A Distinction between Business Groups and Diversified Firms : The Limited Liability Effect

In spite of the clear difference between business groups and diversified firms, they have not been adequately distinguished in prior studies. That an affiliate of a business group is an independent legal entity which can raise its own external funds draws two important distinctions. First, each affiliate has a limited liability. Second, a business group can transfer assets out of the affiliated firms (tunneling). Focusing on these differences, we provide a simple model that distinguishes business groups and diversified firms by comparing their investment strategies and firm values. As is widely known, the tunneling of a business group decreases its value. However, interestingly, we find that when the success probability of a project is low, the high level of tunneling enhances the business group value. This is because tunneling alleviates debt overhang problems. Our model provides an alternative explanation for the better performance of business groups in some developing countries.