Elsevier

Journal of Corporate Finance

Volume 58, October 2019, Pages 307-328
Journal of Corporate Finance

A new order of financing investments: Evidence from acquisitions by India’s listed firms

https://doi.org/10.1016/j.jcorpfin.2019.04.007Get rights and content

Highlights

  • Considerations of control and financial constraints dictate a new order of financing investments in markets with business groups.

  • Group-affiliated bidders exhibit the greatest propensity to finance their intragroup acquisitions with stock.

  • Group-affiliated bidders have the lowest propensity to finance acquisitions outside their groups with stock.

  • Standalone bidders' propensity to finance their acquisitions with stock lies in-between that of the bidders in within-group and outside-group acquisitions.

  • The results are robust to alternative explanations of agency conflicts (tunneling and propping up in business groups) between the majority and minority shareholders.

Abstract

We propose a new order of financing investments based on the considerations of control and financial constraints in a market with the presence of business groups. We base our analysis on a sample of acquisitions, one of the largest forms of investments, made by India's publicly listed firms from 1997 through 2016. We test the relative propensity of group-affiliated firms, as well as that of standalone (non-affiliated) firms, to finance their investments with stock on the one hand, and either cash or debt on the other. We find that group-affiliated bidders have the greatest propensity to finance their investments with stock when taking over firms affiliated with the same business group (within-group acquisitions), followed by standalone firms making acquisitions (standalone acquisitions). Finally, group-affiliated bidders acquiring either standalone firms or firms not affiliated with their group (outside-group acquisitions) have the lowest propensity to finance their investments with stock. The evidence of higher stock-financing of within-group acquisitions is robust to alternative explanations of tunneling and propping up in business groups.

Introduction

Do all firms in a market with the presence of business groups have similar preferences for financing investments? Does a group-affiliated firm finance its takeover deals the same way when it acquires another firm from the same group vis-à-vis when it acquires any other firm not affiliated with its group? How differently does a group-affiliated firm finance its acquisitions when compared to a standalone (non-affiliated) firm? We try to unravel these questions by considering one of the most significant forms of investments, namely corporate acquisitions, made by firms from India, a country with one of the largest number of group-affiliated firms.2

Prior empirical evidence indicates that considerations of corporate control influence how firms choose to finance investments. Amihud et al. (1990) conjecture that corporate insiders of a firm prefer to finance acquisitions, one of the largest forms of investments, with either internal cash reserves or debt in a bid to retain the control over them. If an investment is financed with equity, the control of insiders may be diluted and, at worst, they could lose control of the firm (Harris and Raviv, 1988; Stulz, 1988). This set of arguments is popularly known as the control hypothesis in the literature (Martin, 1996).

While Amihud et al. (1990) confirm a negative and linear relationship between the likelihood of stock-financed acquisitions and insider ownership, Martin (1996) finds this negative relationship holds only for intermediate levels of ownership. Later empirical evidence from several different countries also lends support to the control hypothesis by demonstrating that the ownership of insiders in a firm undertaking an investment plays a crucial role in influencing the source of its financing (Faccio and Masulis, 2005; Gu and Reed, 2016; Martynova and Renneboog, 2009; Yook et al., 1999).

All prior studies have either been set in a context where the insiders of an acquirer and those of a target are almost always different sets of individuals, or they do not consider the possibility of having common insiders at the acquirer, as well as the target, when financing acquisitions. In markets with business groups, both in developing and developed countries, there is a distinct possibility that both the acquirer and the target belong to the same business group in case of corporate acquisitions, and thus, they share the same set of insiders.3, 4

We argue that blind application of the control hypothesis to countries with a dominant presence of business groups is likely to yield inconsistent and sometimes even contrary results. The insiders of a group-affiliated firm in the case of an acquisition within the group do not risk losing their control over the acquiring firm even when the deal is financed with equity, unlike the acquisition of a firm not affiliated with the same group.5 We conjecture that the way firms finance investments is motivated not only by the ownership of insiders in the firm making an investment, but also how these insiders are related to insiders of the firm where the investment is being made.

Additionally, there are two critical factors at play in markets with business groups that can potentially affect the way firms finance investments. First, the insiders of standalone and group-affiliated firms may not value control in the same way. The insiders of group-affiliated firms may value control more so than those of standalone firms as they may want to redistribute resources within their groups for overt or covert reasons in the future (George and Kabir, 2008). All else being equal, the insiders of group-affiliated firms may have a higher tendency to finance investments that could dilute their control with either cash or debt.

Second, group-affiliated firms are financially less constrained when compared to standalone firms (Masulis et al., 2011) owing to the presence of internal capital markets within their respective groups (Chang and Hong, 2000; Khanna and Palepu, 2000), as well as having better access to external capital markets (Ghatak and Kali, 2001; Shin and Park, 1999). The lower financial constraints aid the insiders of group-affiliated firms to preserve their control by financing a greater proportion of the acquisitions made outside their respective groups with either cash or debt. On the other hand, the insiders of standalone firms, due to higher financial constraints, could find it difficult to finance the same proportion of their acquisitions with either cash or debt and may have to issue equity to target shareholders.

Consistent with our proposed order of financing investments based on the considerations of control and financial constraints, we find that the propensity of group-affiliated bidders to finance investments with equity is highest in case of acquisitions of firms affiliated with the same group (within-group acquisitions) and lowest in case of acquisitions of firms not affiliated with their group (outside-group acquisitions). The propensity of standalone firms to finance their acquisitions (standalone acquisitions) with equity lies in-between the above two extremes. Our results are robust to alternative explanations of agency conflicts, which are manifested in the form of tunneling and propping up in business groups, between the majority and minority shareholders.

We focus on only one kind of investment, namely, corporate acquisitions, for two reasons. First, corporate acquisitions are generally large investments and, as such, insider preferences for financing these investments are likely to be more pronounced. If the size of an investment is small, managers may be indifferent to the means of its financing, and we may not be able to capture the true preferences of managers in that case. Additionally, as noted in Amihud et al. (1990), unlike an acquisition where the mode of payment is quite often disclosed publicly, the financial statement of a firm is usually devoid of the sources of financing investments. Thus, it may be difficult, if not impossible, to obtain the sources of financing investments other than acquisitions. We limit the classification of the method of financing investments into two broad categories: first, cash or debt, and second, equity.6 These classifications fit the purpose of this study as we only need to classify the sources of financing investments into two broad categories, ones that may dilute the control of insiders and the others that do not.

We choose India as a setting of our study for two primary reasons. First, India is home to one of the largest numbers of group-affiliated firms (Khanna and Yafeh, 2007) with several instances of within-group investments including acquisitions. This allows us to study the differential financing behavior of group-affiliated firms when they invest within their respective groups vis-à-vis when they invest outside their groups, and contrast the same with that of standalone firms. In addition, once a group-affiliated firm acquires a target, it (the target) usually becomes a part of the acquirer's group. Even an acquirer's group affiliation could change if it is acquired later on by another group-affiliated acquirer. In the absence of historical data pertaining to the group affiliations of both the acquiring and the target firms, the inferences drawn are likely to be highly biased at best. The availability of historical group affiliation data is crucial for the purpose of this study, and this data has recently become available in the Indian context.7 We base our analysis on this unique hand-matched dataset of successfully completed takeover bids announced by India's publicly listed firms over the period 1997–2016.

We contribute to several strands of literature. First, we add to the literature on investment financing by demonstrating that in order to obtain a complete picture of investment financing, it is imperative to distinguish whether the parties to the investment decision, an investor and an investee, share the same set of insiders. We also document the relevance of certain factors in firm financing including a firm's reputation in the capital markets, access to sources of alternative finance, and the existence of debt guarantees, which are often ignored in the literature on firm financing. Our view is also consistent with Allen et al. (2012), who find that alternative finance, a form of non-market and non-bank financing, is an important channel of firm financing in emerging markets like India.

Second, we contribute to the literature on business groups by demonstrating how differently group-affiliated firms finance their investments relative to standalone firms. The prior research does not distinguish between the acquisition financing choices of standalone and that of group-affiliated firms (see, for example, Yang et al., 2019). We show that financing decisions of group-affiliated firms could be very different depending upon whether an affiliate makes an acquisition within or outside the group. Failure to distinguish between the two possibilities may lead us to arrive at erroneous conclusions about the differences in the acquisition financing choices of standalone and group-affiliated firms.

Finally, we also contribute to the burgeoning literature on mergers and acquisitions by providing additional factors that future studies should take into account when explaining the method of payment choices in countries with business groups. We also extend the strand of literature that calls for moving beyond the narrow lens of studying the effect of focal firms' ownership structure on their acquisition decisions without taking into account the possibility of overlapping ownership (Goranova et al., 2010).

The rest of the paper is organized as follows. In Section 2, we provide an overview of the Indian context with a focus on its institutional setting. In Section 3, we review the related literature and develop our hypotheses. Section 4 describes our research design, while Section 5 describes the data and the sample selection steps. In 6 Empirical analyses, 7 Additional analyses, we report the results of our empirical analyses and check their robustness, respectively. In Section 8, we conclude.

Section snippets

The Indian context and the institutional setting

Unlike the U.S. market, the Indian corporate landscape is dominated by firms with concentrated shareholdings in the hands of founding families, popularly known as promoters in India (Narayanaswamy et al., 2012). The promoters of a firm directly or indirectly control its affairs using their positions as shareholders, directors, or managers, and its board of directors is accustomed to acting on their advice.8 That is

Related literature and hypotheses development

In this section, we review and analyze the arguments related to considerations of control and financial constraints that are likely to play an important role in deciding how investments can be financed in markets with the presence of business groups.

Research design

To test how differently group-affiliated firms finance their within-group acquisitions compared to outside-group acquisitions (Hypothesis 1), we employ a subsample of acquisitions made by group-affiliated acquirers. Using this subsample, we perform a set of probit regressions of the following form modeling the probability of financing acquisitions with equity:PROBFIN_EQUITYi=1=α+β1WITHIN_GROUPi+γCONTROLSi+εi

The dependent variable in Eq. (1), FIN_EQUITY, is an indicator variable to represent

Data and descriptive statistics

We obtain our initial sample from the Thomson Reuters' Thomson One database. It includes acquisitions announced by publicly listed Indian bidders over the period 1995–2016 and successfully completed subsequent to their announcement. Since there are very few acquisitions made by Indian firms prior to 1995, we start our sample from 1995 in line with the prior literature (Banerjee et al., 2014; Bhaumik and Selarka, 2012). Our sample spans a period before, as well as after, the global financial

Comparison of acquirers on control considerations and financial constraints

We first compare acquirers in the three sets of acquisitions in our sample with one another depending on whether the financing of these acquisitions with stock can lead to dilution of the insiders' stake in acquiring firms. We call such acquisitions as potentially control-diluting acquisitions. The results given in Panel A of Table 6 indicate that while all (100%) of the outside-group, as well as standalone acquisitions, are potentially control diluting, a significantly lower percentage (26%)

Alternative explanations

In addition to the control considerations becoming unimportant, the greater financing of within-group acquisitions with stock can potentially be driven by at least two alternative explanations – propping and tunneling.20 Below we discuss each of these alternative explanations along with the necessary empirical tests.

Discussion and conclusion

In this paper, we propose and test a new order of financing investments made by firms in markets with business groups. Based on the considerations of control, as well as financial constraints, we demonstrate that the propensity of group-affiliated bidders to finance investments with equity is highest in case of acquisitions of firms affiliated with the same group (within-group acquisitions) and lowest in case of acquisitions of firms not affiliated with their group (outside-group acquisitions).

Acknowledgements

This paper is based on the first chapter of the PhD dissertation by Varun Jindal. We are grateful to the managing editor, Bill Megginson, and two anonymous reviewers for suggestions that significantly improved the paper. We acknowledge valuable comments from Shashwat Alok, Yakov Amihud, Vimal Balasubramaniam, Debarati Basu, Prachi Deuskar, Robert Faff, Arpita Ghosh, Kose John, Subrata Sarkar, Ajay Shah, Vijay Singal, Bin Srinidhi, Anjan Thakor, Danika Wright, Pradeep Yadav, David Yermack, and

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