R&D investment decisions in business groups: Evidence from a natural experiment

• Published date: 01 January 2022
• Author: Daewoung Choi,Seungho Choi,Yong Kyu Gam,Hojong Shin
• Date: 01 January 2022
• DOI: http://doi.org/10.1111/corg.12407

SPECIAL ISSUE ARTICLE

R&D investment decisions in business groups: Evidence from

a natural experiment

Daewoung Choi

1

|Seungho Choi

2

|Yong Kyu Gam

3

|Hojong Shin

4

1

Department of Economics and Finance,

Louisiana State University Shreveport,

Shreveport, Louisiana, United States

2

QUT Business School, Queensland University

of Technology, Brisbane, Queensland,

Australia

3

School of Business, University College Dublin,

Dublin, Ireland

4

Department of Finance, Room 448, College

of Business California State University, Long

Beach, California, United States

Correspondence

Hojong Shin, Department of Finance, Room

448, College of Business California State

University, Long Beach, CA 90840, USA.

Email: hojong.shin@csulb.edu

Abstract

Research Question/Issue: This paper examines R&D investment decisions in firms

under a pyramidal ownership structure in the context of South Korea.

Research Findings/Insights: Using the Monopoly Regulation and Fair Trade Act,

which places limits on group affiliates' equity investments, we provide new evidence

that controlling owners tend to increase long-term R&D expenditures more in firms

that are largely subject to the equity investment regulation in South Korea. More-

over, this result is more significant for firms for which the owners have low cash-flow

rights, firms located in the lower layers of the pyramid, and firms that hold less equity

shares than do other group affiliates.

Theoretical/Academic Implications: This study contributes to the literature that

focuses on R&D investment decisions by providing empirical support regarding how

firms' relative status within their business group influences the firms' R&D invest-

ment decisions in South Korea.

Practitioner/Policy Implications: This study provides important insight into the posi-

tive policy implications of the equity investment regulation on R&D investments for

Korean business groups.

KEYWORDS

corporate governance, ownership structure, investment decision, business group

1|INTRODUCTION

Corporate R&D investments are heterogeneous across firms even

within the same business group. For example, in LG Corporation, one

of the largest business groups in South Korea with a global brand, LG

Innotek's R&D expenditures is up to 5.11% of its total sales in 2013,

but that of LG Display is only 2.67% of its total sales in the same year.

LG Chem's R&D expenditure is even smaller (0.18%) relative to its

sales in the same period.

1

What kinds of drivers differentiate R&D

expenditures among companies within the same business group? A

large body of literature focuses on firm- or industry-level characteris-

tics such as growth potential, industry structure, and corporate gover-

nance to explain the heterogeneity of R&D investment patterns

across firms (e.g., see Choi et al., 2012; Lee et al., 2017; Min &

Smyth, 2016). This study concerns a pyramidal ownership structure of

a business group in South Korea and the relative status of an affiliated

firm in the pyramid as key channels that affect the firm's R&D invest-

ment decisions. The setting of a pyramidal ownership structure is typi-

cal in Korean chaebols, for which family owners of the chaebol

commonly own and control multiple firms. We employ controlling

owners' cash-flow rights over the firm, layers of the firm under the

pyramid, and the firms' centrality

2

as main variables that provide a

measure of each firm's relative status in the group.

This paper identifies the relationship between firms' R&D invest-

ment decisions and the firms' relative status within the business group

by employing the 2001 regulatory reform of firms' equity investments

implemented by the Korea Fair Trade Commission (KFTC) as a shock

to firms' investment environments.

3

In April 2001, a regulation that

Received: 15 May 2020Revised: 26 September 2021Accepted: 30 September 2021

DOI: 10.1111/corg.12407

Corp Govern Int Rev. 2022;30:55–79.wileyonlinelibrary.com/journal/corg© 2021 John Wiley & Sons Ltd55

controlled the equity investments of firms under business groups took

effect. This regulation was applied to firms that belong to large busi-

ness groups with total consolidated assets of 5 trillion Korean won

(KRW) and above. Since then, equity holdings held by an affiliated firm

within the business groups subject to the regulation were limited to

25% of its net assets. Consequently, this new regulation forced firms

to reallocate their resources between different investment alterna-

tives. This study highlights the heterogeneous effects of the regula-

tory reform on R&D expenditures across firms with different

positions under a pyramidal ownership structure.

Using a sample of 1,179 firm-year observations (353 unique firms)

owned by the 24 largest Korean chaebol groups

4

in the period of

1998 to 2004, we present how the Korean firm's R&D investment is

related to its ownership structure or its position in the business group.

We observe lower long-term R&D expenditures in group member

firms under a pyramidal structure when the controlling owners have a

higher level of cash-flow rights. Specifically, a one-standard-deviation

increase in the controlling owner's cash-flow rights is associated with

a 26% lower long-term R&D ratio.

5

We further find that firms' long-

term R&D expenditures are relatively smaller for the firms located in

the upper layer of the pyramid or the firms that hold more equity

shares of the group affiliates.

Next, by employing the difference-in-differences (DiD)

approach,

6

we provide empirical evidence from a quasi-natural experi-

ment that the equity investment regulation of South Korea positively

affects R&D investment decisions of the Korean chaebol firms. The

new equity regulation places limits on group affiliates' equity invest-

ments up to 25% of their net assets and requires controlling owners

to reallocate the excess equity investments. Our results show that,

after the new regulation, the controlling owners are more likely to

increase long-term R&D expenditures in firms for which the equity

investment ceiling is applied. Moreover, we find that this trend of

increasing investments is more profound in firms for which controlling

owners have lower cash-flow rights. This trend, however, is less likely

in the firms located in the upper layer of the pyramid, where the

controlling owners' direct ownership is highly concentrated, and in

high-centrality firms for which equity investment in group affiliates is

highly preferred for governance purposes.

We check that alternative time periods produce similar results by

excluding non-succession or non-crisis periods. We also confirm that

all of these results are consistent with alternative samples that con-

sider the regulatory relaxation period and with exemptions for busi-

ness groups that are transformed into holding company structures.

7

Overall, the results highlight the significance of the regulatory reform

that restricted equity investments by chaebol groups with a pyramidal

ownership structure, thereby allowing controlling owners to change

R&D investment decisions within their business groups. However, as

Adams (2017) alerts, a difference-in-differences approach does not

identify causal effects when the situation does not resemble a medical

experiment. Thus, we do not claim the causal effects of the regulatory

reform on R&D expenditure.

Our study contributes to the literature in several ways. First, this

study contributes to the literature that focuses on R&D investment

decisions in South Korean business groups (Choo, 2014; Heshmati &

Kim, 2011; Min & Smyth, 2016; Oh et al., 2018). The dramatic eco-

nomic growth of South Korea from the 1970s through the 1990s was

achieved mainly through massive R&D investments by Korean firms

(Chang et al., 2006; Kim, 1991; Sakakibara & Cho, 2002).

8

A few stud-

ies have examined the determinants of R&D investments in Korean

business group firms. Min and Smyth (2016) find that Korean firms'

R&D spending is affected by corporate leverage and growth opportu-

nities. Choi et al. (2012) and Lee et al. (2017) find that R&D invest-

ment decisions vary across different types of ownership or industry

R&D intensity. While most prior studies merely use cash-flow and

voting rights to describe the ownership structure of Korean chaebols

(Bae et al., 2002, 2006; Bertrand et al., 2002), we track detailed infor-

mation on each group's pyramidal ownership structure and construct

the metrics of complex ownership structure in chaebols (e.g., cash-

flow rights, layer of pyramid, and centrality) following Almeida

et al. (2011). In addition, to better capture long-term growth strategies

reflected in R&D investment, we employ the capitalized R&D expen-

diture classified under Korean GAAP as a proxy value for each firm's

long-term R&D investment. Thus, our study benefits from the use of

newly developed comprehensive pyramidal ownership metrics and

the proxy value of the long-term R&D investment.

Second, we employ the regulatory change on equity investments

for Korean chaebol firms in 2001 as a shock on the firms' investment

decisions. As a result of the regulatory change, large chaebol firms

with total assets above 5 trillion KRW were required to limit their

equity investments to within 25% of their net assets. This regulatory

shock was largely exogenous to the Korean chaebol groups' own

investment decisions and, thus, provides a desirable natural experi-

mental environment to test how R&D investment decisions are differ-

entiated among group affiliates by their ownership structures within

the business groups after the regulatory reform. Notably, our

regression results provide evidence that the 2001 equity investment

regulation has significant differential effects on chaebol firms' R&D

investments, depending on the firms' relative status within the busi-

ness groups. Overall, this study provides important insight into the

positive policy implications of the equity investment regulation on

R&D investments for Korean business groups.

9

2|LITERATURE REVIEW

2.1 |R&D Investment

R&D investments are distinguished from other investments. For

example, R&D investments are considered risky long-term invest-

ments associated with high failure rates and a large amount of sunk

and adjustment costs, specifically in low-growth environments

(Aboody & Lev, 2000; Kor, 2006; Oriani & Sobrero, 2008). Moreover,

R&D investments are not directly observable, a significant level of

information asymmetry often exists between managers and investors,

and future outcomes of R&D projects are difficult to evaluate (Hall &

Bagchi-Sen, 2002; Oriani & Sobrero, 2008). Given such concerns,

56 CHOI ET AL.