4%).
These results suggest the following. First, pyramidal subsidiaries are an important
channel through which infant firms are being created. Especially in terms of total assets,
they account for more than 2/3 of all combined assets of the newly established firms. This
16
This classification is done manually through extensive web search.
We also tried identifying horizontal group stand-alones that are affiliated with a chaebol, but there were
only 7 cases. Thus, we did not pursue further classification.
17
12
provides a challenge against the traditional convention of employing a pure
entrepreneurial model as the only alternative of setting up an infant firm.
Second, there seems to be substantial differences in firm size between stand-alones
and pyramidal subsidiaries, consistent with what Bena and Ortiz-Molina (2013) find in
their European sample. For example, chaebol subsidiaries’ combined total assets account
for 39.5% of all combined assets while they only make up 6.7% in terms of number of
firms. This suggests that the magnitude of the required investment could be a potential
factor that determines the initial ownership structure of the newly established firm.
Table 2 provides median size and profitability characteristics for our sample of
newly set up firms in different industries. Profitability is proxied by EBIT scaled by total
assets. We also report median equity scaled by total assets in the next column. Overall,
median total assets for the full sample is KRW 8.3 billion, or roughly USD 8 million.18
Median profitability and proportion of equity is 4% and 35.7%, respectively.
A more detailed look at each industry yields some interesting results. For example,
in leather, bags, shoes manufacturing industry which exhibits the highest EBIT margin of
30%, all newly established firms are stand-alones, either horizontal group or pure
entrepreneurial. That is, all 8 infant firms in this industry during our sample period were
set up by individual shareholders regardless of whether or not they own other firms, but no
corporate shareholder participated in the initial establishment. This is consistent with the
idea that controlling families prefer to retain good projects among themselves and not
share them with other outside shareholders of business group firms. (Almeida and
Wolfenzon (2006), Almeida et al. (2011), and Bena and Ortiz-Molina (2013)). This
suggests that the profitability of an investment opportunity could affect the initial
18
This may seem odd at first since the current minimum cutoff for mandatory external auditing is KRW 10
billion. This is potentially due to the following. First, the cutoff was KRW 7 billion up to 2008. Second,
many firms’ reported financial numbers in KIS-VALUE go back further beyond the first year of external
auditing, although they are not available from DART.
13
shareholder structure of a newly established firm. In fact, controlling families of Korean
chaebols are often criticized by the local media for taking advantage of a profitable yet
stable business opportunity by setting up firms solely owned by the family members. 19
4.2. Comparison of Firm Size
In this subsection, we formally compare average firm size between pyramidal
subsidiaries and stand-alones as well as among the four groups of infant firms. 20 We focus
on the first three fiscal years following the initial establishment and define them as infant
firm-years. We consider both total assets and fixed assets as proxies for the size of the
initially required investment.
The results from Panel A of Table 3 indicate that newly set up pyramidal
subsidiaries are much larger than newly set up stand-alones. For example, average total
(fixed) assets for pyramidal subsidiaries is KRW 41.7 (27.5) billion while the
corresponding numbers for stand-alones is only KRW 9.9 (5.7) billion, the difference of
which is both statistically and economically significant. That is, newly set up pyramidal
subsidiaries are on average 4 to 5 times as large as those set up by individual shareholders
only. This is consistent with the intuition provided in Almeida and Wolfenzon (2006) that
pyramids provide financing advantage to the controlling families by allowing them to use
all cash flows retained in the parent firm to set up a new firm. This financing advantage
leads them to set up larger firms as pyramidal subsidiaries.
In Panels B and C, we separate pyramidal subsidiaries into chaebols and nonchaebols, and compare them against stand-alones. The results indicate that pyramidal
subsidiaries are larger than stand-alones regardless of whether they belong to chaebols or
19
The firms directly set up by chaebol families are typically in business services industries which are not
included in the sample used in this study.
20
The structure of analysis in this and the next subsection broadly follows those employed by Bena and
Ortiz-Molina (2013).
14
non-chaebols. In Panel D, we compare chaebol subsidiaries with non-chaebol subsidiaries,
and find that the former is larger than the latter by 5 to 6 times. This suggests that among
business groups, chaebols exhibit greater financing capacity than non-chaebols or smaller
business groups in setting up new subsidiaries.
In Panel E, we compare all pyramidal subsidiaries against horizontal group standalones, i.e. those whose individual shareholders own other existing firms. Individual
shareholders in horizontal groups may be less financially constrained than pure
entrepreneurs since the former has enough financial resources to own other firms. The
results indicate that differences in firm size still exist even when we exclude pure
entrepreneurial stand-alones from the analysis.
In addition to asset size, we next consider inside equity investment as an alternative
proxy for the size of the initially required investment amount. Inside equity is defined as
equity supplied by the largest shareholder. In Table 4, we compare dollar amount inside
equity (in KRW billion) as well as those scaled by total assets across different groups of
firms in a similar way as in Table3.
The results from Panel A of Table 4 indicate that the amount of equity capital
provided by the largest shareholder is much larger in pyramidal subsidiaries than in standalones. For example, the dollar amount invested by the parent firm in a pyramidal
subsidiary is more than 7 times as large as those invested by the individual largest
shareholder in a stand-alone firm. Moreover, the proportion of total assets financed by
inside equity is also significantly larger in pyramidal subsidiaries than in stand-alones,
indicating that stand-alone firms require more outside financing due to potential financial
constraints faced by their individual shareholders. Such differences in inside equity exist
regardless of whether pyramidal subsidiaries are from chaebols or non-chaebols, or
whether stand-alones only include those from horizontal group or not, as we observe in
15
Panels B, C, and E of Table 4. Nevertheless, chaebol subsidiaries are provided with much
larger equity capital from their parent firms compared to non-chaebol subsidiaries as
reported in Panel D of Table 4.
Overall, the results from Tables 3 and 4 strongly suggest that the size of the required
investment is an important determinant of the initial shareholder structure of infant firms,
as predicted by Almeida and Wolfenzon (2006) and verified for a sample of European
firms in Bena and Ortiz-Molina (2013). Firms that require large amount of capital are
more likely to be set up as a subsidiary of a corporate parent, while those that require
smaller amount of initial investment may be set up by individual shareholders.
4.3. Comparison of Profitability
In Table 5, we compare profitability among different groups of infant firms as we
did in Tables 3 and 4. Our baseline measure of profitability is EBITDA scaled by total
assets. We also consider EBIT scaled by total assets since this variable is more readily
available for a larger subset of the full sample. As in Tables 3 and 4, we consider first
three fiscal years following the initial establishment as infant firm-years and include them
in the analysis.
The results from Panel A of Table 5 indicate that on average stand-alones are more
profitable than pyramidal subsidiaries based on both measures of profitability. Further
analyses in Panels B, C, and E suggest that such differences in profitability do not depend
on whether the pyramidal subsidiaries are chaebols or non-chaebols, or whether standalones are owned by individual shareholders who own other existing firms. Moreover, we
do not observe a significant difference between chaebol subsidiaries and non-chaebol
subsidiaries in terms of their profitability. These results suggest that good investment
opportunities are more likely to be taken advantage of by individual entrepreneurs and less
16
likely to be shared with other outside shareholders in the business group, consistent with
the predictions in Almeida and Wolfenzon (2006) and findings in Bena and Ortiz-Molina
(2013).
In Table 6, we consider the effect of firm size and profitability simultaneously on
the initial shareholder structure of infant firms in a multivariate framework. Specifically,
we estimate probit models where the dependent variable, namely pyramid dummy, takes
value of one if the initial shareholders of an infant firm include a corporation and zero if
its initial shareholders consist only of individuals. The main explanatory variables are
profitability measured as EBITDA scaled by total assets and natural logarithm of total
assets (in KRW billion). We also control for the largest initial shareholder’s ownership
stake as well as industry fixed effects and year fixed effects.
The results from the first two columns of Table 6 indicate that the effect of firm size
and profitability on the initial shareholder structure is consistent with those reported in the
previous univariate analyses. Specifically, profitability is negatively correlated while firm
size is positively correlated with the likelihood of an infant firm being set up as a
pyramidal subsidiary even when both variables are considered together after controlling
for the largest shareholder’s ownership stake as well as industry and year fixed effects.
In the next two columns, we exclude pure entrepreneurial stand-alones and reestimate the probit specification. The idea is that individual shareholders of stand-alones
who own other existing firms, i.e. controlling shareholders of a horizontal group, may
have chosen to set up the new infant firm as a pyramidal subsidiary of the firms that they
already own. By excluding pure entrepreneurial stand-alones whose shareholders do not
own any other firms to create a pyramidal subsidiary to begin with, we may examine a
genuine ‘choice’ between a pyramidal subsidiary and a stand-alone. The results from
columns (3) and (4) of Table 6 indicate that the negative (positive) effect of profitability
17
(firm size) on the likelihood of a pyramidal subsidiary still holds even after excluding pure
entrepreneurial stand-alones.
Overall, the results from this and the previous sub-section suggest that the way new
infant firms are set up strongly depends on the size of required investment and potential
profitability. Investment opportunities that require relatively small amount of capital and
provides relatively high profit margins are taken advantage of by individual entrepreneurs
who do not want to share the profits with other outside shareholders. On the other hand,
projects that require a large amount of investment but provide only small or even negative
profitability are implemented through pyramidal subsidiaries where any potential loss
from the project may be shared with the outside shareholders of the existing parent firm. 21
4.4. Related Party Transactions (RPTs) and Profitability
Existing theories in corporate finance typically model investment opportunity
assuming a single stand-alone firm. Even in Almeida and Wolfenzon (2006)’s model
where multiple firms are explicitly considered, respective investment opportunities of a
parent and a potential subsidiary are assumed to be independent. Such tendency is
presumably due to the fact that most firms in U.S. are stand-alone style that do not belong
to a business group. However, growing literature in international corporate finance
documents that most firms outside U.S. belong to a business group, for which internal
transactions among member firms constitute a significant portion of their normal business
activity.
For example, internal sales among member firms within Hyundai Motors Group, the
2nd largest family-controlled business group in Korea, amounts up to 20.7% of their total
21
The controlling shareholders may still benefit from a loss making pyramidal subsidiary if they are able to
divert corporate resources, or tunnel, from the pyramidal subsidiary, as suggested by Almeida and
Wolfenzon (2006). In fact, their theory predicts a pyramidal subsidiary precisely when its after-diversion
NPV is negative.
18
gross sales aggregated across all member firms in 2011. 22 Once we exclude publicly
traded firms and restrict member firms to privately held firms, corresponding proportion
of internal sales increases up to 41.6%. That is, close to a half of all sales by private firms
within Hyundai Motors Group are made to other member firms within the same business
group.
As such, infant firms’ profitability may critically depend on the degree and intensity
of related party transactions. For example, an infant firm may generate easy sales if other
member firms, including the direct parent firm, provide substantial amount of contracts to
the infant firm. On the other hand, an infant firm may easily generate a loss if it buys too
much raw materials, intermediate goods, or even finished goods from other members of
the business group, including the parent. 23
We now explore the implications of related party transactions made by infant firms
on their profitability. To our knowledge, this is the first paper to examine how related
party transactions may subsidize or expropriate the newly established infant firms, which
is the key focus and contribution of this study.
RPT data items are available from KIS-VALUE which collects information on RPTs
originally available from footnotes of audited financial statements. 24 KIS-VALUE
identifies each reported RPT and assigns them into four types; RPT sales, other RPT
revenues, RPT cost of goods (COG) purchased, and other RPT expenses. The first two
types imply cash generated from related parties and the last two imply cash paid to related
22
Press release by the Korea Fair Trade Commission, September 3, 2012 (in Korean).
Related party transactions based on non-market prices inherently favors one party over the other. Thus,
such deals would lead to either tunneling or propping. KFTC imposes a tight regulation on related party
transactions implemented at non-market prices. We do not pursue this issue further in this study, however,
mainly because our measures of RPTs are aggregated over a fiscal year and thus do not provide price
information at the transaction level.
24
Korean GAAP requires all corporations to disclose any transactions with a related party in the footnote of
the financial statements. Related parties include entities (both natural persons and legal persons) that
effectively control or are controlled by or are under the same controlling shareholder as the given firm,
including parents, subsidiaries, and other members of the same business group. Related parties also include
individuals such as executive management of a given firm or a parent firm, and family members of the
controlling shareholder or executives.
23
19
parties. KIS-VALUE then aggregates transaction amount for each type, which we use as
inputs in our calculation of RPT measures.
We consider three RPT metrics that are designed to capture the intensity of internal
sales within a business group, internal purchases within a business group, and overall net
income generated within a business group. Specifically, we define the following three
RPT measures;
𝑅𝑅𝑅𝑅𝑅𝑅 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑅𝑅𝑅𝑅𝑅𝑅 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
=
RPT sales + other RPT revenues
sales + non operating revenues
(1)
RPT COG purchased + other RPT expenses
COG purchased + selling and admin expenses + non operating expenses
(2)
𝑅𝑅𝑅𝑅𝑅𝑅 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
=
RPT sales + other RPT revenues − RPT COG purchased − other RPT expenses
(3)
sales + non operating revenues
We calculate these measures up to 5 years since the initial establishment. Since all
measures are scaled, the estimates reflect relative proportions of sales, expenses, and
earnings that are generated through related party transactions. 25
Table 7 presents averages of each of the three measures of RPTs for each of the four
groups. For all infant firms, RPT revenues account for 9% of all revenues and RPT
expenses account for 7.7% of all expenses. Although proportional RPT expenses are
smaller than RPT revenues, RPT earnings are negative on average, implying that dollar
amount of RPT revenues are smaller than RPT expenses, potentially due to larger scaling
factor for the expenses. We observe negative RPT earnings regardless of whether the
infant firm is a pyramidal subsidiary or a stand-alone. Such negative RPT earnings
25
We scale dollar amount RPT earnings by total sales and total non-operating revenues rather than net
income mainly because net income is negative in many cases.
20
indicate that more resources are transferred out of the newly set up infant firms into other
affiliated firms than into infant firms out of other existing member firms.
Once we separate pyramidal subsidiaries from stand-alones, we observe a stark
contrast. Specifically, the proportion of RPTs is much larger in pyramidal subsidiaries
than in stand-alones in terms of both revenues and expenses. Moreover, magnitudes of the
negative earnings are much larger in pyramidal subsidiaries than in stand-alones,
indicating that member firms may be expropriating the infant firm rather than subsidizing
them. In contrast, stand-alone firms do not exhibit much related party transactions nor are
their RPT earnings extremely negative. These results suggest that RPTs are much more
frequently observed in pyramidal subsidiaries than in stand-alones.
Out of the four groups of infant firms, pyramidal subsidiaries set up by chaebols
exhibit the largest proportion of RPTs. In fact, the proportion of RPT expenses amounts
up to 44.3% of all expenses. That is, close to a half of all expenses paid by a newly set up
chaebol subsidiary is actually paid to other members of the same business group.
Reflecting this huge reliance on affiliates for raw materials and other inputs, earnings
generated from RPTs for chaebol subsidiaries are extremely negative, even though the
proportion of RPT revenues are the highest among the four groups of infant firms. These
results suggest that pyramidal subsidiaries, especially those set up by chaebols, may have
been created to subsidize other existing member firms than to be subsidized by them.
In contrast, pure entrepreneurial firms exhibit the lowest proportion of RPTs in
terms of both revenues and expenses. This may seem odd at first since pure entrepreneurs
do not own any other existing firms and thus there is no other member firm or an affiliated
firm to begin with. However, related parties as defined in the disclosure requirements also
include individual controlling shareholders, executive managers as well as their family
members. Thus, even for pure entrepreneurial stand-alones, the proportion of RPTs may
21
well be non-zero. But still, low levels of proportional RPTs for these firms imply that
RPTs with individual related parties is relatively trivial. We may infer from this result that
the vast majority of RPTs are being generated between firms than between a firm and an
individual.
Finally, we examine how RPTs may affect the overall profitability of infant firms in
a multivariate context. In the previous sections, we have observed that profitability is
lower in pyramidal subsidiaries than in stand-alones. According to Almeida and
Wolfenzon (2006), Almeida et al. (2011), and Bena and Ortiz-Molian (2013), such low
profitability is a result of a selection and reflects the inherent characteristics of the
technology or the investment opportunity, such as high required investment or low
revenues. Hence, they emphasize that the low profitability is not driven by ex post
tunneling motivated through ex post deviation of cash flow rights from voting rights.
However, if the post-establishment profitability is largely driven by RPTs which is clearly
a choice variable of the controlling shareholder, it would be difficult to argue that low
profitability is a result of selection.
In Table 8, we report the OLS results where the dependent variable is profitability
proxied by EBITDA scaled by total assets. The key explanatory variables are the three
measures of RPTs. If RPTs affect the overall profitability of the infant firms, we expect
the coefficients on RPT revenues and RPT earnings to be positive, and those on RPT
expenses to be negative.
It is important to note that above predictions do not simply reflect some mechanical
relationships. For example, if RPT revenues and genuine arm’s length sales to outside
customers are negatively correlated (e.g. affiliates tend to help out the infant firm when
genuine sales decrease), and RPT revenues are relatively smaller than genuine revenues,
the coefficient on RPT revenues may turn out to be negative.
22
In Panel A, we report the results for the pyramidal subsidiaries, and in Panel B,
those for stand-alones. 26 The results from the first column in Panel A of Table 8 indicate
that RPT revenues are positively correlated with the overall profitability while RPT
expenses are negatively correlated , consistent with our predictions. For example, a one
standard deviation increase in RPT revenues increases the overall profitability by 5.7%
points, while a one standard deviation increase in RPT expenses reduces the overall
profitability by 1.1% points.
In column (2), we focus on the effect of RPT earnings, which combines both RPT
revenues and RPT expenses. The results indicate that RPT earnings are positively
correlated with the overall profitability, again consistent with our predictions. When we
separate chaebol subsidiaries and non-chaebol subsidiaries in columns (3), we do not
observe a significant difference between the two groups. Interestingly, the effect of RPT
earnings on overall earnings are much smaller for chaebol subsidiaries than for nonchaebol subsidiaries, which suggests that for chaebols, affiliated firms may be helping out
or propping the infant firm to some extent when overall profitability is low.
In Panel B of Table 8, we estimate similar regression coefficients for the stand-alone
infant firms. In this panel, we interact the three measures of RPTs with a horizontal group
dummy, which equals one if the individual shareholders of the stand-alone firm own other
existing firms. The results indicate that when horizontal group dummy is zero, i.e. for pure
entrepreneurial stand-alones, RPTs do not contribute to the overall profitability. This is
partly due to the fact that there is little variation in RPT measures for pure entrepreneurial
stand-alones since their RPT proportions are quite low. These insignificant results also
suggest that RPTs with individuals do not affect the overall profitability of RPT engaging
firms.
26
The main reason we run two separate regressions is that we were reluctant to employ a triple interaction
term which is cumbersome to interpret.
23
However, for horizontal group stand-alones whose shareholders own other existing
firms, the results are similar to those reported for pyramidal subsidiaries. That is, RPT
revenues and RPT earnings are positively correlated while RPT expenses are negatively
correlated with the overall profitability.
Overall, the results from this subsection clearly indicate that infant firms, especially
pyramidal subsidiaries set up by chaebols, engage in substantial amount of related party
transaction. Moreover, these RPTs influence the overall profitability of infant firms.
Specifically, except for pure entrepreneurial firms, RPT revenues and earnings increase
the overall profitability while RPT expenses reduce the overall profitability of infant firms.
These results cast some doubt on the selection hypothesis proposed by Almeida and
Wolfenzon (2006) and verified by Almeida et al. (2011) and Bena and Ortiz-Molina (2013)
since pyramidal subsidiaries’ profitability is largely determined by ex post subsidization or
expropriation by other member firms than its inherent characteristics of the technology.
In figure 1, we track the average profitabilities (EBITDA/total assets) of both standalones and pyramidal subsidiaries over a longer period, up to 11 years after the initial
establishment. In Panel A, we report the overall profitability including RPT earnings,
while in Panel B, we exclude those earnings generated through RPTs. Specifically,
profitability in Panel B is calculated as (EBITDA – RPT Earnings) scaled by total assets.
The results from Panel A indicate that in earlier years, there is a discrepancy in
profitability between the two groups, but over time, pyramidal subsidiaries catch up and
by year 8, the differences in profitability largely disappears. This pattern is similar to those
reported in Almeida et al. (2011) and Bena and Ortiz-Molina (2013) and suggest that postestablishment tunneling due to deviation of cash flow and control is not likely to be the
cause of the low profitability.
24
When we exclude RPT related earnings in Panel B, however, profitability of
pyramidal subsidiaries seem to remain rather persistent at around zero. This suggests that
their genuine profitability may be much lower that the reported profitabilities which
include earnings generated through RPTs.
4.5. Robustness Checks
Our first set of empirical tests compared firm size and profitability between
pyramidal subsidiaries and stand-alones. But, our initial univariate tests did not
appropriately control for potential heterogeneity in firm characteristics between the two
groups. To address this concern, we first match the firms in the two groups based on twodigit KSIC industry classification and then based on the number of years since the initial
establishment.
The results reported in Tables 9 and 10, respectively, indicate that the baseline
results remain valid after matching firms based on industry and age. Specifically,
pyramidal subsidiaries still exhibit larger firm size and lower profitability compared to
their matched sample of stand-alone firms.
5. Conclusion
Little is known about how firms are created in the very early stages of a firms’
financial life cycle. Even less is known about the dynamics between existing business
group member firms and the newly established pyramidal subsidiary. We directly address
these unexplored research questions.
Based on a sample of 1,368 newly established manufacturing firms in Korea set up
between 2000 and 2011, we first document that new firms whose initial shareholders do
not include any corporation, i.e. stand-alones, exhibit higher profitability and smaller asset
25
size compared to those new firms whose initial shareholders include corporations, i.e.
pyramidal subsidiaries. This finding is consistent with the predictions in Almeida and
Wolfenzon (2006) and findings in Bena and Ortiz-Molina (2013), who suggest that
controlling families prefer to monopolize a good investment opportunity if they can
finance it on their own. But if the project is too big and its’ profitability is expected to be
mediocre or even negative, controlling family would set up a pyramidal subsidiary using
all cash flows available in the parent firm and potentially divert away or tunnel some
corporate resources out of the subsidiary for personal benefits.
We next explore the implications of related party transaction on the profitability of
newly set up firms, which is our key focus and contribution. We find that pyramidal
subsidiaries, especially those set up by the chaebols engage in significant amounts of
related party transactions. Moreover, except for pure entrepreneurial cases where the
entrepreneur does not own any other existing firm, revenues and earnings generated
through related party transactions contribute to the overall profitability of infant firms
while expenses paid to related parties erode overall profitability. These results strongly
suggest that the intensity of related party transactions is a key driver of the profitability of
infant firms.
Most existing corporate finance theories model a firm as an independent business
opportunity. In our sample, pure entrepreneurial stand-alones mostly correspond to this
description. Although they account for almost half of all new infant firms, the remaining
half belong to a business group either as a pyramidal subsidiary or a horizontal group
stand-alone. To fully understand the dynamics of infant firm behavior, especially those in
emerging markets, we believe that it is crucial to explicitly take into account the costs and
benefits of related party transactions that surrounds an infant firm.
26
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28
Table 1
Distribution of Newly Established Firms: Stand-alones vs. Pyramidal Subsidiaries
This table reports the distribution of newly established firms in the Korean manufacturing sector from 2000 to 2011 grouped by initial ownership structure.
Firms estblished through spin-offs, splits, or foreign investments are excluded. We define new firm-years as those fiscal years within 1 to 3 years of the initial
establishment. Each row presents the number of new firms and the sum of total assets of these new firms for each ownership structure type. Total assets are
averaged across years 1 through 3 for a given new firm before being aggregated. Stand-alones are those whose initial shareholders consist of only individuals.
Pyramidal subsidiaries are those whose initial shareholders include at least one corporation. The first column reports the total number and combined assets for
all newly established firms in the sample. The remaining columns report the relative proportions of stand-alone firms and pyramidal subsidiaries. Stand-alone
firms are further broken down into those whose shareholders own other existing firms (horizontal group) and those whose shareholders do not own any other
firms (pure entrepreneurial). Pyramidal subsidiaries are further broken down into those whose shareholders are members of large business groups (chaebols)
designated by the Korea Fair Trade Commission (KFTC), and those whose shareholders are not (non-chaebols).
All
new firms
Number of new firms
Combined total assets (KRW bil)
Stand-alones
Pyramidal Subsidiaries
Horizontal
All
Pure
All pyramidal Large business
Non-chaebol
group
stand-alones
entrepreneurial subsidiaries group (chaebol)
1,368
65.6%
17.0%
48.6%
34.4%
6.7%
27.6%
27,377
31.5%
11.4%
20.1%
68.5%
39.5%
29.0%
29
Table 2
Distribution of Newly Established Firms by Industry
This table reports the distribution of newly established firms in the Korean manufacturing sector from 2000 to 2011 for each industry based on two-digit KSIC-9
codes. Firms estblished through spin-offs, splits, or foreign investments are excluded. We define new firm-years as those fiscal years within 1 to 3 years of the
initial establishment. Total assets are averaged across years 1 through 3 for a given new firm before taking cross-sectional medians. Stand-alones are those
whose initial shareholders consist of only individuals. Pyramidal subsidiaries are those whose initial shareholders include at least one corporation. Stand-alone
firms are further broken down into those whose shareholders own other existing firms (horizontal group) and those whose shareholders do not own any other
firms (pure entrepreneurial). Pyramidal subsidiaries are further broken down into those whose shareholders are members of large business groups (chaebols)
designated by the Korea Fair Trade Commission (KFTC), and those whose shareholders are not (non-c haebols).
Industry
Code
(2 digit)
10
11
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
Industry Category
(Manufacturing)
Food
Beverages
Textiles (exc. Clothing)
Clothing
Leathers, Bags, Shoes
Wood products (exc. Furnitures)
Pulp, Papers
Publishing
Cokes, Coals, Petroleum
Chemicals (exc. Pharmaceuticals)
Phamaceutical
Rubbers, Plastics
Non-metal minerals
Basic Metal
Metal Processing
Electronics
Medical, Precision, Optical
Electric equipment
Other machinery, equipment
Automobiles
Other transportation equipment
Furnitures
Other products
Total
N
61
12
20
43
8
4
20
10
3
106
17
62
60
95
103
254
52
55
177
127
69
3
7
1,368
All New Firms
Stand-alones
Pyramidal Subsidiaries
Median
Median
Median
Pure
Large busiAll
Horizontal
All pyramidal
Total assets
EBIT/Total
Equity/Total
entreness group Non-chaebol
stand-alones
group
subsidiaries
(KRW bil)
Assets
Assets
preneurial
(chaebol)
9.6
2.6%
24.5%
59.0%
13.1%
45.9%
41.0%
8.2%
32.8%
17.7
1.1%
15.6%
50.0%
8.3%
41.7%
50.0%
16.7%
33.3%
10.1
4.6%
19.2%
90.0%
10.0%
80.0%
10.0%
5.0%
5.0%
9.0
10.4%
24.1%
81.4%
25.6%
55.8%
18.6%
4.7%
14.0%
7.7
30.0%
35.6%
100.0%
25.0%
75.0%
0.0%
0.0%
0.0%
4.9
1.7%
33.7%
50.0%
0.0%
50.0%
50.0%
0.0%
50.0%
8.4
2.0%
23.5%
45.0%
15.0%
30.0%
55.0%
5.0%
50.0%
3.4
6.8%
27.2%
90.0%
20.0%
70.0%
10.0%
0.0%
10.0%
12.2
7.2%
33.3%
33.3%
0.0%
33.3%
66.7%
33.3%
33.3%
8.0
1.5%
29.9%
46.2%
11.3%
34.9%
53.8%
24.5%
29.2%
5.9
-3.3%
60.2%
41.2%
29.4%
11.8%
58.8%
11.8%
47.1%
7.1
5.9%
21.4%
79.0%
29.0%
50.0%
21.0%
4.8%
16.1%
11.3
1.6%
23.9%
53.3%
23.3%
30.0%
46.7%
16.7%
30.0%
10.8
4.4%
19.5%
57.9%
16.8%
41.1%
42.1%
8.4%
33.7%
9.0
3.9%
21.8%
72.8%
8.7%
64.1%
27.2%
1.9%
25.2%
7.9
4.0%
31.5%
66.1%
18.5%
47.6%
33.9%
5.1%
28.7%
6.0
6.0%
31.6%
75.0%
5.8%
69.2%
25.0%
1.9%
23.1%
7.2
4.5%
34.4%
70.9%
16.4%
54.5%
29.1%
7.3%
21.8%
6.7
5.7%
24.3%
75.7%
16.4%
59.3%
24.3%
3.4%
20.9%
9.2
3.4%
22.2%
59.8%
19.7%
40.2%
40.2%
3.1%
37.0%
10.4
4.2%
20.0%
65.2%
24.6%
40.6%
34.8%
1.4%
33.3%
17.0
2.1%
29.9%
33.3%
0.0%
33.3%
66.7%
0.0%
66.7%
8.2
6.7%
30.6%
71.4%
0.0%
71.4%
28.6%
0.0%
28.6%
8.3
4.0%
35.7%
65.6%
17.0%
48.6%
34.4%
6.7%
27.6%
30
Table 3
Firm Size: Pyramidal Subsidiaries vs. Stand-alones
This table presents average total assets and fixed assets (in KRW billion) for various groups of newly
established firms in the Korean manufacturing sector from 2000 to 2011. We define new firm-years as
those fiscal years within 1 to 3 years of the initial establishment. Differences between the groups and
related t-statistics are also reported. Panel A compares all pyramidal subsidiaries against all standalones. Panel B compares pyramidal subsidiaries whose parent companies are affiliated with large
business groups (chaebol subsidiaries) against all stand-alones. Panel C compares pyramidal
subsidiaries whose parent companies are not affiliated with large business groups (non-chaebols
subsidiaries) against all stand-alones. Panel D compares chaebol subsidiaries against non-chaebol
subsidiaries. Panel E compares all pyramidal subsidiaries against stand-alones whose shareholders
own other firms (horizontal group). Large business group affiliation is based on KFTC’s annual
designation. The last two columns report the number of firm-years (up to three per firm) used for each
group of new firms.
Panel A: All Pyramidal Subsidiaries vs. All Stand-alones
Total Assets
Fixed Assets
All Pyramidal
All Stand-alones
Subsidiaries
41.7
9.9
27.5
5.7
Difference
t-statistic
31.8
21.7
8.42
7.96
N (pyramidal
N (stand-alones)
subsidiaries)
1,241
2,410
1,233
2,396
Panel B: Chaebol Subsidiaries vs. All Stand-alones
Total Assets
Fixed Assets
Chaebol
All Stand-alones
Subsidiaries
121.5
9.9
80.3
5.7
Difference
t-statistic
111.6
74.6
6.39
5.92
N (chaebol
N (stand-alones)
subsidiaries)
247
2,410
247
2,396
Panel C: Non-chaebol Subsidiaries vs. All Stand-alones
Total Assets
Fixed Assets
Non-chaebol
All Stand-alones
Subsidiaries
21.9
9.9
14.3
5.7
Difference
N (non-chaebol
N (stand-alones)
subsidiaries)
9.94
994
2,410
9.28
986
2,396
t-statistic
12.0
8.5
Panel D: Chaebol Subsidiaries vs. Non-chaebol Subsidiaries
Total Assets
Fixed Assets
Chaebol
Subsidiaries
121.5
80.3
Non-chaebol
Subsidiaries
21.9
14.3
Difference
t-statistic
99.6
66.1
5.70
5.23
N (chaebol
subsidiaries)
247
247
N (non-chaebol
subsidiaries)
994
986
N (pyramidal
subsidiaries)
1,241
1,233
N (horizontal
group)
596
594
Panel E: All Pyramidal Subsidiaries vs. Horizontal Group Stand-alones
Total Assets
Fixed Assets
All Pyramidal
Subsidiaries
41.7
27.5
Horizontal
Group
14.2
8.6
Difference
27.5
18.9
31
t-statistic
6.88
6.56
Table 4
Inside Equity Investment: Pyramidal Subsidiaries vs. Stand-alones
This table presents averages of inside equity investment defined as equity supplied by the largest
shareholder (in KRW billion) for various groups of newly established firms in the Korean
manufacturing sector from 2000 to 2011. We also report averages of inside equity scaled by total
assets.We define new firm-years as those fiscal years within 1 to 3 years of the initial establishment.
Differences between the groups and related t-statistics are also reported. Panel A compares all
pyramidal subsidiaries against all stand-alones. Panel B compares pyramidal subsidiaries whose
parent companies are affiliated with large business groups (chaebol subsidiaries) against all standalones. Panel C compares pyramidal subsidiaries whose parent companies are not affiliated with large
business groups (non-chaebols subsidiaries) against all stand-alones. Panel D compares chaebol
subsidiaries against non-chaebol subsidiaries. Panel E compares all pyramidal subsidiaries against
stand-alones whose shareholders own other firms (horizontal group). Large business group affiliation
is based on KFTC’s annual designation. The last two columns report the number of firm-years (up to
three per firm) used for each group of new firms.
Panel A: All Pyramidal Subsidiaries vs. All Stand-alones
Inside Equity
Inside Equity/Total Assets
All Pyramidal
Subsidiaries
11.5
24.6%
All StandDifference
alones
1.6
9.9
16.1%
8.5%
N (pyramidal
subsidiaries)
8.09
1,235
10.16
989
t-statistic
N (standalones)
2,382
2,382
Panel B: Chaebol Subsidiaries vs. All Stand-alones
Inside Equity
Inside Equity/Total Assets
Chaebol
Subsidiaries
39.3
32.7%
All Standalones
1.6
16.1%
Difference
37.6
16.6%
t-statistic
6.60
10.13
244
218
N (standalones)
2,382
2,382
N (nonchaebols)
415
771
N (standalones)
2,382
2,382
N (chaebols)
Panel C: Non-chaebol Subsidiaries vs. All Stand-alones
Inside Equity
Inside Equity/Total Assets
Non-chaebol
Subsidiaries
4.7
22.3%
All Standalones
1.6
16.1%
Difference
3.1
6.2%
t-statistic
8.69
6.82
Panel D: Chaebol Subsidiaries vs. Non-chaebol Subsidiaries
Inside Equity
Inside Equity/Total Assets
Chaebol
Non-chaebol
Subsidiaries
Subsidiaries
39.3
4.7
32.7%
22.3%
Difference
34.6
10.4%
t-statistic
6.05
5.78
N (chaebols)
244
218
N (nonchaebols)
415
771
Panel E: All Pyramidal Subsidiaries vs. Horizontal Group Stand-alones
Inside Equity
Inside Equity/Total Assets
All Pyramidal
Subsidiaries
11.5
24.6%
Horizontal
Difference
Group
2.5
9.1
15.5%
9.1%
32
N (pyramidal N (horizontal
subsidiaries)
group)
7.02
1,235
593
8.96
989
593
t-statistic
Table 5
Profitability: Pyramidal Subsidiaries vs. Stand-alones
This table presents averages of two measures of profitability, namely EBITDA/total assets or
EBIT/total assets, for various groups of newly established firms in the Korean manufacturing sector
from 2000 to 2011. We define new firm-years as those fiscal years within 1 to 3 years of the initial
establishment. Differences between the groups and related t-statistics are also reported. Panel A
compares all pyramidal subsidiaries against all stand-alones. Panel B compares pyramidal subsidiaries
whose parent companies are affiliated with large business groups (chaebol subsidiaries) against all
stand-alones. Panel C compares pyramidal subsidiaries whose parent companies are not affiliated with
large business groups (non-chaebols subsidiaries) against all stand-alones. Panel D compares chaebol
subsidiaries against non-chaebol subsidiaries. Panel E compares all pyramidal subsidiaries against
stand-alones whose shareholders own other firms (horizontal group). Large business group affiliation
is based on KFTC’s annual designation. The last two columns report the number of firm-years (up to
three per firm) used for each group of new firms.
Panel A: All Pyramidal Subsidiaries vs. All Stand-alones
EBITDA/Total Assets
EBIT/Total Assets
All Pyramidal
Subsidiaries
4.8%
-0.4%
All StandDifference
alones
10.7%
-5.9%
5.0%
-5.4%
N (pyramidal
subsidiaries)
-9.07
885
-9.34
1,232
t-statistic
N (standalones)
1,246
2,403
Panel B: Chaebol Subsidiaries vs. All Stand-alones
EBITDA/Total Assets
EBIT/Total Assets
Chaebol
Subsidiaries
3.8%
0.9%
All Standalones
10.7%
5.0%
Difference
-6.9%
-4.1%
t-statistic
-7.43
-4.98
220
247
N (standalones)
1,246
2,403
N (nonchaebols)
665
985
N (standalones)
1,246
2,403
N (chaebols)
Panel C: Non-chaebol Subsidiaries vs. All Stand-alones
EBITDA/Total Assets
EBIT/Total Assets
Non-chaebol
Subsidiaries
5.1%
-0.7%
All Standalones
10.7%
5.0%
Difference
-5.6%
-5.7%
t-statistic
-7.79
-9.09
Panel D: Chaebol Subsidiaries vs. Non-chaebol Subsidiaries
EBITDA/Total Assets
EBIT/Total Assets
Chaebol
Non-chaebol
Subsidiaries
Subsidiaries
3.8%
5.1%
0.9%
-0.7%
Difference
-1.3%
1.6%
t-statistic
-1.36
1.84
N (chaebols)
220
247
N (nonchaebols)
665
985
Panel E: All Pyramidal Subsidiaries vs. Horizontal Group Stand-alones
EBITDA/Total Assets
EBIT/Total Assets
All Pyramidal
Subsidiaries
4.8%
-0.4%
Horizontal
Difference
Group
11.4%
-6.7%
5.2%
-5.6%
33
N (pyramidal N (horizontal
subsidiaries)
group)
-7.15
885
332
-7.73
1,232
593
t-statistic
Table 6
Newly Established Firms’ Initial Ownership Structure: Multivariate Analysis
This table reports the results of probit regressions where the dependent variable, pyramid dummy
equals one if the newly established firm’ initial shareholders include at least one corporation and zero
if its initial shareholders consists of only individuals. In the first two columns, we report the results for
the full sample of infant firms. In the next two columns, we drop those stand-alone firms whose
shareholders do not own any other firm (pure entrepreneurial) and keep only those with shareholders
who own at least one other firm (horizontal group). The sample consists of newly established firms in
the Korean manufacturing sector during the period between 2000 and 2011. Profitability is
EBITDA/total assets. Ln(Size) is the logarithm of the book value of total assets. Ownership % is the
largest individual shareholder’s stake for stand-alone new firms, and largest corporate shareholder’s
ownership stake for new pyramidal subsidiaries. In column 3 and 4, we include industry and
established year fixed effect. z-statistics are in parenthesis.
Dependent Variable:
Pyramid Dummy
Intercept
Profitability
Ln(Size)
Ownership%
Industry Fixed Effect
Established Year Fixed Effect
Number of Observations
Pyramidal Subsidiaries
Stand-alones
Full Sample
Exclude Pure Entrepreneurial
Stand-alones
(3)
(4)
(1)
(2)
-5.374
(-13.23)
-3.340
(-9.37)
0.535
(12.59)
0.417
(2.52)
No
No
-5.464
(-0.09)
-2.977
(-8.11)
0.482
(10.81)
0.346
(1.92)
Yes
Yes
-1.931
(-4.04)
-3.686
(-7.21)
0.302
(6.13)
0.542
(2.32)
No
No
0.650
(0.01)
-3.771
(-6.66)
0.241
(4.56)
0.421
(1.63)
Yes
Yes
2,114
884
1,230
2,114
884
1,230
1,214
884
330
1,214
884
330
34
Table 7
Related Party Transactions (RPTs) in Newly Established Firms
This table reports the averages of related party transactions (RPTs) undertaken by newly established
firms in the Korean manufacturing sector from 2000 to 2011. Stand-alones are those whose initial
shareholders consist of only individuals. Pyramidal subsidiaries are those whose initial shareholders
include at least one corporation. Stand-alone firms are further broken down into those whose
shareholders own other existing firms (horizontal group) and those whose shareholders do not own
any other firms (pure entrepreneurial). Pyramidal subsidiaries are further broken down into those
whose shareholders are members of large business groups (chaebols) designated by the Korea Fair
Trade Commission (KFTC), and those whose shareholders are not (non-c haebols). We consider three
measures of RPTs; RPT Revenues defined as (RPT sales + other RPT revenues) / (sales + nonoperating revenues), RPT Expenses defined as (RPT cost of goods purchased + other RPT expenses) /
(cost of goods purchased + selling and administrative expenses + non-operating expense), and RPT
Earnings defined as (RPT sales + other RPT revenues - RPT cost of goods purchased - other RPT
expenses ) / (sales + non-operating revenues). RPT measures are calculated up to 5 years after
establishment.
RPT Revenues RPT Expenses RPT Earnings
22.6%
44.3%
-1319.2%
14.8%
9.7%
-175.8%
16.4%
16.5%
-399.6%
Pyramidal Subsidiaries Chaebols (N=460)
Non-chaebols (N=1,890)
All
Stand-alones
Horizontal group (N=1,160)
Pure entrepreneurial (N=3,330)
All
All Infant Firms
35
9.8%
3.6%
5.2%
5.2%
2.4%
3.1%
-5.4%
-3.6%
-4.0%
9.0%
7.7%
-140.0%
Table 8
Effect of Related Party Transactions (RPTs) on Profitability
This table presents regression results where the dependent variable is profitability defined as
EBITDA/total assets. Chaebols equals one if the pyramidal subsidiary’s initial shareholders include a
member of a large business group or chaebol and zero otherwise. Horizontal group equals one if the
stand-alone’s individual shareholders own other existing firms and zero otherwise. Profitability and
RPT measures are calculated each year from year 1 to year 5 of establishment. RPT Revenues is (RPT
sales + other RPT revenues) / (sales + non-operating revenues). RPT Expenses is (RPT cost of goods
purchased + other RPT expenses) / (cost of goods purchased + selling and administrative expenses +
non-operating expense). RPT Earnings is (RPT sales + other RPT revenues - RPT cost of goods
purchased - other RPT expenses) / (sales + non-operating revenues). Ln(Size) is the logarithm of the
book value of total assets. Leverage is total liabilities over total assets. Ownership % is the largest
individual shareholder’s stake for stand-alone new firms, and largest corporate shareholder’s
ownership stake for new pyramidal subsidiaries. Panel A reports the results for firms with parents
while panel B reports those for stand-alone firms.
Panel A: Pyramidal Subsidiaries
Intercept
Chaebols
RPT Revenues
RPT Revenues
*Chaebols
RPT Expenses
RPT Expenses
*Chaebols
RPT Earnings
RPT Earnings
*Chaebols
Ln(Size)
Leverage
Ownership %
Dependent Variable: Profitability
(1)
(2)
(3)
(4)
-0.112
-0.128
-0.132
-0.149
(-4.92)
(-5.69)
(-5.63)
(-6.47)
-0.030
-0.030
(-3.01)
(-3.48)
0.057
0.061
(5.56)
(5.04)
-0.004
(-0.17)
-0.011
-0.022
(-2.71)
(-1.54)
0.014
(0.95)
0.003
0.013
(3.72)
(4.58)
-0.011
(-3.71)
0.022
0.024
0.025
0.027
(9.84)
(11.10)
(10.46)
(11.73)
-0.047
-0.048
-0.052
-0.051
(-5.41)
(-5.47)
(-5.88)
(-5.86)
-0.055
-0.050
-0.052
-0.047
(-5.14)
(-4.68)
(-4.88)
(-4.34)
R2
0.089
0.078
0.095
0.09
N
1,957
1,960
1,957
1,960
36
Table 8 - continued
Panel B: Stand-alones
Intercept
Horizontal group
RPT Revenues
RPT Revenues
*Horizontal group
RPT Expenses
RPT Expenses
*Horizontal group
RPT Earnings
RPT Earnings
*Horizontal Group
Ln(Size)
Leverage
Ownership %
Dependent Variable: Profitability
(1)
(2)
-0.192
-0.183
(-9.67)
(-9.42)
-0.013
-0.016
(-2.27)
(-2.98)
-0.020
(-0.98)
0.094
(3.33)
-0.014
(-0.43)
-0.129
(-2.62)
-0.006
(-0.29)
0.099
3.53
0.046
0.045
(21.17)
(21.29)
-0.200
-0.200
(-21.78)
(-21.73)
0.039
0.039
(4.49)
(4.53)
R2
0.182
0.183
N
3,889
3,890
37
Table 9
Matching Firm Analysis
This table reports the differences in average size, inside equity, and profitability between new
pyramidal subsidiaries and new stand-alones, after matching firms based on two-digit KSIC industry
affiliation. Stand-alones are those whose initial shareholders consist of only individuals. Pyramidal
subsidiaries are those whose initial shareholders include at least one corporation. Panel A compares
total assets, while Panels B and C compare inside equity investment and profitability, respectively, of
new pyramidal subsidiaries with new stand-alone firms. The last two columns report the number of
firm-years (up to three per firm) for each group of new firms.
Pyramidal
Subsidiaries
Panel A: Size
Total Assets (KRW bil)
Fixed Assets (KRW bil)
Stand-alones
Difference
t-statistic
N (pyramidal
subsidiaries)
N (standalones)
36.9
22.4
10.0
5.8
26.8
16.6
7.31
5.44
1,227
1,217
2,317
2,304
Panel C: Inside Equity
Inside Equity (KRW bil)
Inside Equity/Total Assets
10.8
21.4%
1.7
16.3%
9.1
5.1%
5.98
3.12
1,215
1,215
2,298
2,298
Panel B: Profitability
EBITDA/Total Assets
EBIT/Total Assets
4.4%
-1.1%
9.5%
4.8%
- 5.1%
- 5.8%
-4.12
-7.28
1,207
1,207
2,291
2,291
38
Table 10
Matching Age Analysis
This table reports the differences in average size, inside equity, and profitability between new
pyramidal subsidiaries and new stand-alone ones, after matching based on firm age. Stand-alones are
those whose initial shareholders consist of only individuals. Pyramidal subsidiaries are those whose
initial shareholders include at least one corporation. Panel A compares new firrms at age 1 only, while
Panels B and C compare new firrms at age 2 only and at age 3 only, respectively. The last two
columns report the number of firm-years (up to three per firm) for each group of new firms.
Pyramidal
Stand-alones
Subsidiaries
Difference
t-statistic
N (pyramidal
subsidiaries)
N (standalones)
Panel A: Age 1 Only
Total Assets (KRW bil)
Fixed Assets (KRW bil)
EBITDA/Total Assets
EBIT/Total Assets
Inside Equity (KRW bil)
Inside Equity/Total Assets
30.6
19.8
2.3%
-1.9%
9.3
31.6%
5.8
3.4
6.2%
1.0%
0.9
18.2%
24.8
16.3
-3.9%
-2.9%
8.4
13.4%
4.09
3.49
-2.85
-2.76
4.83
8.43
391
382
211
383
389
311
739
725
228
732
730
730
Panel B: Age 2 Only
Total Assets (KRW bil)
Fixed Assets (KRW bil)
EBITDA/Total Assets
EBIT/Total Assets
Inside Equity (KRW bil)
Inside Equity/Total Assets
42.9
27.0
4.2%
-0.4%
12.7
23.0%
10.0
5.9
10.8%
5.3%
1.6
14.6%
32.9
21.1
-6.6%
-5.7%
11.1
8.5%
5.10
4.77
-5.75
-5.32
4.79
6.08
427
426
321
426
425
341
821
821
431
821
812
812
Panel C: Age 3 Only
Total Assets (KRW bil)
Fixed Assets (KRW bil)
EBITDA/Total Assets
EBIT/Total Assets
Inside Equity (KRW bil)
Inside Equity/Total Assets
50.8
34.9
6.8%
1.0%
12.4
19.6%
13.4
7.6
12.3%
8.2%
2.2
15.7%
37.4
27.3
-5.5%
-7.2%
10.2
4.0%
5.36
5.44
-5.88
-8.27
4.61
3.05
423
425
353
423
421
337
850
850
587
850
840
840
39
Figure 1
Evolution of Profitability over Time: Stand-alones vs. Pyramidal Subsidiaries
This figure reports the averages of reported profitabilities up to 11 years after the initial establishment
for new pyramidal subsidiaries and new stand-alone firms. The sample consists of newly established
firms in the Korean manufacturing sector during the period between 2000 and 2011. Stand-alones are
those whose initial shareholders consist of only individuals. Pyramidal subsidiaries are those whose
initial shareholders include at least one corporation. The vertical axis plots the average profitability,
EBITDA/total assets, and horizontal axis plots number of years since establishment. Panel A presents
profitability including RPTs while Panel B presents profitability after removing those generated by
RPTs. Specifically, profitability in Panel B is calculated as (EBITDA-RPT Earnings)/Total Assets.
Panel A: Profitability including RPT Earnings
Panel B: Profitability excluding RPT Earnings
40