Do Business Groups Use Dividends to Fund Investments?

Abstract

In this paper we offer a theory of dividends in business groups. We hypothesize that business groups operate a type of internal capital market and use dividends as a transparent means of transferring cash across group firms. The intuition, formalized in a simple model, is that insiders use their share of dividends to finance investment in member firms, thereby limiting the dilution of their equity stake when firms raise outside capital. The correlation between dividends and investments is predicted to be stronger for smaller and more profitable investments and when the legal regime is more protective of shareholder rights. We test our predictions using firm level data from 23 countries from Asia and Europe. Our evidence is consistent with the predictions. Changes in group firm dividends are positively associated with changes in both contemporaneous and subsequent equity-financed investments in other member firms. The association is stronger for smaller and more profitable investments and in firms located in countries with strong legal regimes. Aggregate dividends paid by group firms in a year finance upto 10% of insider equity investment in the next year. Consistent with our model, insider holding in group firms is positively related to dividend distribution from the other member firms.