Effect of Controlling Shareholder's Private Guarantee on Ownership Structure and Business Portfolio of Business Group

This paper is the first to show the existence of equilibrium where the practice of private guarantee mitigate the incentive problem of the controlling shareholder, and to explain why such practice is viable in the financial market. In a business group, the controlling shareholder may have incentive to extract private benefit, due to the discrepancy of the cashflow rights and the control rights. However, such behavior increases his/her liability if the controlling shareholder provides private guarantee for the affiliated firm. Thus, the controlling shareholder may trade off their private benefit and liability. Also, the controlling shareholder has an increased need for risk management because he/she has expanded liability. This affects the operation of the business group. This paper explores how the ownership and business structures are chosen, depending on the extent of private benefit and guarantee. The ownership structure is represented by the cross-equity holdings. As for the business structure, this paper focuses on the correlation(diversification) of the business group's project portfolio. It implies that the agency problem of outside equity can be mitigated by providing the controlling shareholder with adequate incentives. It is not sufficient to either eliminate private benefit or impose direct regulation on cross-equity holdings. Rather, private benefit helps mitigate the agency problem because it facilitates the aligning of the controlling shareholder's interests with firm-value maximization. Additionally, it is necessary to expand the controlling shareholder's liability. The practice of private guarantee accomplishes this job. It is viable in the market because it not only protects the lenders but also benefits the controlling shareholder him/herself.