The Rise and Fall of Pyramidal Firms

One of the popular justifications of business groups in emerging markets is that they provide internal capital market and, thus, enhance the firm value. Firms forming a pyramidal structure can provide equities, debts, and collaterals to one another. On the other hand, the same pyramidal structures are mostly condemned for tunneling and destroying the firm value. No serious attempt has so far been made to model both the value-enhancing and value-destroying qualities of pyramidal structure. In this article, we present a model that combines those two qualities and answer the two puzzling questions: why investors in emerging markets buy into the central firms of pyramidal structures; why governments would not go all the way to dismantle pyramidal structures. The model still recognizes that pyramidal structures can have lower value than horizontal structures, which conforms to the general empirical findings.