Business Groups and Debt

Business groups are a widespread corporate organizational form across developed and developing countries. This paper studies debt financing within pyramidal groups. Our starting point is the observation that the holding company in a group is not responsible for its subsidiaries' debt obligations, due to limited liability. We then model debt allocation between the holding and its subsidiaries when bankruptcy is costly, depending on whether lenders can observe the risk of investment projects. We also analyze how it is affected by the controlling shareholder's cash-flow share in each company. Our empirical analysis departs from existing ones by providing a description of the allocation of debt within pyramids, and interpreting it on the basis of our model. External debt over assets is smaller in operating than in holding companies, and is also smaller in listed companies after controlling for the usual determinants. The correlation between external debt and the controlling shareholder's cash flow share - when statistically significant - is positive. These results are consistent with one equilibrium configuration of our model, in which the controlling shareholder commits not to increase risk in subsidiaries by effectively giving up limited liability of the holding company.

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