The Deep-Pocket Effect of Internal Capital Markets

Research on internal capital markets has shown that, within multi-segment firms, investment capacity in one sector can be enhanced by cash generated in other sectors. This suggests that firms that enjoy access to internal capital markets can take actions that are not available to their stand-alone rivals due to financial constraints, which would explain why group firms and conglomerates engage more in corporate innovation. Although conglomerates and business groups are ubiquitous both in advanced and emerging economies, the economic literature on the product market effects of groups is fairly limited. In particular, it is not obvious how internal capital markets operating within groups affect the competitive behaviour of affiliated firms. This analysis sheds light on one of the channels through which groups shape the economic environment, exploring the idea that internal capital markets – by alleviating financial constraints – enhance a firm’s actual and perceived competitive strength. This research does so by investigating whether entry in manufacturing industries is affected by the cash reserves hoarded by incumbent and entrant groups.

Relying on a unique French data set of business groups, this paper shows that entry in manufacturing industries is negatively related to the cash hoarded by incumbent-affiliated groups, and positively related to entrant groups’ cash.  In line with theoretical predictions, we find that the impact on entry of group cash holdings is more important in environments where financial constraints are pronounced and in more financially dependent sectors. The cash holdings of incumbent and entrant groups also affect the survival rate of entrants in the 3 to 5 year post-entry window. Overall, our findings suggest that internal capital markets operate within corporate groups and affect the product market behaviour of affiliated firms by mitigating financial constraints.

The full draft version of this research is available for download below.