| I present a theory of the optimal capital structure and dividend policy for expanding family business groups vertically or horizontally. When private control benefits are substantial, takeover threats impose a constraint on external equity financing. Debt can overcome this restriction but introduces the possibility of bankruptcy where control benefits are also lost. Relative to a horizontal structure, a vertical pyramid enhances internal capital financing, but the family has to share more of the profit from the new firm with its existing shareholders, implying that a pyramid is more likely when external financing constraints are more severe, or the new firm is less profitable but capital intensive. In equilibrium, subsidiaries are less leveraged than horizontal entities directly controlled by the family, because the parent firm supports subsidiaries with greater amounts of internal capital. Within a pyramid, the leverage ratio should decrease from top to bottom because the parent firm has a larger collateralized debt capacity. At the same time, dividend payout should increase from top to bottom because this is how the family transfers wealth out of the subsidiaries, without selling control shares to ensure its control over the parent firm against default. Therefore, the theory predicts a decreasing leverage ratio from top to bottom of the pyramid, supported by a dividend policy where the parent firm pays out less to maximize group internal capital, while subsidiaries pay out more to service the parent firm's debt. I confirm these predictions using a unique data set on Korean business groups. Together, the empirical results and theory suggest that the structure of a business group is strategically designed to maximize control. |
