Academic journal article IUP Journal of Applied Finance

Hidden Leverage in Conglomerates: An Unintended Systemic Risk

Academic journal article IUP Journal of Applied Finance

Hidden Leverage in Conglomerates: An Unintended Systemic Risk

Article excerpt

(ProQuest: ... denotes formulae omitted.)


Debt plays a crucial role in growth of a firm. It also acts as a check against exuberance by entrepreneurs. According to agency theory, debt is a useful governance mechanism for curbing the tendency of managers to overinvest in firm growth. The periodic interest payments reduce managerial discretion over internal funds. Further, the threat of bankruptcy provides them with strong disincentives against wasteful expenditure. In small traditional Indian businesses, debt was associated with risk. Many family-run business houses in India even today shun it despite the many advantages it offers; tax deductibility being the most important. Perusal of the history of Indian industry reveals the fact that it is intricately linked to the evolution of family-run businesses, that started off as local focused ones, into large diversified conglomerates. This is not to deny the existence of independent business houses that are run by professional managements or to belittle their role in any way.

Industrial and Financial Conglomerates (FCs) tend to be family-owned and hold large market shares of businesses in most market segments. There are other firms that are unaffiliated to such groups but could either be focused in a particular market segment or be running large diversified businesses as divisions within the firm. The primary objective is to establish the hypothesis that firms belonging to conglomerates are more leveraged than those that are not affiliated to groups. In other words, the idea is to bring to the fore, shadow leveraging that takes place through the act of setting up separately incorporated firms (as part of the group) through seemingly arm's length relationships.

A simple illustration (presented in Figure 1) demonstrates the manner in which riskbearing capital in the form of equity brought by an entrepreneur can be used in a conglomerate to back far more amount of debt than otherwise possible for a single isolated firm. A firm set up with one unit of capital in a parent company, A, can be used to borrow say nine units to set up a subsidiary B with 10 units of capital which in turn becomes eligible for borrowing 90 units of debt. This can be iterated with a step down subsidiary, C, leading to 1,000 units of assets. In real life subsidiarization can be carried out through numerous subsidiaries at each level in a manner as to obfuscate the ownership to suppliers of debt of subsidiaries lower down in the chain.

In the case of financial firms such as banks and non-banks (Non-Banking Financial Companies or NBFCs in India), the extent of capital that is reckoned as such, has been limited through prudential regulation. That is not the case with non-financial firms. However, in their case, while there are no explicit capital adequacy requirements, the number of step down subsidiaries that can be set up is limited to two levels in the Company Law in India. Further, accounting standards in India require firms to consolidate accounts at the parent level. These do impose a barrier to leveraging to some extent but do not prevent an entrepreneur from raising debt completely. Debt holders are, however, unable to see through the extent of leverage undertaken in the case of complex group structures in conglomerates and the circumvention of the regulatory requirement for consolidation of accounts to see the full and fair picture of the extent of indebtedness.

Our supposition is also that firms belonging to conglomerates are, on average, more indebted. Further, within conglomerates, those that are either regulated or listed on stock exchanges exhibit much lower levels of leverage than the ones that remain "under the radar" but as part of complex group structures. The operating companies that tend to be in regulated businesses such as banking and finance or ones that are listed (where trading of their equity or bonds takes place) are monitored by financial regulators and investors, respectively. …

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