Agency conflict in diversified business groups and performance of affiliated firms in India

Abstract

This study examines how diversification in Indian business groups creates multiple forms of agency problems and has performance implications for group affiliated firms. Departing from prior literature which emphasizes the principal–principal agency conflict in business groups, we argue that business group diversification leads to dual agency problems between controlling and minority shareholders (principal–principal) and managers and shareholders (principal–agent) in affiliated firms. Both these agency problems arise in diversified business groups through cross-subsidization of affiliated firms by inefficient capital investment, continuing presence of affiliated firms in declining industries, tunneling of resources from profitable affiliated firms, lack of attention by business group headquarters to affiliated firms, and affiliated firm managers’ sense of perceived security which negatively impacts affiliated firms’ performance. These agency issues are reduced with the increase in product market competition from exposure to international markets and through concentrated promoter ownership in the affiliated firms. Our hypothesized model finds empirical support in a sample of 828 business group affiliated firms in India.