Optimal Capital Structure and Dividend Policy for Control Efficient Family Business Groups: Theory and Empirical Evidence

I present a theory of the optimal capital structure and dividend policy for family business groups expanding in countries where the private control benefit is substantial and the market for corporate control is active. Here, issuing debt overcomes the limited dilution capacity of equity, but reduces the expected control benefit by increasing the probability of default. When family business groups grow, they may either (i) establish a subsidiary of an existing parent firm (Pyramidal structure), or (ii) establish a new stand-alone entity (Horizontal structure). The pyramidal structure intrinsically generates greater availability of internal capital, but limits the family’s ability to extract rent from the subsidiary. Therefore, in equilibrium, a large scale, less profitable firm emerges as a pyramidal subsidiary, and the subsidiary should be less leveraged than a stand-alone firm directly controlled by the family. Furthermore, the pyramidal structure implies (i) the parent firm can augment its own cash flow with dividends paid by subsidiaries (Co-insurance benefit), and (ii) control on subsidiaries is exercisable only if the parent firm is solvent (Control optionality). These two properties imply that the parent firm should be more leveraged than its subsidiaries. Therefore, the theory predicts decreasing leverage ratio from the top to the bottom along the pyramid, and this capital structure decision is supported by a dividend policy such that the parent firm should pay out less to maximize group internal capital while subsidiaries should pay out more to service the parent firm’s debt. Using a unique comprehensive data set of Korean business groups, Chaebols, I provide empirical evidence that is consistent with the theoretical predictions. Together, the empirical results and theory suggest that the controlling family of Korean Chaebol strategically designs the business group structure by making capital structure decision and dividend policy to optimize the control efficiency of the business group.