Business Groups in Emerging Markets - Substitutes for Missing Institutions

Abstract: Business groups in emerging markets perform better than unaffiliated firms. We study how business groups can substitute some functions of missing institutions, for example, enforcing contracts. In a two period model, there is no contract enforcement in the first period. The firms within the business group are connected to each other by a vertical production structure, resulting in externalities due to double marginalization, and an internal capital market. Our model derives the sequencing of investments and the credit contract offered by the headquarters that solve the ex post moral hazard problem. Thus, the business group's organizational mode and the financial structure facilitate relational contracting.