Business Group Dominance and Capital Allocation Externalities: Evidence from Korean Chaebols

This study investigates how dominant business groups affect investment decisions of other standalone firms in the economy. Using intra-group equity transactions within the top 40 largest business groups in Korea, this study finds that high levels of internal capital allocation within the groups exert a negative influence on investments of standalone firms that require external capital. Due to financial market imperfections associated with low investor protections, business groups prefer internal investment rather than outside investment. However, when internal capital allocation is prevalent in the economy, lots of capital is trapped inside business groups and available capital in external markets becomes scarce. Standalone firms outside business groups have difficulties raising external finance and thus reduce investment. The negative influence on investments of business group dominance is particularly pronounced for private standalone firms and the firms that hold fewer tangible assets. Findings in this study suggest a negative externality that business groups impose on other standalone firms: the bias toward internal investment makes it harder for good projects outside business groups to obtain capital.