The Emergence of Corporate Pyramids in China

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The Emergence of Corporate Pyramids in China

• Joseph P.H. Fan
• T.J. Wong
• Tianyu Zhang
• Chinese University of Hong Kong

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Pyramidal Ownership Structure

• A controlling owner sitting on the apex of the
  pyramid, exercising his/her control through
  layers of intermediate corporations
• Highly popular around the world
• Why the owner builds pyramid is a puzzle

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A Chinese Pyramid
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Why pyramiding?Existing conjectures

• Be warned few theoretical and empirical works
• Separating control from ownership
• Pyramids facilitate the controlling owners
  ability to capture private benefits, sometimes at
  the expense of minority investors
• Relieving financial constraints
• Pyramids enable the creation of internal markets
  that allow cross-subsidization of funds

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Why study Chinese pyramids?

• Chinas young market economy allows us to
  investigate corporate pyramids close to their
  inception
• Chinas diverse markets and geographic regions
  provide variations in institutional settings
• The co-existence of state and private owners
  allows a comparison of how the different
  institutional constraints affect their behaviors

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The Different Types of Ownership of Public-listed
Firms in China
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This research focuses on local government and
entrepreneur controlled firms upon their going
public
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Chinese Corporate Pyramids
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Why Chinese build pyramids?

• No prior research
• We investigate a few incentives
• Decentralization of decision rights of firms
• Relieving financing constraints

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Key Property Rules Regulating Firm Owners in China

• For local government owners, state ownership of
  shares and assets are not freely transferable
• For entrepreneur owners, they are disadvantaged
  (relative to government owners) in accessing
  external funds from the finance sector

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Effects of Non-transferability of Ownership on
Pyramiding Incentives

• Local government owners
• Not able to decentralize firm decision rights by
  freely selling off firm shares or assets
• Pyramiding as an alternative means of
  decentralization
• Compared with a policy order, pyramid is more
  credible to firm management
• Credible because of high bureaucratic costs if
  the government intervene ex post
• Entrepreneur owners
• Able to freely sell off firm ownership
• Smaller incentive of decentralization through
  pyramiding

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Effects of Financial Constraints on Pyramiding
Incentives

• Local government owners
• Less of a problem because they have policy tools
  to influence the finance sector and obtain funds
• Entrepreneur owners
• More of a problem
• Strong incentive of creating internal financial
  markets
• Strong incentive of pyramiding

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The extend of separation between ownership and
control of Chinese firms (cash flow rights over
voting rights)
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Predictions (local government controlled firms)

• Decentralization incentive affected by their
  objectives and the degrees to which these
  objectives conflict with those of firm mangers
  (agency problem)
• Regional unemployment problem (-)
• Fiscal health ()
• Government long-term incentive (RD and education
  expenditure) ()
• The degree of conflicts of interest reduces when
  the market and the laws provide strong
  disciplines
• Regional market development ()
• Regional legal environment ()
• Regional property rights protection ()
• Government deregulation ()

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Predictions (entrepreneur controlled firms)

• Entrepreneur firms
• Deep pocket (-)
• Whether the entrepreneur is one of the top-100
  rich people in China

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Empirical Design

• Regression analysis to find the determinants of
  pyramids
• Regression analysis to find whether any effects
  of pyramids are capitalized and reflected in the
  initial (first day) returns upon initial public
  offerings

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Table 3Decriptive Statistics
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Determinants of Corporate Pyramids
Government-controlled Firms (Table 4)
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Determinants of Corporate Pyramids
Government-controlled Firms (Table 5)
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Determinant of Corporate Pyramids
Entrepreneur-controlled Firms (Table 6)
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IPO first-day market-adjusted stock return (Table
7)
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Corporate Pyramids and IPO Underpricing
Government-controlled Firms (Table 8)
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Corporate Pyramids and IPO underpricing
Entrepreneur-controlled Firms (Table 9)
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Summary of Findings

• The extent of a government-owned corporate
  pyramid is positively related to local
  governments decentralization incentive
• The extent of a private-owned corporate pyramid
  is positively related to the controlling
  entrepreneurs wealth constraint
• Government firms that build pyramids are
  associated with smaller IPO underpricing

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Conclusions

• The pyramidal ownership structures of Chinas
  state and private enterprises are fundamentally
  related to a few property rights constraints
• The rights to transfer ownership
• The rights to access markets
• We need more research on the effects of these
  (and other) property rights constraints on firm
  behaviors
• Can the decentralization explanation of
  pyramiding behavior be generalized to private
  firms and/or outside China?
• Potentially so when outright transfer of
  ownership is undesirable