Should business groups be

dismantled? The equilibrium

costs of efficient internal
capital markets

Almeida and
Wolfenzon (JFE 2006)
 Motivation
• Restructuring pressure on business
groups in 1990s
• Internal capital allocation of business
groups (in isolation)
– Efficient allocation: Gertner et al. (1994),
Stein (1997)
– Inefficient allocation: Shin and Stulz (1998),
Rajan et al. (2000), Scharfstein and Stein
(2000)
 Main Contribution
• Models negative externality of efficient
internal capital market of business
groups
– External capital market is subject to a
financing friction (limited pedgeability)
– Internal capital market of business groups
faces no friction
– The relationship between degree of investor
protection and degree of conglomeration
 Simple Example
• 3 investment projects = {H, M, L}
– Requires 1 unit investment
– Payoff: H=5, M=3, L=1
– 1 unit of capital supply, happens to be invested
in L
• Limited pledgeability of external capital
market, full pledgeability of interanl capital
market
– λ: maximum fraction that can be credibly
pledgeable to outside investors
– 1-λ: private benefits of control
 Simple Example
• First economy: 3 stand-alone firms
– Firm L can keep the unit of capital or reallocate
to M or H to realize 3λ or 5λ, respectively.
• Second economy: Conglomerate has L and
M, H is stand-alone
– Conglomerate can reallocate the unit of capital
internally to M and realize 3
– Conglomerate can reallocate the unit of capital
externally to H and realize 5λ
 Simple Example
• Degree of limited pledgeability λ
– Low (λ<1/5): Conglomerate is better.
– Medium(1/5<λ<3/5): Conglomerate is
inefficient.
– High(λ>3/5): Efficient allocation in both
economy
Timeline
 Model
• J set of projects
– Stand-alone firms i∈ J
– Conglomerates j,k∈ J
– c/2 conglomerates and 1-c stand-alones
• Constant aggregate capital K>1
• Project productivity: H, M, L
• General technology: less productive than
M but more productive than L
 Limited pledgeability
• Assume that only a fraction of λ of the returns of
the second unit invested is pledgeable.

• Poor investment protection (Shleifer and Wolfenzon,

2002)
• Inalienability of human capital (Hart and Moore,
1994)
• Moral hazard in project choice (Holmstron and Tirole,
1997)
 Internal Capital Markets
• Once external capital market closes, the
conglomerate allocate its internal capital
to maximize its total payoff.
• Private benefit of control: (1-λ)Y
• Internal capital market is privately
efficient as long as private benefits are
positively correlated with total cash flows
• Internal capital markets may not be
privately efficient
 External Finance at t 0
• Assume away dynamic interaction of t 0
external financing and t1 capital
reallocation.
• Ex ante commitment of entrepreneur to
liquidate L
– Low external financing needs: always feasible
– High external financing needs: if t1 cash flows
are positively correlated with the productivity of
the project, standard debt contract would work
 Multiple Equilibria with
Endogenous Pledgeability
• Equilibria with low c and high c if
intermediate investor protection
• No natural mechanism to move toward
the equilibrium with low c even if it is
socially superior
• May increase λ
– Political process: Lobbying power of
conglomerates
Implications
Implications
 Conclusion
• Conglomerates can be detrimental to capital
allocation even when they have efficient internal
capital markets.
• Conglomeration could impose negative
externality to other firms outside by making it
more difficult to raise funds for good projects.
• The negative externality depends on the degree
of investor protection of external capital market.
• Conglomerates do not have incentives to
dismantle voluntarily.