Asia Pacific J Manage (2006) 23:419–437 DOI 10.1007/s10490-006-9012-5

Business groups and their types Alvaro Cuervo-Cazurra

Published online: 23 November 2006 # Springer Science + Business Media, LLC 2006

Abstract We clarify what business groups are and analyze their various types. We first distinguish business groups from other types of firm networks based on the strategic relationships among companies; business groups are defined as those networks that exhibit unrelated diversification under common ownership. We then separate business groups into three types based on their ownership: family-owned, widely-held, and state-owned. We argue that each type has different agency costs and diversification logics. As a result of these differences, their performance varies, with family-owned business groups outperforming widely-held ones, and these in turn outperforming state-owned business groups. Keywords Business groups . Diversification . Family-ownership . Theory of the firm Business groups have recently emerged as a distinct theme in the literature. Part of the increased interest in business groups arises from the internationalization of developingcountry firms and their ability to compete against, and even acquire, developed-country firms. Close examination reveals that the largest firms in many developing countries, particularly in Asia, are widely diversified and have multiple links to many other companies. This is in contrast to the much-studied public firms in the USA. Researchers refer to these diversified sets of firms as business groups, and view them as a new organizational form that requires an explanation. Khanna and Yafeh (2005) provide a detailed overview of the recent literature.

I am grateful to Michael Carney, Andrew Delios, Mike Peng, Kendall Roth, Annique Un, two anonymous reviewers, and participants at the Asia Pacific Journal of Management special issue conference on conglomerates and business groups in Asia-Pacific for their suggestions. The Asia Academy of Management and the National University of Singapore provided financial support to attend the Asia Pacific Journal of Management special issue conference. Additional funding was provided by the Center for International Business Education and Research at the University of South Carolina. All errors remain mine. A. Cuervo-Cazurra (*) Sonoco Department of International Business, Moore School of Business, University of South Carolina, 1705 College Street, Columbia, SC 29208, USA e-mail: [email protected]

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However, it is not clear that the studies of business groups analyze the same organizational form, not only across countries, but even in within one country. Despite the wealth of studies, the definitions of a business group vary widely from one study to another. This limits the accumulation of knowledge and the advancement of theory because a business group analyzed in one study may not qualify as such in another. The current paper contributes to the literature on business groups by clarifying precisely what a “business group” is and discussing its various types. Such a clarification is important to facilitate the accumulation of knowledge and build a coherent body of research. New research can successfully build on previous studies only when the objects analyzed are similar. Otherwise, we run the problem not only of comparing apples and oranges, but also of providing suggestions on how best to grow apples when we only know how to grow oranges. We propose two types of separation to help compare apples to apples and provide appropriate recommendations: we distinguish business groups from other types of firm networks based on the relationship among firms, and we separate business groups into three types based on their ownership. First, we propose to distinguish business groups from other types of firm networks based on the relationship among firms. We narrow down the definition of a business group to a set of legally-separate firms with stable relationships operating in multiple strategicallyunrelated activities and under common ownership and control. Although being a set of legally-separate firms with stable relationships is accepted as an identifying characteristic of the business group in many definitions, not all definitions include strategic unrelatedness and common ownership as distinguishing characteristics. Second, we propose to separate business groups into three types based on their ownership: family-owned, widely-held, or state-owned. The ownership of the business group is important, but discussion of this in the literature has been surprisingly limited. This paper is one of the first to explicitly discuss the different types of business groups in terms of their ownership. Differences in who owns, manages, and controls the business group result in differences in agency costs and access to external finance, and in differences in diversification logic. Both of these in turn affect the performance of the business group. As a result, we expect that, in general, family-owned business groups will outperform widelyheld ones, and these in turn will outperform state-owned ones. We discuss these ideas in the remainder of the paper as follows. In the coming section we briefly review existing definitions of business groups and highlight their multiplicity and lack of coherence. We then clarify how business groups differ from other types of firm networks based on the relationship among firms and differentiate among three types of business groups based on their ownership: family-owned, widely-held, or state-owned. We explain how the ownership of each type of business group results in different agency costs and diversification behavior, both of which result in different performance. We conclude with a discussion of the future research areas opened up by separating business groups into different types.

What is a business group? Despite the multiplicity of studies of business groups (see Khanna & Yafeh, 2005, articles in this special issue, and the references there), there is no accepted definition of business group in the literature. There appear to exist two camps in the literature: one, which tends to be more based in sociology, presents broad definitions of business groups that highlight the multiplicity of relationships among the firms, and another, which tends to be more based in

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economics, holds a narrower definition that highlights unrelated diversification as the defining relationship. Many of the sociology-based definitions of business group are quite broad, highlighting the multiple relationships that tie firms in a business group together. This provides richness in the relationships analyzed. For example, Leff defines a business group as “a group of companies that does business in different markets under a common administrative or financial control” and that are “linked by relations of interpersonal trust, on the basis of a similar personal, ethnic or commercial background (Leff, 1978: 663).” In his analysis of Indian firms, Encarnation discusses the concept of “business houses” and highlights a multiplicity of relationships among group members: “[I]n each of these houses, strong social ties of family, caste, religion, language, ethnicity and region reinforced financial and organizational linkages among affiliated enterprises (Encarnation, 1989: 45).” Granovetter reviews previous studies of business groups and provides an all-encompassing definition of a business group as “a collection of firms bound together in some formal and/or informal ways (Granovetter, 1994: 454)”; this definition is followed by Guillén (2000). More recently, Yiu, Bruton, and Lu define business groups as “a collection of legally independent firms that are bound by economic (such as ownership, financial, and commercial) and social (such as family, kinship, and friendship) ties.” (Yiu, Bruton, & Lu, 2005: 183). Although these definitions open the scope for rich studies, they create the challenge of not always clearly separating business groups from other types of firm networks. All companies have multiple economic and social, formal and informal relationships with other firms. These relationships are a normal outcome of conducting business and result in firm networks. However, not all firm networks are business groups, as we discuss below. Economics-based definitions of business groups are generally narrower. They highlight diversification as the hallmark of business groups, providing a sharper distinction from other networks of firms. Additionally, many of these economics-based definitions also discuss family ownership as the second separating characteristic. For example, Ghemawat and Khanna (1998) define business groups as “an organizational form characterized by diversification across a wide range of businesses, partial financial interlocks among them, and, in many cases, familial control” (p. 35). Chang and Hong define business groups as “a collection of formally independent firms under single common administrative and financial control, that are owned and controlled by certain families” (Chang & Hong, 2002: 266). Mahmood and Lee (2005) follow this definition. Recently, Fisman and Khanna defined the business group as a “diverse set of businesses, often initiated by a single family, and bound together by equity crossownership and common board membership (Fisman & Khanna, 2004: 609)”. However, although most economists analyzing business groups agree that unrelated diversification and common control are defining characteristics of a business group, there is less accord with respect to family ownership as a defining characteristic. For example, Almeida and Wolfenzon (2005) specify the family aspect of the business groups to distinguish them from other types of conglomerates. Additionally, there are other sets of firms in unrelated industries and under common ownership and control that are not familyowned but that have been at times discussed as business groups, such as the Japanese keiretsus (e.g., Hoshi & Kashyap, 2001), bank-centered groups (Cuervo-Cazurra, 1997), or state-owned groups (Keister, 2004). Therefore, to provide clarity for future studies, we propose to limit the definition of business groups to a set of legally-separate firms operating in multiple strategically-unrelated activities that are under common ownership and control. This definition identifies the business group as a type of firm network. Additionally, we argue that there are different types of business groups based on their ownership: family-owned, widely-held, and state-owned.

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Figure 1 summarizes the arguments of the paper, illustrating how business groups are distinct from other types of firm networks, and how there are different types of business groups based on their ownership. We now turn to the difference between business groups and other firm networks, and then discuss how the type of ownership results in three distinct types of business groups that have different agency costs, diversification behavior, and performance.

Separating business groups from other firm networks Firm networks, or collections of firms with stable relationships, are an organizational form that falls in between the market and hierarchy extremes, as discussed in the theory of the firm (for a review of this theory, see Holmstrom & Tirole, 1989). Firm networks are not markets because the relationships among firms are stable and long-term. At the same time, firm networks are not hierarchies because the firms that compose the network are legally separate entities that can enter into contracts independently of one another. Business groups are a type of firm network. Although some authors define business groups as sets of separate firms with multiple stable relationships, this definition applies to all networks of firms; however, not all firm networks are business groups. We distinguish five types of firm networks in terms of the relationship among firms: supplier, distributor, strategic, geographic, and diversified. We do not claim that this classification is exhaustive; it is rather designed to illustrate the separation of business groups from other firm networks. A network of suppliers is a collection of legally separate firms that have stable relationships as well as formal and informal exchanges among personnel, and that share knowledge in order to reduce opportunism and facilitate innovation (Takeishi, 2002). However, this network does not constitute a business group. The basis for the relationship in a network of suppliers is backward vertical integration. In a network of suppliers of a leading firm, such as the Toyota network (Dyer & Nobeoka, 2000), sub-suppliers provide

Markets

Hierarchies

Firm networks

Supplier networks (e.g., parts suppliers, subcontractors)

Distribution networks (e.g., franchisees) Strategic networks (e.g., tech alliances, research consortia)

Diversified networks (business groups) Widely-held (e.g., Japanese keiretsus, bank-centered groups)

State-owned (e.g., Chinese state-owned business groups)

Family-owned (e.g., Indian houses, Korean chaebols, Japanese zaibatsus, Latin American grupos)

Geographic networks (e.g., Bollywood, Silicon Valley, Route 128)

Figure 1 Separating business groups from other firm networks

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leading suppliers with parts, who, in turn, provide the leading firm with systems to assemble into a complete product. A network of distributors is also composed of legally separate firms with stable and multiple types of exchanges, but it is not a business group. The basis of the relationship is forward vertical integration. For example, in a network of franchisees (Brickley, 1999), the franchisor and its franchisees establish both economic exchanges in the form of the provision of products and common promotion and advertisement. They also have a social relationship, through the training of employees in specialized facilities to generate a common corporate culture. These relationships are subject to multiple layers of controls, supervision, and coordination to maintain a consistent quality and image of the overall network of franchisees. Strategic networks have stable relationships among competitors in the same or related industries, but are not business groups. The relationship is horizontal among competitors (Brandenburger & Nalebuff, 1996). For example, competitors collaborate to develop new technologies or enter new markets. These strategic networks result in identifiable groups, typified by those found in the automobile industry (Nohria & Garcia-Pont, 1991). Geographic networks, or clusters of companies located in geographic proximity, are not business groups. The relationship among these firms is based on geography (Fujita, Krugman, & Venables, 1999). The companies are located in defined geographical spaces and tend to operate in complementary industries. These firms have multiple economic and social exchanges facilitated by the complementarity of economic activities and by geographic proximity, as seen with firms in Silicon Valley or Route 128 (Saxenian, 1994). Finally, diversified networks are collections of firms that operate in unrelated businesses but that have stable relationships on the basis of common ownership. Business groups are diversified networks. In addition to unrelated diversification, business groups can also have vertical integration or related diversification. However, since these strategies are not a distinctive characteristic of business groups, they will not be discussed here. This characteristic of unrelated diversification under common ownership challenges existing theory, which suggests that firms should avoid unrelated diversification because it adds little value (for a review of arguments see Montgomery, 1994 and more recently Bergh, 2001). However, in developing countries where there are multiple market imperfections, business groups provide value (Khanna & Palepu, 2000a). Nevertheless, one can find highly diversified business groups not only in developing countries where such market imperfections are larger, but also in developed countries, where there are few market imperfections that support unrelated diversification. For example, in Japan one finds highly diversified keiretsus, such as Mitsubishi; in South Korea there are highly diversified chaebols, such as Samsung; and in the UK there are diversified groups, such as Virgin. The phenomenon of business groups is widespread and in need of further research. The use of the term business group to refer to these diversified networks is not universally accepted. Previous studies of diversified networks referred to them as conglomerates (e.g., Edwards, 1955; Mueller, 1955), whereas more recent literature prefers to use the term business groups (e.g., Khanna & Yafeh, 2005). The term conglomerate appears to be used when the companies are quoted in the stock market (e.g., Baker, 1992), whereas the term business group appears to be used when companies are under family control (e.g., Chang & Hong, 2002; Ghemawat & Khanna, 1998). Hence, we could use the term business group to refer to diversified networks that are family-controlled and use the term conglomerate to refer to diversified networks that are quoted. However, being quoted in the stock market does not provide a clear separation between business groups and conglomerates. In some of the Latin American grupos the parent

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company is quoted and at the same time family-controlled (Cuervo-Cazurra, 1999a). In many of the Japanese keiretsus the bank, which partially acts as the parent firm in terms of provider of funds to the other companies, is quoted, and many of the members of the keiretsu are also quoted (Hoshi & Kashyap, 2001; Yafeh, 2003). In the Indian houses, the parent company is private but some of the affiliates are quoted in the stock market (Khanna & Palepu, 2000a). Additionally, there are diversified business networks that are not quoted or family owned. Instead, they are state-owned. In many Latin American countries and in some European countries like Italy and Spain, the government controlled and run a diverse set of businesses to promote the development of the country (Aganin & Volpin, 2004; CuervoCazurra, 1999a). More recently, in China, governments at the central, provincial, or local levels have created firms in multiple businesses to promote industrialization (Keister, 2004). These state-owned diversified networks used to be called state-owned conglomerates. More recently they have been referred to as business groups. In sum, diversified networks can be separated from other firm networks in terms of the relationship among firms, whereby there exists unrelated diversification under common ownership. However, there appears to be confusion regarding whether a business group is the same as a diversified network, or whether it is a type of diversified network. We propose to solve this confusion in the literature by equating the term business group with a diversified network. At the same time, we argue that care should be taken in separating types of business groups according to their ownership because of important differences in their behavior. We now turn to a discussion of these differences.

Types of business groups We propose the need to separate three types of business groups based on their ownership: widely-held, state-owned, and family-owned. Each type has different actors who own, control, and manage it. In a widely-held business group there is no distinct majority shareholder who exercises control. Ownership is dispersed among many shareholders, each of whom does not have a controlling stake. Managers are professionals who control decision-making. These managers are appointed by the board, which in many cases is controlled by the managers. Other firms, either industrial firms or financial entities, may own large blocks of shares. However, these firms, in turn, are also widely held. As a result, the ultimate ownership of the business group is widely dispersed among multiple shareholders and managers are the ones in control. In state-owned business groups, ownership is legally vested in the citizens of the country, since the firms are officially owned by the government, either at the national level or at a sub-national or local level. However, politicians and civil servants are the ones who exercise control. They manage the firm either directly or indirectly, through the control of appointed managers. In a family-owned business group, an individual or family are involved in the ownership, control, and management of the business group. In contrast to other business groups, there is no separation of the roles. Although in some cases professional managers run the firms, these are under close control by the family. These differences in terms of the actors involved in the ownership, management and control of each type of business group are important. First, they result in differing agency costs because the objectives of the actors who own, control, and manage the business group

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vary. These different agency costs have a direct influence on the ability of the business group to access external sources of funds. Second, differences in the actors result in different reasons for increases and decreases in diversification, again because of the differences in each actor’s objectives. As a result, the performance of each type of business group is likely to vary. The study of differences among types of business groups is an area of research that has been underexplored. One reason is that most studies have focused on comparing business groups to firms that do not belong to business groups. Here, we are interested in a different comparison, that is, of one type of business group to another. Therefore, we will not discuss agency problems or motives for diversification that are common to all business groups. For a review of these, see Khanna and Yafeh (2005). Agency costs The variation in ownership results in different agency costs. Table 1 summarizes the agency costs that each type of business group faces. The differences in ownership, management and control of business groups result in different agency costs because of the divergence in objectives among actors. Here we discuss not only the traditional shareholder-manager problem (Jensen & Meckling, 1976), but also the shareholder-debtholder (Harris & Raviv, 1991) and employment (Milgrom & Roberts, 1992) agency problems. We find that, whereas the agency problems of widely-held and state-owned business groups have been analyzed in the literature, agency costs in family-owned business groups have yet to be adequately explored. Owner-manager agency problem Differences in actors who own, run, and control the business groups result in different types of owner-manager agency problems. As traditionally discussed in agency theory, problems arise as a result of managers seeking to fulfill their own objectives rather than those of shareholders, unless shareholders control managers through corporate governance mechanisms (Fama & Jensen, 1983). A direct outcome of these agency problems is differences in access to external sources of funds. A secondary outcome is variation in performance, which will be discussed below. The agency problems of widely-held business groups have been analyzed in the financial economics literature (for a review, see Becht, Bolton, & Roell, 2003). They suffer from the traditional agency problems associated with the separation of ownership and control. The owners only indirectly control the managers through corporate governance mechanisms. However, these are imperfect mechanisms because there are no controlling shareholders to check managers’ behavior. The outcome of this separation is that managers follow their own objectives, such as empire-building (Edwards, 1955; Mueller, 1955). Another result of this separation of ownership and control is an increased cost of funds for the business group because shareholders are reluctant to invest in firms where managers do not aim to increase shareholders’ wealth (Jensen & Meckling, 1976). Widely-held business groups were the focus of much attention in the literature in the 1970s and 1980s, following their growth in the US in the 1960s and 1970s. The Boston Consulting Group’s growth matrix provided the strategic basis for the creation of such business groups. However, in the 1980s widely-held business groups fell out of favor, as many were unable to create value (Baker, 1992; Lang & Stulz, 1994). Nevertheless, one can still find widely-held business groups, called conglomerates in the US, such as General Electric or Tyco.

Control

Employment agency problems

Owner-debtholder agency problem

Owner-manager agency problems

Objective Actor

Management

Separation of objectives, imperfect alignment with incentives/governance, difficult/costly access to equity No traditional separation of owner and debtholder (no owner control). In some cases no separation of owner and debtholder (bank-centered business groups)

Debt is senior claimant, easy access to debt

Outcome

Outcome

No additional conflict among managers

Selection/promotion of managers open. Remuneration of managers not restricted as board controlled by managers.

Problem

Outcome

Problem

Separation of ownership and control. Owners imperfectly control managers through corporate governance mechanisms.

Dispersed shareholders Wealth objectives Professional manager appointed by board, which is controlled by managers Growth, influence objectives Managers or managers of other widely-held firms Growth, influence objectives

Problem

Objective

Actor Objective Actor

Ownership

Widely-held

Type of business group

Table 1 Agency problems by type of business group.

Conflict between professional managers and politician-managers Selection/promotion of managers limited to politicians or politically-appointed managers. Remuneration of managers restricted by politicians (civil servant salaries)

Power (votes/support), development, employment objectives Largest separation of ownership and control. Owners do not control managers through corporate governance mechanisms. Politicians, not owners, control managers Multiple objectives, change of objectives with change of politicians, very difficult/costly access to equity No traditional separation of owner and debtholder (no owner control), but political control creates similar separation. However, soft budget constraint and use of state-owned banks reduces problem Debt is senior claimant, easy access to debt

Citizens Provision of goods and services objectives Politician or professional manager appointed by politicians Power objectives Politicians

State-owned

Debt may become junior claimant, more difficult access to debt Conflict between professional managers and owner-managers Selection/promotion of managers limited to family members. Remuneration of managers restricted by owners or owner-managers

Separation of owner and debtholder

No separation of ownership and control. Owners are managers or owners have large control over managers. Effective corporate governance, but potential expropriation of minority shareholders Alignment of objectives, easier/cheaper access to equity

Wealth, growth, independence objectives

Family Wealth, growth, independence objectives Family or professional manager appointed by family Wealth, growth objectives Family

Family-owned

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In some cases the widely-held business group has a bank as a dominant shareholder. However, since the bank is widely-held, we also consider such business groups to be widely-held. These bank-centered business groups are particularly prominent in Japan in the form of keiretsus, where a bank provides both debt and equity finance to industrial firms, which in turn have cross-shareholdings among them (Hoshi & Kashyap, 2001; Morck & Nakamura, 2005). Bank-centered business groups are not exclusive to Japan, however. They were also common in Germany, where banks were given the power to vote on the shares held in trust for individual investors and thus had a great deal of influence over industrial firms (Fohlin, 2004), and in Spain, where the government encouraged banks to be both shareholders and debtholders of industrial firms (Cuervo-Cazurra, 1997). They were even common in the US in the late 19th and early 20th century, before the Glass– Steagall act of 1933 forced the separation of investment and commercial banking (Becht & DeLong, 2004; Simon, 1998). As a result, one does not find bank-centered business groups in the US. Instead, the holding firm takes on the bank’s role of providing funds. Even in bank-centered business groups there is separation of ownership and control because it is the managers of the bank, not the shareholders, who exercise control over managers in the business group. In these bank-centered business groups, cross shareholdings among firms prevent external investors from disciplining managers through a takeover (Jensen, 1988). Nevertheless, bank-centered business groups partially attenuate the problem of accessing external funds because the bank can act both as a source of equity and as a source of debt to the firms in the business group (Cuervo-Cazurra, 1999b). The agency problems of state-owned business groups have been explored in the extensive literature on state ownership (Lindsay, 1976; for a review, see World Bank, 1995, and Shirley & Walsh, 2000). These business groups are created through the grouping of state-owned firms under a common organizational umbrella, or through the unrelated diversification of state-owned firms into areas of high political value. The creation of stateowned firms is explained by the intervention of the government in the economy directly through the ownership of firms. Such ownership is part of the normal landscape of communist countries like China, where state-owned business groups are not only prevalent but growing (Keister, 2004). There, the central government or elements of the central administration, such as the army, provincial governments, or local governments, create firms in diverse industries to promote rapid industrialization and development. However, state-owned business groups were also a common feature in countries where the government took an active role in industrialization, such as Italy (Aganin & Volpin, 2004), or in countries that followed an import substitution model of economic development, as in Latin American countries (Bruton, 1998). Such state-owned business groups have been disappearing as governments have engaged in economic reform and privatized stateowned firms. However, they still exist; for example, the Spanish Sepi groups all stateowned firms together. State-owned business groups suffer from substantial agency problems of separation of ownership and control. State-owned business groups are nominally owned by the citizenry, but they are controlled by politicians and run by politicians, or by managers appointed by politicians. The owners—citizens—have no corporate governance mechanisms at their disposal to influence how the managers—politicians or political appointees—run the business group (Alchian, 1965). As a result, many state-owned firms are charged with undertaking projects that have little business value but high political benefits, such as sustaining employment or promoting the development of a given region (Boycko, Shleifer, & Vishny, 1996; Vickers & Yarrow, 1988). Additionally, many state-owned firms are not disciplined in the markets because the politicians that run them also have the power to

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regulate the industry (Shleifer & Vishny, 1994). These factors mean that losses in stateowned business groups are relatively unimportant (Boyd, 1986). These large agency costs result in great difficulty in accessing external funds for state-owned conglomerates, since shareholders are unlikely to invest in firms that are not disciplined and where losses are unimportant. For this reason, it is not uncommon for the government to be obligated to use its access to the general budget or its control of state-owned banks to provide funds and a soft budget to state-owned firms (Kornai, 1990). Family-owned business groups do not suffer agency problems of separation of ownership and control as do other types of business groups because there is no such separation. The family owns the business group and either runs it, or has professional managers running the firms under tight family control (Claessens, Djankov, & Lang, 2000). Their large shareholding enables the family to exercise control over management (Shleifer & Vishny, 1997). Moreover, since much of the wealth of the family is tied to the business group, they have an incentive to control managers. As a result, there is an alignment of objectives between owners and managers that does not occur in other business groups. Using family members as managers solves the agency costs of managerial misbehavior thanks to the social control provided by the family relationship (Davis, 1983). This lack of agency problems and alignment of objectives helps family-owned business groups access funds because other shareholders are aware that managers and shareholders have aligned objectives. However, family-owned business groups have specific agency problems that the literature has yet to adequately address. Although there is no separation of ownership and control problem, a business group has a new agency problem between the controlling family and other shareholders (Claessens, Djankov, Fan, & Lang, 1999). The control exercised by the family can result in the expropriation of other shareholders (Morck & Yeung, 2003). However, such expropriation may be lower than in the case of widely-held business groups, since family misbehavior has direct wealth repercussions. Owner-debtholder agency problem Each type of business group also has a different type of owner-debtholder agency problem. Although debt can serve to reduce managerial misbehavior (Jensen, 1986), it creates an additional agency problem. This problem arises as a result of owners’ interest in high risk-high reward actions, which they take because they receive most of the benefits if successful. This conflicts with debtholders’ priorities; they are not interested in taking high risk-high reward actions, since their benefits are limited to interest and capital repayment (Harris & Raviv, 1991). Widely-held business groups do not suffer from the traditional owner-debtholder agency problem. Owners have limited ability to influence the business group to take risky actions because they have little control over managers. Managers are generally not interested in taking high risks that may lead the firm to bankruptcy. They purposefully diversify the business group in order to reduce risk. Additionally, in some widely-held business groups, the debtholders become owners, as in the case of German bank-centered business groups or Japanese keiretsus. In such cases, there is no owner-debtholder problem. In bank-centered business groups, firms have higher leverage but lower profitability as the bank protects the repayment of the debt and limits the risk and potential higher performance (Cuervo-Cazurra, 1999b). Bank debt becomes a senior claimant, while other debtholders and shareholders become junior claimants, and the widely-held conglomerate has easy access to external debt. State-owned conglomerates also suffer minimally from the problem of separation of owners and debtholders. Citizens, who are nominally shareholders, have little influence on the behavior of the business group since politicians are the ones in charge, and are in no

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position to induce the state-owned business groups to take high risks. However, stateowned business groups may suffer from agency problems similar to those that exist between owners and debtholders because politicians take actions that are not commercially beneficial but that have high political payoff, placing the financial health of the business group in jeopardy. As a result, banks may be less inclined to lend to state-owned business groups. However, this may not always occur for two reasons (World Bank, 1995). First, state ownership provides the benefit of a soft budget constraint. Losses in the firm are absorbed by the state and debt is repaid by the state even when the business group does not have assets to repay it. Second, in many cases, politicians also control state-owned banks. They induce these banks to provide loans to the state-owned business group even when there is no economic basis for doing so. As a result, debtholders remain as senior claimants and state-owned business groups have easy access to external debt. Family-owned business groups suffer from owner-debtholder agency problems. The family owns the business group and controls management. It can influence the actions of the business group to protect its interests. For example, if a firm in the business group is experiencing financial difficulties, the family can orchestrate the transfer of assets and cashflow to other firms in the business group before declaring bankruptcy (Faccio, Lang, & Young, 2001). In such case, debtholders become junior claimants. As a result, familyowned business groups will face more difficulties accessing debt. Debtholders will impose additional controls on asset use to minimize their expropriation by family shareholders. Employment conflicts Each of the business groups suffers from different employment conflicts as a result of the differences in the relationship between managers and owners. All business groups suffer from the adverse selection and moral hazard problems of employment in large diversified firms (e.g., Scharfstein & Stein, 2000). However, shareholders’ control over managerial positions, or lack thereof, creates additional employment conflicts between professional managers and owner-appointed managers. Widely-held business groups do not suffer from additional employment conflicts between owners and managers because managers control the company. As a result, managers are likely to be the best available. Selection and promotion are open to all managers, both inside and outside the firm. Their remuneration is subject to controls by the board of directors, but such controls are not likely to be stringent since the board is controlled by managers (Shleifer & Vishny, 1997). State-owned business groups also do not directly suffer from additional employment conflicts between owners and managers because owners—i.e., citizens—do not control the firm. However, these business groups suffer from a similar conflict between the politicians, who do not own but control the company, and the professional managers—technocrats— who run the firm. The selection and promotion of professional managers, especially to the top level, is limited. In many cases, politicians or politically-connected managers are directly appointed to the top by politicians on the basis of loyalty rather than merit (World Bank, 1995). Additionally, changes in the government tend to result in changes in the top management, which may drive away good managers. The remuneration of managers is also problematic (Shirley & Xu, 1998). In many cases, the remuneration has an upper bound, determined by the salaries of politicians or civil servants. As a result of all of this, managers may not be good, which has a negative impact on performance. Family-owned business groups suffer from additional conflict between professional managers and the family owners. As a result, the managers may not always be the best available. In many cases, top management positions are reserved for family members,

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regardless of ability or merit (Singell & Thornton, 1997). The remuneration of professional managers may have upper limits that are below the norm in the industry because ownermanagers cap the salaries of other managers while they receive additional income from their ownership of the firm. While family members are not necessarily poor managers, the exclusion of professional managers from consideration or the imposition of inexperienced family members as top managers may hurt the firm. This “dark side” of family ownership has received little systematic treatment in the business group literature. Diversification Each type of business group has different diversification logic. All business groups have unrelated diversification by definition; all of them are diversified networks. Their unrelated diversification is driven by the existence of market imperfections (Khanna & Palepu, 1997). However, the process through which they arrive there varies. The differing objectives of each type of owner result in different strategies for each type of business group. Table 2 summarizes the differences among types of business groups in terms of the reasons driving the increase and reduction in diversification. Increase in diversification The logic for increasing unrelated diversification varies across types of business group. Although all business groups may increase their diversification over time, the motivations for entering new businesses, as well as the resources used to operate in the new businesses, differ across types. These differences are likely to result in divergence in performance. In widely-held business groups, the driver for diversification into unrelated industries is the intrapreneurship of professional managers and a slowdown in growth in existing businesses. Managers seek new industries with high growth potential or those where an opportunity for profit opens, such as privatizations, because their salaries are tied to the Table 2 Diversification by type of business group. Type of business group Widely-held Increase in Driver diversification

Intrapreneurship, high growth (slowing of current businesses), profit opportunities Entry Relatively quick decision decision Supporting Internal capabilities, resources deep pockets, business acumen

Reduction in Driver diversification Exit decision

State-owned

Family-owned

Market imperfections with Entrepreneurship, family social impact, avoid dynamics (children, unemployment (bankrupt siblings, marriage), family private firm), public interest, profit benefit opportunities Slow decision (unless Quick decision bankruptcy of private firm) Regulatory power, deep Internal capabilities, pockets financial limitations (pyramid to avoid loss of control), business acumen, contacts Losses, low growth Extremely large losses, Losses, succession change in government Very easy Difficult (citizens/unions Easy (except for original opposition, soft budget) business)

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growth and performance of the business group (Mueller, 1955). Their entry into new industries is relatively quick, since managers are minimally constrained in their decisionmaking by shareholders. The managers will use their own business acumen in selecting companies, and may also benefit from contacts with the government that facilitate obtaining the necessary permits or the purchase of privatized firms. Expansion into other industries is supported by internal capabilities to manage diverse activities, although there may be some technological and marketing connections with existing activities. In either case, the firm can use internally-generated funds (Williamson, 1988). In state-owned business groups, the driver for unrelated diversification is the solution of market imperfections that have social benefit, that is, activities that are important for the country but that private investors are not willing to develop, such as the provision of subsidized public goods or the development of a region (Sappington & Stiglitz, 1987; Willner, 1996). Additionally, in some cases state-owned conglomerates are forced into new activities that have high political value, such as ensure that a given product continues to be available to the public, or to avoid the unemployment that follows the bankruptcy of a private firm (Vickers & Yarrow, 1988). The government purchases the firm and continues to support its activities even though private investors have decided that it is not profitable to do. The decision to enter into a new industry tends to be slow, except when there is a bankruptcy. State-owned business groups benefit from the government’s regulatory power (Shleifer & Vishny, 1994). The government can determine that a particular sector of activity is of national interest and reserve this sector for itself, providing the state-owned firm with exclusive rights of control over assets, exclusive monopoly rights of operation, or both. Additionally, entry into the sector of activity can easily be financed, since the government has access to a large general budget. Family-owned business groups are driven to enter new activities by the entrepreneurship of the family owners, who see opportunities for new activities. Family owners’ business acumen and their contacts with government can help expand the business group into new activities by accessing required permits or new firms in the privatization process (Ghemawat & Khanna, 1998). The decision to enter into new activities tends to occur very rapidly, since the owners are also managers and can thus take a decision without obtaining approval from others. Additionally, family dynamics can lead the business group to diversify, which is not the case in other business groups (Anderson & Reeb, 2003). For example, the children of a group’s founder can help diversify the business group as they undertake activities that they like or for which they have received an education. Similarly, a business group may increase its diversification through marriage, or when relatives who have started their own companies decide to join them under a business group. Such diversification is supported by the capabilities of existing activities. It requires financial resources that other firms in the business group can provide. However, the family, which has limited wealth, faces the problem of maintaining a controlling stake in the business group as it expands. A solution is the use of pyramidal structures, whereby the family maintains a limited participation in capital, but still holds effective control (Almeida & Wolfenzon, 2005). Reduction in diversification The logic for reducing diversification also varies across types of business groups. Business groups change the industries in which they are active over time, especially after crises (Chang, 2005). However, the drivers of change differ depending on their ownership (e.g., Hoskisson, Johnson, Tihanyi, & White, 2005). Widely-held business groups exit from an activity that has sustained losses, has low growth and low profitability, or both. Managers’ desire to achieve growth drives the exit

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from activities that are not profitable and growing. The exit is easy, since managers are only minimally constrained in terms of staying in any particular line of business. The business group can sell the assets in one business line and use the funds to finance expansions into other areas. State-owned business groups are less likely to exit activities unless these sustain very large losses. Even then, it usually requires a change of government for state-owned business groups to reduce diversification. The reason is that a state-owned business group has the objective of providing a product or service to the public that is a public good, solves market imperfections, or aids in development or employment (World Bank, 1995). These objectives reduce the need to achieve profitability. As long as the business group achieves some of these objectives, the state will continue to support diversification even if it is not profitable. Only when the business group has very large losses may the state consider exiting the business. However, even in such cases it is difficult (Vickers & Yarrow, 1988). There will be opposition from citizens and unions that are negatively affected. In many cases, only when there is a change in government, and the new government is not burdened by previous ideologies or promises, will state-owned business groups exit businesses that are not economically viable. Family-owned business groups, in contrast, exit businesses when they are facing losses because these losses are borne by the family owners. Their position of control allows for easy decision-making, since the family is in control of ownership and management. It may even decide to cash out completely and sell the firms in the stock market (Morck, Percy, Tian, & Yeung, 2004). The exception to this easy exit may be the original activity of the business group to which the family has sentimental connections. Additionally, family dynamics influence the reduction of diversification. Successors that inherit a business group may choose to refocus the business group, as in the case of the Mexican business group Cemex (Ghemawat & Matthews, 2000). Alternatively, family dynamics may result in the separation of the original group into smaller groups as children fight for control, as in the case of the split of the Indian business group Reliance into two (Economist, 2005). Performance Differences in ownership result in differences in agency costs and diversification patterns, which lead to variation in performance across types of business groups. We suggest that, on average, family-owned business groups are likely to outperform widely-held business groups, and that both are likely to outperform state-owned business groups. The discussion that follows does not focus on whether business groups have higher or lower performance than firms unaffiliated to business groups, however. Many studies have found that firms with unrelated diversification tend to underperform in comparison with focused firms, although this remains a topic of debate (for a review, see Campa & Kedia, 2002). Business groups have been shown to outperform independent firms (Khanna & Rivkin, 2000), but this is not always the case in all countries nor across time in the same country (Khanna & Yafeh, 2005). For the current purposes, we are interested in the relative performance of one type of business group relative to other types. There will be variation within types of business groups based on other characteristics, but at this point we are interested in exploring the differences across types. Family-owned business groups are likely to have the best performance. The reduction in ownership-management conflicts helps achieve superior performance: managers are not likely to engage in actions that would have a negative impact on performance since they

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would bear the consequences (Maury, 2006; Shleifer & Vishny, 1997). Employment conflicts between owners and managers can result in family members replacing professional managers in running the business, but these costs may be compensated by a reduction in the separation of ownership and control. Additionally, the diversification process can also generate superior performance. The founder’s ability to identify new businesses and take rapid decisions, as well as his or her contacts, enables family-owned business groups not only to succeed but also to achieve superior performance. This business acumen is not restricted to the founder, however. In many cases it is not the founder of the company but rather the second and subsequent generations the ones who expand the family-owned firm and convert it into business group. Widely-held business groups are likely to have good performance, but not as good as family-owned ones. The agency conflicts between managers and shareholders are likely to affect performance, as managers are free to pursue projects that do not necessarily increase shareholder wealth. Corporate governance mechanisms may not put enough pressure on the managers to achieve superior performance because shareholders are dispersed (Shleifer & Vishny, 1997). However, the threat of a takeover may ensure that managers do not allow the business group to sustain losses. Large losses sustained over a period of time will depress the share price and set the stage for a hostile takeover (Fama & Jensen, 1983). Additionally, the performance of the business group will be good thanks to the lack of limitations in the selection and promotion of the best managers to the top positions. State-owned business groups are likely to have the worst performance of any of the types of business groups. Although the business group may be run by competent professional managers, many of the firms are subject to conflicting objectives that detract from achieving superior performance (Vickers & Yarrow, 1988; World Bank, 1995) and lack incentives to improve performance (Hart, 1983), resulting in poor performance (Shirley & Walsh, 2000). They may be induced to provide products or services that are not economically viable. In some cases they may suffer from a lack of investment, since the profits they generate are transferred to the government coffers to support other government expenditures. Additionally, the firms may be run by politicians who are not effective business managers (Niskanen, 1975; World Bank, 1995).

Conclusions The current paper argues for the need to separate business groups from other firm networks, as well as to distinguish among types of business groups, if we wish to generate a coherent body of research on business groups. This way of thinking highlights new avenues for research on business groups. First, most research on business groups has focused on analyzing their diversification. For example, studies have discussed how business groups are profitable (Khanna & Palepu, 2000a; Khanna & Rivkin, 2000) and how they alter diversification over time (Khanna & Palepu, 2000b; Kim, Hoskisson, Tihanyi, & Hong, 2004; Kosacoff, 2000). This paper highlights how the logic followed in their diversification strategy differs across types. Thus, ownership must be included as another explanation of diversification in business groups (e.g., Ramaswamy, Li, & Pettit, 2004), complementing previous explanations of multimarket power, related resources, informational imperfections and entrepreneurial scarcity, and policy distortions (Ghemawat & Khanna, 1998). Second, this study emphasizes the need to study family ownership, since this is one aspect of family-owned business groups that has been neglected; there is a large literature

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explaining the behavior of widely-held and state-owned business groups, but much less research has been conducted on family-owned business groups. Future studies can study how family type (e.g., one founder, founder and children, later generations, multiple families) and family dynamics (e.g., succession, death, marriage, divorce) affect business group diversification and performance. Although there exists some literature on family ownership and firm performance (e.g., Anderson & Reeb, 2003b; Villalonga & Amit, 2004), insights from these studies of US public firms may not apply to family-owned firms outside the US (e.g., Filatotchev, Lien, & Piesse, 2005; Maury, 2006) or to family-owned business groups because the latter are private and diversified. Future studies should explore whether the drivers of family-owned business groups’ performance are diversification, family ownership and dynamics, or both. Third, institutional context affects the behavior of business groups, and their behavior may in turn affect the context. Business groups have been presented as being characteristic of developing countries, where poorly developed markets and low governmental provision of public goods and services induce firms to diversify (e.g., Khanna & Yafeh, 2005). However, in the present paper we have shown that business groups exist not only in developing but also in developed countries, such as Japan and Korea. Future studies can analyze the ways in which the characteristics of the country support the creation of business groups by providing opportunities for diversification (e.g., Lee & Park, 2005), or induce the transformation of business groups (e.g., Ahlstrom & Bruton, 2004). Additionally, changes in the institutional environment may negatively affect the business group (e.g., Carney, 2005; Carney & Gedajlovic, 2003), although group affiliation may reduce the negative impact (e.g., Wang, Huang, & Bansal, 2005). Finally, business groups may also influence changes in the institutional environment (e.g., Chung, 2005), although such institutional changes may not have the consequences that were initially intended (e.g., White, 2004). All this will help generate contextualized knowledge that contributes to a better understanding of firm behavior (Tsui, 2004).

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Alvaro Cuervo-Cazurra is an assistant professor of International Business at the Moore School of Business, University of South Carolina. His primary research interest is understanding how firms develop resources to become competitive and how then become international. He is also interested in governance and corruption issues. He has started a long-term project to analyze the emergence and success of developing-country multinationals. Professor Cuervo-Cazurra received PhD from the Massachusetts Institute of Technology and a PhD from the University of Salamanca.