Propping and Pyramids in Family Business Groups: Evidence from Korean Chaebols Myung Sub, Choi Master of Business (Research) in Finance, Queensland University of Technology Bachelor of Business in Finance, Queensland University of Technology Submitted in fulfilment of the requirements for the degree of Doctor of Philosophy School of Economics and Finance Faculty of Business Queensland University of Technology Brisbane, Australia 2018 Keywords • Business Groups • Family Business Groups • Chaebol • Related Party Transactions • Related Party Sales • Resource Allocation • Propping • Tunneling • Internal Capital Market • Ownership Structure • Pyramid • Cross-shareholdings • 2008 Financial Crisis • Korea i Abbreviations GFC Global Financial Crisis KFTC Korea Fair Trade Commission KIS Korea Investor Service KOSDAQ Korea Securities Dealers Automated Quotation KOSPI Korea Composite Stock Price Index KSE Korea Stock Exchange RPP Related Party Purchases RPS Related Party Sales RPT Related Party Transactions ii Abstract The design of my thesis is inspired by Riyanto and Toolsema (2008) who argue that in response to a negative an economic shock, propping occurs through related party transactions in which the controlling family transfers resources from higher-level firms to lower-level firms in the pyramidal business group. Using the universe of Korean chaebol firms with available data during the period 2006-2011, I study the mechanism of propping in chaebol groups by investigating related party sales following the 2008 financial crisis, and its effects on the performance and investment of chaebol firms. I find Korean chaebols are able to use intra-group transactions to mitigate the negative effects of the crisis. Using a discrete classification of firms into four pyramidal layers, the controlling chaebol family uses related party sales to prop up firms in the third layer in the period following the crisis, perhaps at the expense of central firms. My results suggest a positive role of propping in chaebols in the aftermath of the recent crisis and that the controlling family transfers the cost of propping to outside minority shareholders instead of absorbing it on personal account. I also find evidence showing that the negative effects of the recent financial shock are alleviated by propping rather than by the operation of chaebols’ internal capital markets. This result is contrary to the recent empirical work by Almeida et al. (2015) who show the operation of active internal capital markets during 1997 Asian crisis in Korea. My findings for the recent financial crisis however support the view that a business group whose primary function is to form an internal capital market is likely to disappear or shrink in response to financial market development (Khanna and Yafeh, 2007). iii Table of Contents Keywords .......................................................................................................................................................i Abbreviations .............................................................................................................................................. ii Abstract ....................................................................................................................................................... iii List of Tables ............................................................................................................................................ viii List of Figures ............................................................................................................................................. ix List of Appendices ...................................................................................................................................... x Statement of Original Authorship .......................................................................................................... xii Acknowledgements .................................................................................................................................. xiii CHAPTER 1 Introduction .................................................................................................................... 1 1.1 Background and Motivations .....................................................................................................1 1.2 Research Aims and Design ........................................................................................................4 1.3 Summary of Main Findings ........................................................................................................8 1.4 Addressing Endogeneity Issues .............................................................................................. 11 1.5 Contributions ............................................................................................................................ 13 1.6 Thesis Layout ............................................................................................................................ 16 CHAPTER 2 Litetature Review .......................................................................................................... 17 2.1 Introduction ................................................................................................................................ 17 2.2 Family Business Groups ........................................................................................................... 17 2.2.1 Definition ................................................................................................................... 17 2.2.2 Motivations for Establishing Family Business Groups ....................................... 18 2.2.3 Ownership Structure of Family Business Groups ............................................... 20 2.3 Internal Capital Markets of Business Groups........................................................................ 24 2.3.1 Tunneling ................................................................................................................... 24 2.3.2 Propping ..................................................................................................................... 27 2.3.3 Internal Capital Markets .......................................................................................... 29 2.4 Chapter Summary ...................................................................................................................... 33 CHAPTER 3 Hypotheses .................................................................................................................... 35 3.1 Introduction ................................................................................................................................ 35 3.2 Empirical Predictions ................................................................................................................ 35 3.3 Chapter Summary ...................................................................................................................... 40 CHAPTER 4 The Institutional Setting .............................................................................................. 41 4.1 Introduction ................................................................................................................................ 41 4.2 Korean Family Business Groups: Chaebols .......................................................................... 41 iv 4.2.1 Definition of Chaebol .............................................................................................. 41 4.2.2 The Rise and Fall of Chaebols ................................................................................ 42 4.2.3 The Controlling Mechanism ................................................................................... 44 4.3 Chapter Summary ...................................................................................................................... 46 CHAPTER 5 Ownership Structure of Korean Family Business Groups ..................................... 47 5.1 Introduction ................................................................................................................................ 47 5.2 Metrics and Algorithms of Ownership Variables ................................................................. 47 5.2.1 Ultimate Cash Flow Rights ...................................................................................... 47 5.2.2 Position and Loop .................................................................................................... 53 5.2.3 Control Rights ........................................................................................................... 55 5.2.4 Centrality and Separation between Control and Ownership .............................. 61 5.3 Application of Metrics and Algorithms to Chaebols ............................................................ 62 5.3.1 Ownership Data ........................................................................................................ 62 5.3.2 An Example ............................................................................................................... 64 5.4 Chapter Summary ...................................................................................................................... 76 CHAPTER 6 Research Design and Data .......................................................................................... 77 6.1 Introduction ...............................................................................................................................