Internal capital market mergers in weak external market environment: An emerging market evidence

• Date: 01 October 2019
• Published date: 01 October 2019
• Author: Jason Laws,Abhinav Goyal,Hong Zhang,Wei Huang
• DOI: http://doi.org/10.1002/ijfe.1739

RESEARCH ARTICLE

Internal capital market mergers in weak external market

environment: An emerging market evidence

Wei Huang

1

| Hong Zhang

1

| Abhinav Goyal

2

| Jason Laws

2

1

Nottingham University Business School,

University of Nottingham, Ningbo, China

2

University of Liverpool Management

School, University of Liverpool, Liverpool,

UK

Correspondence

Abhinav Goyal, UniversityLiverpool

Management SchooI University of Liverpool

Chatham Street, Liverpool, U.K.

Email: a.goyal@liverpool.ac.uk

Abstract

Using Chinese split-share structure reform as backdrop, we study the alternative

theories explaining the change in objectives of internal capital markets (ICMs) aft er

regulatory intervention. Focusing on related party merger and acquisitions, as the

primary form of ICM transactions in China, we document significantly positive

performance improvement among the acquiring firms around related party than

nonrelated party merger and acquisitions in the period following the split-share

structure reform. This evidence is particularly stronger among acquirers with lower

institutional shareholding. Our findings are invariant to the length of performance

evaluation window, matched samples, model specifications, acquirers' ownership

structure, and business group affiliations. After controlling for alternative channels

of tunnelling and propping, contrary to the popular belief, our findings suppor t the

bright-side view of ICMs postregulatory intervention in an emerging market set-up.

KEYWORDS

China, internal capital market, M&A, related party, tunnelling

JEL CLASSIFICATION

G3; M4

1|INTRODUCTION

For the last two decades, corporate governance has been on

the forefront of policy debates (OECD, 2015). Essentially, it

relates to the mechanisms, processes, and relations by which

corporations are controlled and directed. Corporate gover-

nance not only encompasses the relationships and ensuing

patterns of behaviour between different agents in a limited

liability corporation but also requires the assistance of public

policy in the form of periodic regulatory intervention,

because ultimately all corporate strategies have to be formu-

lated within a legal and regulatory framework.

In their seminal study, Shleifer and Vishny (1997) argue

that “understanding the subject of corporate governance

improvements is of enormous practical value in transition

economies, which will stimulate governance reform for bet-

ter economy.”In this paper, we re-evaluate the competing

views of internal capital markets (ICMs) in an emerging

economy. We use a major corporate governance reform in

China as an exogenous shock to examine its impact on

changes in merger-related value creation for ICMs among

We are especially grateful to the editors, Ioannis Kyriakou and Keith

Cuthbertson, and the anonymous referee in helping us improve this paper.

We would also like to thank our colleagues, Weimin Liu, Yi Zhang, Dayong

Zhang, and Xiaogang Bi, for their comments on previous versions of this

paper. This paper has improved significantlyfrom the comments of the

discussants and seminar participants at BAFA Conference (2017) and

Emerging Market Corporate Governance Conference—De Nederlandsche

Bank (2018). Abhinav Goyal is thankful to the hospitality shown by

colleagues at the banking and finance group in the Monash Business

School, Monash University,where par t of this research wasunder taken.We

are grateful to the author's respective institutions for financial support. We

alone are responsible for any errors and the usual disclaimer applies.

DOI: 10.1002/ijfe.1739

wileyonlinelibrary.com/journal/ijfe

Int J FinEcon. 2019;24:1486–1505.

1486

© 2019 John Wiley & Sons, Ltd.

Chinese listed firms. In particular, Allen, Qian, and Qian

(2005) show that Chinese laws for investor protection,

financial system, and corporate governance mechanism are

significantly inferior to most developed countries. Tradition-

ally, besides tradable shares (mainly classified as A-shares),

firm ownership structure in China was comprised of non-

tradable shares classified as state shares and/or legal person

shares. Until the beginning of 2005, around two third of the

outstanding shares were nontradable in China. Moreover, the

majority of listed firms in China are carve-outs from large

state-owned enterprises (SOEs) under the control of the

Chinese government or its agencies at central and local or

provincial level (Li, Wang, Cheung, & Jiang, 2011; Liao,

Liu, & Wang, 2014). On September 4, 2005, China Securi-

ties Regulatory Commission announced a market wide

nontradable share reform plan after successfully piloting a

first batch of three companies on May 9, 2005, and a second

batch of 42 companies on June 20, 2005. This split-share

structure reform granted legitimate trading rights to the

state-owned shares of listed SOEs with a compensation

paid by nontradable shareholders to tradable shareholders,

thereby opening up the gate to China's secondary

privatization (Firth, Lin, & Zou, 2010; Li et al., 2011; Liao

et al., 2014). Overtime, the reform has been well justified as

an exogenous shock that led to risk sharing between minor-

ity and controlling shareholders (Li et al., 2011), perfor-

mance improvement (Campello, Ribas, & Wang, 2014 Liao

et al., 2014; Hou, Jin, Yang, Yuan, & Zhang, 2015),

1

reduced tunnelling activities (Liu & Tian, 2012), changes in

earnings management, and tax avoidance activities (Hou et

al., 2015).

The above literature generally examines the impact of the

split-share structure reform on firms, and in comparison,

very limited attention has been paid to its consequences on

business transactions. Business groups and related party net-

works in China not only internalize goods and service trans-

actions but also capital transactions. Therefore, merger and

acquisition (M&A) decisions can be a vital capital resource

allocation mechanism within ICMs (Chen, Harford, & Li,

2007). In light of extensive evidence documented in the prior

literature on corporate governance and takeover outcome,

we believe that M&As are ideally suited in the context of

our study on value gains from ICMs following a major regu-

latory reform. As per the basic statistics from our data for

the Chinese M&A market, related party M&A deals account

for almost 45% of total deal volumes, simultaneously

accounting for over one third of the total transaction value

even in the postsplit-share structure reform period.

2

How-

ever, so far, no prior work has paid sufficient attention to the

shareholder value implications of the ICMs or equivalently

stock price stability around these important transactions, par-

ticularly with respect to M&A investment decisions within

ICMs after the completion of a major government initiated

regulatory intervention, that is, split-share structure reform.

In this study, we try to bridge this vital gap.

We conduct a battery of difference-in-differences tests

and document two important findings. First, bidders' short-

term excess return around deal announcement increased

principally in the postsplit-share structure period compared

with presplit-share structure reform period, and the perfor-

mance improvement was significantly larger for related party

than nonrelated party M&A. Second, these effects are partic-

ularly strong among the subsample of low mutual fund

shareholding acquirers compared with the high mutual fund

shareholding acquirers. Our evidence is consistent with

Berkman, Cole, and Fu (2011) and Campello et al. (2014)

on heterogeneous effect of major corporate governance

reform, wherein weakly governed firms benefited substan-

tially more from the government initiated regulatory reform

in China. These results remain robust for group-affiliated

and nonaffiliated acquirers.

Abusive related party transactions—where a party in con-

trol of a company enters into a transaction leading into the

value destruction for the noncontrolling shareholders—are

one of the main attributes to stock market instability and the

biggest corporate governance challenge facing the Asian

business landscape (OECD, 2015). In this paper, we present

new findings that are contradictory to a negative view of

related party transactions (Bae, Kang, & Kim, 2002;

Cheung, Rau, & Stouraitis, 2006; Jiang, Lee, & Yue, 2010;

Jian & Wong, 2010; Peng, Wei, & Yang, 2011; Liao et al.,

2014; etc.). In particular, we extend Bae et al.'s (2002) study

that examines tunnelling through value-destroying acquisi-

tions by Korean business group-affiliated (Chaebol-affili-

ated) bidders, or Peng et al. (2011) wherein financial

conditions play an important role in affecting tunnelling- or

propping-based related party transactions in China. Contrary

to these prior studies, our empirical evidence is in line with

the bright-side view of ICMs (Ger tner, Scharfstein, & Stein,

1994; Stein, 1997) and offers new insight to ICMs theoreti-

cal framework, that is, corporate governance improvement

through regulatory intervention within a country can deter-

mine the trade-off between advantages and disadvantages of

ICMs. This study hence provides Chinese experience that

governments in Asia may compare while seeking answers to

common problems in fighting abusive related party

transactions.

On another front, privatization continued in post-2000

period, but the pattern of global privatization shifted from

secondary-share public offering in Western Europe to a wide

variety of divestment methods in emerging markets, which

calls for further policy evaluations, especially in China

where it significantly accelerated in postsplit-share structure

reform period (Megginson, 2017). In 2000, China's GDP at

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