A striking feature about the ownership structure of Indian firms is the very high promoter stake. For example, the average promoter holding among publicly traded Indian firms in 2015-16 as per Prowess, a database maintained by CMIE (which includes almost all publicly listed firms), is 55.6%. More interestingly, the median number is closer to 58%. That means that in half to two-thirds of all publicly traded Indian firms, the majority ownership is held by promoters—hereafter referred to as insiders. In comparison, my co-author and I found that the average insider holding among the largest firms from 22 countries in Asia and Europe, excluding India, was at 18.75%. Why this vast difference between Indian ownership and the others?
A simple and proximate cause is the need for insiders to control their firm. Indian promoters feel that owning close to half or more of the shares is the easiest way for them to retain control. They feel a lower-share ownership may leave them open to the possibility of losing control to an outsider. This need for control is not unique to India or Indian promoters but is universal. No entrepreneur wants to work hard, create a firm, grow it and then lose control as soon as it becomes valuable.
Given this universal control motive, how are insiders in other countries able to control their firms with much less direct ownership? They employ alternative means of control. For one, family-owned businesses in South Korea and Japan, which are called chaebols and keiretsus, respectively, have complex ownership structures with cross-holding among group-affiliated firms that enable the insider’s group to control the business with very little direct ownership stake. Cross-holdings involve one group firm having a large equity stake in another group firm. For example, the single largest shareholder of Samsung Electronics (as documented in a famous global study of firms’ ownership structure) is Samsung Life, a life insurance company belonging to the Samsung group. Why an insurance firm? Simply because that is where the money is.
Among the new technology firms, the preferred mode of control is through a dual-class share structure, which involves two classes of shares with different levels of voting rights. While the Class-A shares held by the insider have, say, 10 votes per share, the Class-B shares issued to outside shareholders will have one vote per share. In the past decade, most of the blockbuster success stories in the technology space carry a dual-class share structure. That list includes household names such as Google, Facebook, Alibaba, Xiaomi, etc.
Now we turn to the consequence of Indian promoters trying to control their firm with high direct ownership.
To my mind, the most important consequence is the insider’s reluctance to raise outside equity. Insiders feel that raising too much outside equity will dilute their stake and loosen their grip over their firm. This aversion to outside equity, in turn, translates into a love for borrowed money. Indian firms are happy to finance their projects with bucketloads of borrowed money if that means they can avoid raising outside equity.
Just to give you an example, for a project involving, say, an investment of ₹1,000 crore, the optimal financing mix may contain ₹600 crore of debt and ₹400 crore of equity. The same project in the hands of an Indian promoter will end up being 100% debt financed. First, the promoter will manage to negotiate a higher debt-equity mix with the banks, say 70% debt and 30% equity. Then they will manage to finance the 30% equity investment in the project using debt borrowed by an affiliated firm. The consequence of such financing was highlighted by the “House of Debt” notes. Indian promoters are able to borrow large sums of money from friendly bankers for a simple reason: Bankers find lending to established business groups easier than lending to first-time entrepreneurs.
Thus, the main consequence of the high promoter holding among Indian firms is their preference for debt finance. Interestingly, promoters do not face any adverse consequences for this over-reliance on debt. Till date, even defaulting on this debt did not affect the insider’s control over their firm as they could infinitely prolong the resolution process. Hopefully, that is changing with the new bankruptcy law.
This love for debt finance can bring down whole economies. We saw that in the US when households and banks borrowed too much money, and we are again seeing it in the ongoing banking crisis in India. Banks in India are so weak that they are reluctant to lend to even healthy firms, and many need a taxpayer-funded bailout to survive. This is an unfortunate and unacceptable situation.
Here is a radical solution to this problem.
Provide Indian entrepreneurs alternative means to control their firms. For example, allow them to issue dual-class shares. This will help overcome their aversion to outside equity and wean them away from too much reliance on debt.
Other commentators and countries have come to the same conclusion. Their motivation is to allow young Indian entrepreneurs to retain control as they grow their firms.
A legitimate concern with this proposal is what happens to corporate governance? How will this affect the already battered outside shareholders? I will discuss this in my next column.
Radhakrishnan Gopalan is a professor of finance in Olin Business School at Washington University in St Louis.
This is the first in a two-part series.
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