Corporate Financial Constraints and Internal Capital Markets: Evidence from Emerging Countries

Abstract

This paper investigates whether the internal capital markets of business groups mitigate the financial constraints of affiliated firms,and affect their financing policies.It aims to extend the evidence on internal capital markets to emerging countries where financing constraints are prevalent, and adds to the literature on trade credit by revealing that the distressed group-affiliated firms rely less on trade credit than their non-affiliated counterparts despite the positive relation between trade credit and distress. Group firms that have high investments in prior periods use less trade credit in the subsequent periods than non-affiliated firms. The study rests on panel data regressions covering 3906 firms from six emerging countries for the 2006-2012 period. The findings indicate that the Q-sensitivity of the investments of affiliated firms is lower than that of their unaffiliated counterparts in all countries and that the investment cash flow sensitivity of affiliates is lower in five countries, strongly indicating that group-affiliated firms are financially less constrained. The distressed group firms use significantly lower leverage than distressed unaffiliated firms despite the positive relation between distress and leverage. Group firms in high-Q industries invest less than unaffiliated firms. This paper contributes to the existing literature on internal capital markets by expanding the scope to emerging countries where market imperfections and financing constraints are more pronounced, and provides strong evidence for the role of business groups, prevalent in most emerging countries, in mitigating the constraints on the investments and financing choices of the group-affiliated firms.

How does the internal capital market influence R&D spending? New evidence

“…This paper explores the role played by business groups in improving firms' R&D incentives. Business groups present entry barriers that allow R&D information to be obtained within internal markets (Ugurlu et al , 2016). Better-informed internal market participants then lead private R&D spending to reach the socially-optimal level (Mahmood and Lee, 2004).…”

“…As a result, firms forgo capital-dependent but value-enhancing projects. However, those firms affiliated with a business group can benefit from the group's internal market, which might mitigate external market failures (Ugurlu et al , 2016). Business groups can help firms mitigate external market failures because they allow affiliated firms to share resources (Santioni et al , 2020).…”

“…Theoretically, special organisations (such as business groups) could serve as a substitute for external capital markets (Ugurlu et al , 2016; Buchuk et al , 2020). Business groups are collections of publicly traded firms with a significant amount of common ownership and control (Khanna and Palepu, 2000).…”

“…That is, internal capital markets mitigate financial constraints and promote the allocation of resources from cash-rich entities to R&D firms. Second, while prior studies show that internal capital markets stimulate R&D spending, few studies focus on the mechanisms through which internal capital markets benefit R&D investments (Ugurlu et al , 2016). This paper demonstrates that internal capital markets make R&D investments sensitive to group affiliates' cash reserves, and group affiliates use internal cash and equity to support partners' R&D activities.…”

Capital Structure and Business Groups: Evidence from Pakistan

“…The business groups are better able to emerge themselves with the changes of the financial environments (Khanna, 2000) and perform better (Zattoni et al, 2009). Using the cross country data, (Ugurlu, Altiok-Yilmaz, & Akben-Selcuk, 2016) show that business groups have better access to the institutional loans to fulfill their capital expenditure needs, even in an economic downturn and their active internal capital markets (H. Lee et al, 2014) help to mitigate the financial constraints of their distress affiliates. The external finance providers may have relatively more confidence to lend to business groups, where they may be able to get more tangible guarantees to secure their investment.…”