TUNNELING AND PROPPING: INDIAN EVIDENCE A THESIS SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE FELLOW PROGRAMME IN MANAGEMENT INDIAN INSTITUTE OF MANAGEMENT INDORE By Pankaj Gupta March, 201 Thesis Advisory Committee Prof. Yogesh Maheshwari [Chair] Prof. Ganesh Kumar N. [Member] Prof. Pradip Banerjee [Member] i
Abstract Business groups (BGs) is one of the most dominant and prevailed organizational structures in emerging economies like India. The Business group is a set of legally independent firms tied through various formal and informal ways (Granovetter, 1995; Khanna and Yafeh, 2007). BGs was known as controlling minority structures wherein, the separation between ownership & control prevails through structural devices like pyramids, cross-shareholdings and dual class shares (Bebchuk et al., 2000). While there have been several critiques for BGs like crony capitalism, taking tax advantages, and political linkages, the demand for corporate control in addressed by researchers through different lenses and perspectives. Our study is an effort in this direction. Theoretical literature suggests the direct and indirect control of the controlling owners in the expropriation of minority shareholders. This is known as Principal-principal agency problem (Dharwadkar et al., 2000). The conflict further increases due to the asymmetry of information, development of the internal capital market and easy access to external finance. When the control motivation works in a manner that causes moral hazard problem and the interplay between external-internal markets, the resource transfer activity in a listed firm expropriates minority shareholders. This resource transfer activity is known as Tunneling. Tunneling is the transfer of resources from low-cash-flow-right to high-cash-flow-right firms (Bertrand et al., 2002). Propping happens when a firm is in financial difficulty and receives resources from a firm with high cash flow right, i.e., negative tunneling (Friedman et al., 2003). The market views such activities and reacts accordingly. Here, the monitoring role of controlling owner, the board of monitoring mechanism by the board and auditors is present, it limits the minority shareholders expropriation caused by the collusion between owners and managers. Tunneling and Propping is one form of such expropriation that causes the diversion of resources to related parties of these insiders. To examine the role of these insiders (internal governance mechanism), a corporate governance index is used in the study based on the lines of Black et al. (2015) and Sarkar et al. (2012). The iv
role of efficient monitoring mechanism is crucial because its absence may aggravate the expropriation through increased Tunneling and Propping. Our research considers this framework and provides evidence of Tunneling and Propping in BGs in India. We consider the direct and indirect methods of detecting Tunneling and Propping which still is not addressed for BGs in India. The Indirect method approach considers the earnings announcement effect. Under this, it is evident that when a firm of the group announces its earnings, a positive return of other non-announcing firms confirms the Propping hypothesis. Here, a negative impact of corporate governance mechanism is evident for the positive returns relationship between announcing and non-announcing firms. When considering the direct method approach, Related Party Transactions (RPTs) used as a proxy for the detection of Tunneling and Propping activity. The result suggests that large firms have the high amount of RPTs with Tunneling effect and the market penalizes them. Corporate governance mechanism plays a deterring role to Tunneling. Finally, when controlling owner has institution-driven motivations other than business transactions, the relationship between Tunneling and Propping is found to exist. This work is comprehensive in its nature when considering the Tunneling and Propping activities in India. This study can be a guide to the investors planning to invest in group firms. now more capable of analyzing various activities happening between group enterprises and its implications on their investment. We emphasize that, in certain cases, the firms with improved corporate governance system are less likely involve in activities that may expropriate the investors hard earned money. Policy makers and regulatory bodies may use this as a reference when formulating policies and regulations to protect the rights of shareholders. Keywords Business groups, Ownership and control, Tunneling and Propping, Related Party Transactions, Performance. v
Contents Acknowledgement Abstract List of Figures... List of Appendix List of Tables ii iv iii ix Chapter 1... 1 1 Introduction... 2 1.1 Motivation... 3 1.2 Organization of Thesis... 6 Chapter 2... 10 2 Tunneling and Propping: Theoretical Framework... 11 2.1 Introduction... 11 2.2 Tunneling and Propping in Business Groups: A Review of Literature... 12 2.3 Inter-linkages andtheoretical Framework... 21 2.4 Tunneling and Propping: A justification through The Fixed Investment Model... 23 2.5 Conclusion... 37 Chapter 3... 39 3 Tunneling and Propping: Evidence through Indirect Method... 40 3.1 Introduction... 40 3.2 Literature Review... 41 3.3 Hypothesis Development... 45 3.4 Data, Sample and Methodology... 49 3.5 Results and Analysis... 57 3.6 Conclusion... 83 Chapter 4... 84 4 Tunneling and Propping: Evidence through Direct Method... 85 4.1 Introduction... 85 vi
4.2 Literature review and hypothesis... 86 4.3 Data and Methodology... 90 4.4 Results and Analysis... 98 4.5 Conclusion... 118 Chapter 5... 119 5 Relationship between Tunneling and Propping: Empirical evidence... 120 5.1 Introduction... 120 5.2 Literature review and hypothesis... 123 5.3 Data and methodology... 126 5.4 Results and Analysis... 131 5.5 Conclusion... 141 Chapter 6... 142 6 Conclusion... 143 6.1 7 6.2 8 Appendices... 147 References... 171 vii
List of Figures Figure No Title Page No. Figure 2.1 22 Figure 2.2 Resource transfer activity in group affiliated firms 24 Figure 2.3 Allocation of control rights and decision process 25 Figure 2.4 Incentives scheme for the controlling owner when involve in 34 Tunneling decision Figure 3.1 Group wise classification of earnings announcement made by group 51 firms during the period 2007-2015 Figure 3.2 Cumulative abnormal returns for all announcing firms and subgroups- 59 Top 50 and Other groups, around the earnings announcement day (EAD) Figure 3.3 Cumulative abnormal returns for all announcing firms vs. portfolio of non-announcing firms around the earnings announcement day (EAD) 60 List of Appendix Appendix No Title Page No. A1.1 (a) Controlling ownership in business group structure: Tata Group 148 (Year 2008) A1.1 (b) Controlling ownership in business group structure: Tata Group 149 (Year 2015) A1.2 Variables definition and description 151 A1.3 Definition of Related Party Transactions and classifying RPTs as 156 ex ante having Tunneling and Propping effect A2.1 Event study method: Measurement of Abnormal returns 159 A2.2 Panel Data Estimation Strategy 164 A3.1 Effect of various characteristics on the portfolio returns and change 167 in ROA A3.2 Year wise RPTs with related parties for group affiliated firms 170 viii
List of Tables Table No. Title Page No. Table 3.1 Earnings announcement classification according to the group name and group category 51 Table 3.2 Descriptive statistics and correlation analysis for financial 53 characteristics Table 3.3 Cumulative abnormal return (CAR) analysis 58 Table 3.4 Cumulative abnormal returns (CAR) for announcing firms and the 61 portfolios of non-announcing firms in the same group Table 3.5(a) Cumulative abnormal returns (CAR) for the announcing firms and 64 portfolios of non-announcing firms by the sign of the ROA change and the sign of the CAR (-5, 5) Table 3.5(b) Cumulative abnormal returns (CAR) for the announcing firms & 65 portfolios of non-announcing firms by the sign of the ROA change and the sign of the CAR (1, 10) Table 3.6 Regression of CAR and ROA changes for the portfolios of nonannouncing 69 affiliates on the financial characteristics of the announcing firms Table 3.7 The role of corporate governance for the relationship between return 73 (portfolio) of non-announcing firms and return of announcing firm Table 3.8 Regression analysis for the portfolio return (CAR) of non-announcing 79 firms when announcing firm is in different industry than nonannouncing firms Table 3.9 Regression analysis of returns relationship with no delisting history 81 Table 4.1 Correlation Matrix and multicollinearity analysis 100 Table 4.2 Descriptive statistics 102 Table 4.3 Effect of Related Party Transactions (RPTs) on firm performance 106 Table 4.4 Performance analysis of ex ante Tunneling (TRPT) and Propping (PRPT) Related Party Transactions 111 ix
Table 4.5 Analyzing role of corporate governance mechanism in RPTperformance 113 relationship Table 4.6 Effect of Abnormal RPTs (TUNN and PROP) on firm performance 114 ( ) Table 4.7 Sensitivity Analysis: The effect of Tunneling and Propping Related 116 Party Transactions (TRPT and PRPT) on firm performance ( Q) Table 5.1 Sample description of companies involve in Propping and Tunneling 133 activities Table 5.2 Distribution of firms showing Propping behavior under different 133 motivations Table 5.3 Propping behavior under different motivations 134 Table 5.4 Relationship between the excess Propping behavior of the firm and 136 motivation to prop up the firm Table 5.5 Relationship between Tunneling and Propping under control 139 motivations Table 5.6 Performance analysis of Propping in current yr and Tunneling in next year 140 x