Economics focus | Pharaoh capitalism |
Economics focus

Pharaoh capitalism
Feb 12th 2009
From The Economist print edition

The costs and benefits of “pyramid” business groups

Illustration by Jac Depczyk
Illustration by Jac Depczyk

Correction to this article

LIKE a blot on corporate India’s copybook, the Satyam scandal is still spreading. Two auditors from PricewaterhouseCoopers are in police custody, where they are trying to explain why they signed off on the outsourcing company’s cooked books. The chief minister of Satyam’s home state is trading furious accusations of negligence and worse with his predecessor. And on February 6th the government revealed that its serious fraud office is investigating no fewer than 325 companies wrapped up in the scam perpetrated by Satyam’s founder, B. Ramalinga Raju, and at least one of his brothers.

In India, as in many emerging markets, companies rarely stand or fall alone. Tarun Khanna of Harvard Business School and Yishay Yafeh of the Hebrew University of Jerusalem report* that a third of Indian firms in the 1990s belonged to wider business groups, controlled by wealthy families or corporate “promoters”. These clubable firms were typically 4.4 times bigger than stand-alone companies.

Elsewhere in Asia, business groups are equally prevalent. In Hong Kong 15 families control corporate assets worth 84% of GDP, according to a 2000 article** by Stijn Claessens, now at the University of Amsterdam, Simeon Djankov of the World Bank and Larry Lang, now at the Chinese University of Hong Kong. In Malaysia the figure is 76%.

These families exercise far more control than they pay for; their corporate reach exceeds their financial stake. This is sometimes because they hold a privileged class of shares that carry more votes than common equity. Sometimes they appoint a loyal relative as chief executive. But the most ambitious strategy for projecting control is to build a corporate “pyramid”.

The geometry works like this: the family holds a controlling stake (say 51%) in a company at the top of the pyramid. This firm then holds similar stakes in a second tier of companies, which will in turn maintain stakes in a third tier. In this way, the family controls the entire pyramid from top to bottom, even though its financial commitment to the second tier is only 26% (51% of 51%) and its stake in the third tier is only about 13%.

Pyramids solve what Yoshisuke Aikawa, the founder of the Nissan group in pre-war Japan, once called the “capitalist’s quandary”: how to raise money from outsiders without ceding control. Students of corporate governance view them less benignly. To them, pyramids combine the twin dangers of entrenched management and diffuse ownership.

In a closely held company, the manager is hard to oust because he owns most of the firm. But at least he will want to make a good return on equity, given that he owns most of it. In widely held companies, managers are easier to replace—they are hired help. But, by the same token, they have less skin in the game.

Pyramids combine the “worst of both worlds”, point out Randall Morck# of the University of Alberta and Daniel Wolfenzon and Bernard Yeung of New York University. They are tightly controlled by families, who have only a paltry stake in the companies at their base. When this gap between control and ownership grows too large, the pharaohs have an incentive to divert resources from companies at the bottom of the pyramid (where they might claim only 13 cents on the dollar) to the top (where their claim is 51 cents).

In a study of eight East Asian economies (Hong Kong, Indonesia, South Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand), Mr Claessens and his co-authors show that a family’s “control rights” often exceed their equity claim by a wide margin. When this gap grows to 35 percentage points or more, the market value of firms drops to only 80% of their book value.

Satyam may not have been part of a pyramid, but it is a good example of control exceeding ownership. The Raju family’s stake had dwindled to 5% or less on the eve of Mr Raju’s January 7th confession. What started out as a small family firm had become a widely held corporation, to which 218,000 shareholders had entrusted their money. But as subsequent revelations have made clear, it was still firmly in Mr Raju’s grip. Its market value has since plummeted. No one knows its book value.

Pharaonic sacrifices

If pyramids are such a threat to minority shareholders, Mr Khanna asks, why does anybody ever buy shares in them? One answer is that the danger is reflected in the price small investors are willing to pay for their shares. In some countries, the cost per share for a minority stake is 40% lower than the share price for a controlling block.

Another answer is that the pyramid can be a source of stability as well as exploitation. Mr Khanna shows that firms in heavily diversified Indian business groups outperform their free-standing rivals. Perhaps firms in a pyramid can prop each other up, offering “mutual insurance” that may be hard to buy on the market.

In a recent working paper, Yan-Leung Cheung@ of the City University of Hong Kong and his co-authors look at over 290 related-party transactions between listed Chinese firms and their controlling shareholders. They found that 132 of these transactions ended up benefiting minority shareholders. In August 2001, for example, Luoyang Glass, which is listed on the Shanghai stock exchange, received a $28m loan from its unlisted state-owned godfather. In the days after the announcement, its shares beat the market by 8.1%.

In his confession, Mr Raju said he had personally raised 12.3 billion rupees ($250m) in loans to help keep Satyam afloat. He may even be telling the truth. But pharaohs like to be buried in their pyramids, not for them. According to the Indian Express, a newspaper, he is now asking Satyam for the money back.


*“Business groups in emerging markets: paragons or parasites?”, by Tarun Khanna and Yishay Yafeh

**“The separation of ownership and control in East Asian corporations”, by Stijn Claessens, Simeon Djankov and Larry H.P. Lang. Journal of Financial Economics, October 2000

#“Corporate governance, economic entrenchment and growth”, by Randall Morck, Daniel Wolfenzon and Bernard Yeung. Journal of Economic Literature, September 2005

Disentangling the incentive and entrenchment effects of large shareholdings”, by Stijn Claessens, Simeon Djankov, Joseph P.H. Fan and Larry H. P. Lang. Journal of Finance, December 2002

@“Tunneling and propping up: an analysis of related party transactions by Chinese listed companies”, by Yan-Leung Cheung, Lihua Jing, Tong Lu, P. Raghavendra Rau and Aris Stouraitis

Correction: unfortunately we misspelt “Pharaoh” in this article's original headline. This was corrected on February 16th 2009.

Copyright © 2009 The Economist Newspaper and The Economist Group. All rights reserved.