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 Thursday, 17 April 2014
The Pyramid Structure – Explaining Benjamin Graham’s Concern   PDF  Print  E-mail
Written by Roger Tan  
Thursday, 22 April 2004

Benjamin Graham devoted a chapter (chap 48) on corporate pyramid in his book Security Analysis 1934.  In that chapter, he voiced many concerns over the use of the pyramid structures by corporate America.

But what is a pyramid structure?  It looks something like this: Firm A owns 51% of Firm B, who owns 51% of Firm C, who owns 51% of Firm D, who finally owns 51% of firm E.

Ever wondered the true intention of creating these structures?  In this article, we will explore one of the hidden “wonders” of the corporate world – The Pyramid Structure.  We will further highlight the implications of Agency Theory on company expansion plans and take over plans.

Excuses to Creating Pyramids

When asked, management would often stress these few reasons for creating such a corporate structure:

1. Certain projects are risky.  To put such projects in the “parent” company would expose good projects to unlimited claims.  It is therefore necessary to incorporate special project entities to take advantage of “separate legal entity”.

2. Since each project is a profit center, it makes sense to create a subsidiary to facilitate proper accounting of revenue and costs especially if projects are medium to long-term.

3. Projects are sometimes undertaken by CEOs of subsidiary.  To increase the autonomy of CEO, it is more sensible to structure the project as subsidiary of that subsidiary.

4. Furthermore, by structuring these projects as subsidiaries, these projects can subsequently raise funds independently.  Investors now only need to assess the riskiness of that project and not a nexus of projects under the “parent” company.

5. The shareholders of the parent company can also prevent dilution of their shareholdings especially when it needs to undertake more share issues to undertake large and profitable projects.

Though these arguments stress that business groups do add value by risk sharing (hypothesis), the empirical support for this hypothesis has been weak (Khanna and Yafeh (2000)).  There is another less moral intention for creating business group structures and this is known in academic jargon as "tunneling".

Value Adding or Subtracting?

Does the pyramid structure add value to shareholders?  Two opposing hypotheses were postulated to explain the intentions.
1. Value Adding hypothesis
2. Tunneling hypothesis

In many emerging economies, capital markets are often under-developed and therefore inefficient.  To increase efficiency of capital allocation, firms instead create structures such as cross holdings and pyramids.  This is also known as the internal capital markets.  This sub-hypothesis to the value-adding hypothesis is known as the Incomplete Markets hypothesis.

Therefore, such pyramid structures add value when external capital markets are inefficient. Conversely, pyramid structures do not add value as these capital markets become progressively more efficient.  Empirical tests conducted by Khanna and Rivkin (1999) seems to suggest that this hypothesis is supported but only weakly.

Proponents of the agency theory suggest, on the other hand, that pyramid structure is an avenue for “tunneling” (this is an the academics’ polite way to describe the act of controlling shareholders or management transferring resources out of a company for their own private benefit).  They postulate that the pyramid structure allows owners to separate control rights and cash flow rights.  But what exactly is “separating control and cash flow”?  Referring back to the example given in the introduction, Firm A’s ultimate right to the cash flow of Firm E is 6.8% but it controls 51% of the company.  Had Firm A held Firm E directly, it would have owned 51% of the cash flows and at the same time 51% control over the company.

Why is this a problem?  As explained in the article “Agency Theory …” the lower the ownership by owner-managers the lower the cost of tunneling.  Since Firm A only holds 6.8% ownership of Firm E’s cash flow, it will only cost Firm A $0.068 per $1 profits tunneled.  The “tunneling” hypothesis is supported by research conducted by Clasessens, Djankov, Fan and Lang (1999b).

Agency Exploitation of Separating Cash Flow and Control

In situations where there are benefits (net benefits to be correct) to the exploitation of the agency relationship, the value of the firm will suffer from this divergence of interest.  We have explored how the value of a firm is reduced when an agency relationship was created in a previous article.  We will now explore three other areas of exploitation of agency relationship:

1. Expansion and Contraction Decisions
2. Investment Decisions
3. Transfer of Control Decision

In general, the agent will only undertake all the above decisions when the benefits from the decisions are more than the cost - namely the value the agent’s share plus his forgone private benefits.  To better explain the behavior of an agent, lets use a hypothetical company REMM Pte Ltd, which owns a pyramid structure of companies as stated above.

1. When to scale up and down the company?

Imagine the Co. B of REMM (REMM owns 51% of Co. B) has received an offer to sell one of its projects.  The value of the project is $100,000 while the value of its private benefits is $20,000.  To convince REMM to sell the project,the offer will have to be at the amount such that the proceed that REMM is entitled to is more than the their claim over value of the project plus its private benefits, or:

Value from Sale  >      Value from Project
  Alpha x S.P     >  (Alpha x VoP less PB) + PB


S.P  = Selling price
Alpha = % of ownership
VoP  = Value of Project
PB  = Private Benefits

In this case the offer price must be above $120,000 to entice REMM to sell.  As we move the project down the pyramid, we will find that the required purchase price will increase as ownership reduces.  This is how it looks like

Likewise, even thought the value of the project is only worth $100,000, the agent is willing to pay more for the project as we move lower into the pyramid structure.  Owner-managers are therefore always more willing to expand operations then to downsize them.

2. Which Project to Undertake?

When an agent is presented two projects, superior (provides higher cash flow) and inferior (provides lower cash flow), which one should he undertake?  The likely answer is superior of course.  But we know that is often not the case.  He will often undertake the one that provides him the highest net benefit after taking private benefits into consideration.

Here is another example.  Project Superior has a value of $120,000 and provides a total cash flow of $90,000 but on $10,000 private benefits. Project Inferior also has a value of $100,000 but provides a total cash flow of $60,000 and total private benefits of $40,000.

At a glance, Superior would be the dominant choice but the agent’s choice will be Superior only if the benefits are more than those provided by Inferior:

 Value from Superior             >       Value from Inferior
[Alpha x (Vs - P.Bs) + P.Bs]   >  [Alpha x (Vi - P.Bi) + P.Bi]

Alpha  = % ownership
Vs = Value of Project Superior
P.Bs = Private Benefits from Project Superior
Vi = Value of Project Inferior
P.Bs = Private Benefits from Project Inferior

Not surprisingly, the agent will choose Project Superior at the main company level but would prefer Project Inferior when the project is presented at different entity levels in the pyramid.

3. Transferring Control

It is naturally understood if an alternate party can increase the value of a firm, ownership and control over the company should have relinquished to that party for the good of the whole.  Unfortunately, its appeal is lost under agency theory.  Ownership is transferred from the old owners to the new owners only when the value that the new owner will pay is higher than the current benefits – even if the value of the firm is lower under the new regime.

For example, Crook Pte Ltd wishes to take over the whole of Co.B from REMM Pte Ltd and other shareholders of Co.B (general takeover).  The value of Co.B is $100,000 but Crook values the company at $250,000.  REMM currently enjoys $20,000 private benefit.  REMM will only allow transfer of ownership and control to Crook only if the portion of Crook’s value it is entitled to is more then its current undertaking under its control.

Value Before Transfer          > Value After Transfer
[Alpha x (Vbt – PBbt)+PBbt] >     [Alpha x Vat]
Alpha = % ownership
Vbt = Value of firm before transfer
PB = Private befits before transfer
Vat = Value of firm after transfer (valuation by buyer)

In this case, REMM would transfer ownership to Crook.  Assuming that the same valuation by Crook applies to the other companies (C to E), REMM will be reluctant to transfer ownership.

Clearly, the above illustrations explain why many investors do not view pyramid structures favorably. In fact even without any theoretical underpinning, the great Benjamin Graham viewed pyramid structures with caution. I would like to conclude this discussion with the following quotations:

“Individuals are not only self-interested but pursue their self-interest with guile”

– Williamson (1995)

“The directors of such [joint stock] companies, however, being managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own.  Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves to dispensation from having it.  Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.”

- Adam Smith (1776)


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