The Future of Business Groups in Emerging Markets

The Future of Business Groups in Emerging Markets: Long-Run Evidence from Chile
Author(s): Tarun Khanna and Krishna Palepu

Source: The Academy of Management Journal, Vol. 43, No. 3 (Jun., 2000), pp. 268-285
Published by: Academy of Management
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c Academy of Management Journal

2000, Vol. 43, No. 3, 268-285.
THE FUTURE OF BUSINESS GROUPS IN EMERGING
MARKETS: LONG-RUN EVIDENCE FROM CHI.E

TARUN KHANNA
KRISHNA PALEPU
Harvard University
We demonstrate variation in the extent to which firms benefited from their affili-
ation with Chilean business groups in the 1988-96 period. The net benefits of
unrelated diversification were positive if group diversification exceeded a threshold level, though this threshold increased with time. Sizable group benefits unrelated to diversification also existed, but they atrophied over time. We conjecture
that the evolution of institutional context alters the value-creating potential of
business groups, albeit slowly.
Diversified business groups dominate the economies of most countries. Vigorous academic discourse about this organizational form is ongoing,
with several scholars offering a range of reasons for
the existence of business groups (Amsden & Hikino,
madjiam, 1996). Our conceptual contribution is to
1994).
The central theoretical issue of interest concerns
distinguish between the diversification-related effects emphasized by economists, who have tended
to view business groups as efficient responses to
the existence of transaction costs in an economy
(Caves, 1989; Leff, 1976, 1978), and the non-diversification-related effects of group affiliation that
have primarily been emphasized by sociologists
(Granovetter, 1994; Hamilton, 1996). Further, most
prior studies have analyzed the effects of business
group affiliation at one point in time. Our related
conceptual contribution is an examination of theoretical predictions, from a variety of disciplines,
about the rate of change in the value creation potential of business groups as the ambient institutional context changes. These results speak to the
future of business groups as emerging markets
the effects of the institutional context on the rela-
evolve.
tive values of different organizational forms (North,

1990; Williamson, 1991). Although the literature
Chile offered an ideal setting for our analysis, for

the simple reason that it has experienced extensive
and early changes in its institutional context (especially in the extent of development of its markets).
This variation allowed us to study changes in value
creation by business groups between the late 1980s
and the mid 1990s. We employed cross-sectional
and panel estimation techniques to analyze a
unique and newly assembled data set, parts of
which were obtained and cross-checked through
extensive fieldwork in Santiago, Chile, between
1996 and 1998, and parts of which are publicly
available from regulatory authorities in Chile.
1994; Ghemawat & Khanna, 1998; Granovetter, 1994;
Guillen, 1997; Khanna & Palepu, 1997; Leff, 1976,

1978; Strachan, 1976). Policy makers and business
group owners in China, India, Malaysia, Mexico,

South Africa, and South Korea, to name but a few
countries, are currently debating the future of busi-
ness groups in their national business presses, especially as a wave of deregulation brings about
sweeping changes in the economic landscape (Ghemawat, Kennedy, & Khanna, 1998; Sachs & Warner,
on groups in several countries is rich in historical

and descriptive detail, performance effects have
been speculated about but analyzed much less often (Caves & Uekusa, 1976; Chang & Choi, 1988;
Khanna & Palepu, 2000a; Lincoln, Gerlach & AhWe gratefully acknowledge assistance in our research
and data collection from Universidad Adolfo Ibanez, in
particular from Professor Carlos Caceres. We are grateful

to Ranjay Gulati, Robert Hoskisson, Jan Rivkin, Andrei
Shleifer, Brian Silverman, and three anonymous referees
for helpful comments and to James Schorr and Catherine
Conneely for research assistance. We acknowledge discussions with seminar participants at INSEAD, at the
William Davidson Institute at the University of Michigan, at the 1988 Academy of Management meeting, and at
the 1998 NBER Corporate Finance meetings. The
THEORY AND HYPOTHESES
Theoretical Antecedents
The existing work on business groups in emerging markets falls broadly into three streams. In one
line of work, groups are conceptualized as reprovided financial support. All errors remain our own.
Division of Research at the Harvard Business School
268
2000
Khanna and Palepu
sponses to market imperfections. This line of work

was pioneered by Leff (1976, 1978), whose writings
emphasize transaction costs primarily in capital
269
institutional context changes, whereas existing

work primarily focuses on business groups at one
point in time (though Lincoln and colleagues
markets and, to a lesser extent, in the market for
[1996] used time series data). We derived and ex-
entrepreneurial talent. Subsequent uses of this organizing framework include Caves and Uekusa's
(1976) early work on Japanese keiretsus and Chang
and Choi's (1988) work on Korean chaebols. This
stream's emphasis on capital market imperfections
has perhaps been accentuated by studies of Japan's
"main bank" system (Aoki, 1990; Berglof & Perotti,
1994; Weinstein & Yafeh, 1998), which emphasize
the preferential access to capital enjoyed by keir-
amined predictions regarding the underlying drivers of changes in performance effects. The effects of
contextual change, though of central concern to
policy makers and entrepreneurs, are entirely unexamined in the business group literature.
etsu affiliates. In other recent research (Khanna &
Palepu, 1997, 2000a), we have argued that there is

no a priori theoretical reason to focus on capital
market imperfections in searching for a reason for
the existence of business groups; groups might also
alleviate failures in product markets, labor markets,
and in cross-border markets for technology.
A second important stream of work, emerging
from sociology (Granovetter, 1994), emphasizes
solidarity norms and codes of behavior in business
groups. This rich body of research consists largely
of descriptive work from a range of different countries, though there is also large-sample statistical
work set in China (Keister, 1998) and Japan
(Gerlach, 1992; Lincoln et al., 1996). In both the
transaction costs and sociological streams of work,
groups are seen as value-enhancing organizational
forms. In contrast, the third important stream,
grounded in political economy, emphasizes a view
of groups as socially counterproductive rent seekers, in which groups are primarily devices through
which rents in an economy accrue disproportionately to the handful of families that control major
groups, to the detriment of the majority of the population (Ghemawat & Khanna, 1998). Much of the
work in this tradition is descriptive, detailing the
patterns of relationships between groups and political power structures (Encarnation, 1989; Gill,
Institutional Voids Framework: Hypotheses on
Value Creation by Business Groups

Several prominent economists and sociologists
have emphasized that institutions affect economic
outcomes (Aoki, 1990; Granovetter, 1984; North,
1990; Williamson, 1985). Economists have tended
to view institutional contexts primarily in terms of

the extent to which they are characterized by the
presence of specialized intermediaries (Spulber,
1996). Efficient intermediation resolves information and contracting problems and thus reduces the
costs of transacting in product (Akerlof, 1970), labor (Spence, 1973), and capital markets (Diamond,
1984). Transaction cost theories (Coase, 1937;
Teece, 1980, 1982; Williamson, 1975, 1985) suggest

that the optimal scope of a firm is a function of
ambient transaction costs and, hence, of the extent
of specialized intermediation.
In the U.S. institutional context, which is char-
acterized by efficient intermediation, it is less

likely that an entrepreneur will benefit by being
associated with a corporate entity that is diversified
across unrelated industries than is the case for an
entrepreneur with such an association in an economy with more severe imperfections. Hence, the
costs of unrelated business diversification are
likely to exceed any potential benefits. Several re

cent reviews of the literature (Hoskisson & Hitt,
1990; Montgomery, 1994; Ramanujan & Varadarajan, 1989), although providing evidence of some of
the benefits of diversification across related indus-
1999; Schwartz, 1992).
Our current article is an attempt to overcome two

important concerns in the literature. Most existing
studies have eschewed a multidisciplinary approach. Thus, the issue of the extent to which
groups might play multiple roles has been left
largely unaddressed. One conceptual contribution
of this study is derivation and empirical examination of different kinds of performance effects associated with business group affiliation. We argue
that a richer conceptualization of business groups
than that suggested by the dominant transaction
cost paradigm is perhaps in order.
Second, we are interested in changes in the per-
tries (Rumelt, 1974), support this assessment of the

costs of unrelated diversification.
In emerging markets, in contrast, there are a variety of market failures. For example, financial markets are characterized by a lack of adequate disclosure and weak corporate governance and control.
Intermediaries such as financial analysts, mutual
funds, investment bankers, venture capitalists, and
a financial press are either absent or not fully
evolved. Securities regulations are generally weak,
and their enforcement is erratic. The resultant
transaction costs imply that an enterprise can oft

be more profitably pursued as part of a large diver
formance effects of business group affiliation
sified
as business group that can act as an intermedi-
270
ary between individual entrepreneurs and imperfect markets. Such groups may use their broad
scope to smooth out income flows and thereby
June
flows, such benefits are likely to increase with the

extent of unrelated diversification. Similarly, the
benefits of running an internal managerial labor
ensure access to internal finance in an environment
market increase with the extent of unrelated diver-
in which external finance is even more costly than

it is in advanced economies. A similar paucity of
sification. It follows that only groups that exceed

threshold group diversification levels will under-
intermediaries leads to institutional voids in labor
take such investments.
and product markets. We have argued (Khanna &

Palepu, 1997) that groups can fill some subset of
institutional voids in imperfect markets.
Indeed, the descriptive literature on groups in several countries emphasizes a panoply of benefits that
arise out of the intermediation functions played by
groups in capital markets (Leff, 1976; Lomnitz &
Perez-Lizaur, 1987; Pan, 1991) and labor markets
(Leff, 1978). The earliest econometric evidence came
from studies of Japanese keiretsus (Caves & Uekusa,
1976; Nakatani, 1984). More recently, Lincoln and
colleagues (1996) described a variety of coordination
mechanisms within Japanese keiretsus and their role
in reducing the variability of returns of affiliates.
Chang and Hong (1999) suggested that value creation
in Korean chaebols might occur primarily through
product and capital market intermediation. Several
studies have demonstrated that business groups in
Chile and India add value through a combination of
product, labor, and capital market intermediation
(Fisman & Khanna, 1998a, 1998b; Khanna & Palepu,
1999, 2000a).
However, the benefits of diversification in emerging markets may not be sufficient to offset the costs.
Oft-studied problems of unrelated diversification

in advanced economies may be exacerbated by conflicts of interest between controlling family shareholders and minority shareholders. Economically
inefficient decisions may persist because of weak
disclosure requirements, ineffective governance
mechanisms, and poorly developed markets for
corporate control (La Porta Lopez-de-Silanes, &
Shleifer, 1999; La Porta, Lopez-de-Silanes, Shleifer,
& Vishny, 1998). Econometric evidence (Khanna &
Palepu, 2000b) suggests that Indian business group
affiliates are more difficult to monitor than other-
wise comparable unaffiliated firms.

Each business group needs to invest in creating
coordinating mechanisms (Gerlach, 1992; Lincoln
et al., 1996) that facilitate the sharing of information and the enforcement of explicit and implicit
intragroup contracts. Recent case studies (Khanna,
1997; Khanna, Palepu, & Wu, 1998) suggest that
such investments are characterized by fixed costs,
implying that there is an economic rationale to
undertake them only once the benefits exceed such
costs. If internal capital markets, for example, are
predicated on having a large enough pool of busi-
nesses across which to collectively smooth cash
Such a threshold effect of diversification can also
be generated by an explanation grounded in political economy, emphasizing a rent-seeking view of

groups (Granovetter, 1994; Olson, 1982). Consistent
with this view, Encarnation (1989) mentioned "in-
dustrial embassies" set up by the largest diversified

groups in India in the capital city, ostensibly for the
purpose of lobbying bureaucrats; White (1974) documented a handful of Pakistani family-run groups
organized around state-sanctioned monopolies;
Amsden (1989) talked about the favors granted
from 1948 through 1960 by Syngman Rhee to a
handful of Korean firms; and Robison (1986) dis-
cussed the "politico-economic" empires that take

advantage of government favors in Indonesia.
Shleifer and Vishny's (1993) formal political economy model of bureaucrats allocating favors in exchange for bribes provides a foundation for understanding an alternative mechanism for generating the
threshold effect discussed above. Favors have multi-
ple purposes, such as circumventing regulatory impediments and preventing appropriation of assets,
and they can be thought of as nontradable assets
(Teece, 1980, 1982). They are also scarce, since favor
dispensers are increasingly likely to be caught the
greater the number of favors they (illegally) dispense,
and would thus trade off this cost of dispensing more

favors against the benefits of allocating them to potential beneficiaries. Extensively diversified groups
have greater opportunities to use such an asset than
do less diversified groups or undiversified firms.
Therefore, the most diversified groups are likely to
bid high values for such favors, to disproportionately
be the recipients of such favors, and to show performance benefits relative to other firms as a result;
taken together, these factors yield a threshold effect.
Thus, both the rent-seeking view of groups and a
focus on the economics of groups providing intermediation functions to compensate for inefficient markets lead to the following hypothesis:
Hypothesis 1. The net performance effects of
affiliation with a diversified business group

will be curvilinear. Firm performance will decline with increases in unrelated group diversification until group diversification reaches a
threshold. Beyond this threshold, marginal increases in group diversification will yield marginal increases in firm performance.
Khanna and Palepu
2000
Several arguments point to a non-diversificationrelated role for groups as well. Goals like institutional legitimacy, political power, and social
fitness (DiMaggio & Powell, 1983) may be as important for business groups as economic considerations. Certainly, the family, or kinship group, is a
common mechanism through which social relationships are institutionalized (Dutta, 1997). Zeitlin's study of Chilean corporations in the 1960s
alludes to a "complex kinship unit in which economic interests and kinship bonds are inextricably
intertwined (1984: 109). To the extent that business
groups coexist with numerous such social relationships, behavior within the groups may be governed
by norms that have little to do with economic costs
and benefits. Indeed, Granovetter (1994) raised the
possibility of the existence of a "principle of solidarity," which may originate in family, kinship, or
ethnic ties among a group's members. Pointing to

evidence provided by Strachan's (1976) work in
Nicaragua, he suggested that groups might create a
"moral community" within which there is less likelihood of opportunistic behavior than would be
predicted by economic considerations. This phenomenon should positively affect the performance
of group affiliates.
Of course, it is also possible to view the role of
the family or kinship group through an economist's
lens. The family can be conceptualized as a mechanism through which intragroup transaction costs
are lowered, by encouraging information dissemination among group firms, reducing the possibility
of contractual disputes, and providing a low-cost

mechanism for dispute resolution. This is not an
unfamiliar argument to students of nonmarket,
nonhierarchical forms of organization such as clans
(Ouchi, 1980), fiefs (Boisot & Child, 1988), and
bazaar economies (Geertz, 1963, 1973). Family relationships might also help in resolving contracting
problems, in much the same way emphasized by

Dore's (1983) study of the role of relational con-
271
erates, like business groups, ought not to survive,

though he offers the anecdotal observation that
groups appear to possess much staying power. The
broader theoretical question concerns changes in

the efficiency of an organizational form as the ambient context changes. Our inquiry is predicated on
a systematic understanding of changes in the institutional context in our subject country, Chile,
which we turn to first in this subsection, and on a
subsequent examination of associated changes in

the performance effects of group affiliation.
Chile has steadily opened up to global competition, deregulated domestic markets, and reduced
the role of the state (Bosworth, Dornbusch, & La-
ban, 1994; Cortazar, 1997). The Appendix provides

details for our sample period, 1988-96. The first
stage of Chile's policy changes began with Pinochet's takeover from Allende's socialist regime
in 1973 and was characterized by rapid and drastic
reform. Massive privatization of state-owned firms
(including firms appropriated by the state during
the Allende years) was coupled with removal of
entry barriers in product markets for domestic and
foreign firms and by the imposition of severe restrictions on labor unions. However, the extensive
retreat of the state in the absence of an appropriate
regulatory framework, coupled with unfavorable
macroeconomic circumstances, precipitated a currency and debt crisis in 1981. Consequently,
1981-83 was a period of renationalization, takeover by the state of several firms, and reversal of
some of the earlier deregulation.
A second wave of reforms commenced in 1985,
with extensive privatization, not only of the recently taken-over firms, but also of so-called core
sector state-owned enterprises. Even social services
were privatized, with social security privatization
being the most salient change. New capital market
regulations strengthened the financial markets.
There were also attempts to encourage exports and
to provide better access to foreign technology and
tracts in Confucian economies. These ideas lead to
capital.
our second hypothesis:
The third phase, triggered by the introduction of

democracy in 1990, restored the role of unions in
Hypothesis 2. After group diversification is
controlled for, group affiliation will be associated with positive firm performance effects.
Changes in the Institutional Context in Chile
labor markets and further developed product and

capital markets. Financial markets experienced especially explosive growth. The year 1990 marked
the first issue of an American depository receipt
(ADR; this is a security that allows companies to
access U.S. exchanges) by a Chilean company,
The staying power of business groups has been Compafila de Telefonos de Chile, and the resultant
the subject of much policy debate but of virtually arrival in Chile of financial analysts, who are crit-
no academic inquiry. Granovetter's (1994) readingical information intermediaries in financial marof Chandler's (1982) thesis on the importance of kets. Though information in financial markets has
formal multidivisional systems is that coalitions of greatly improved, Chilean managers aver that, eight
firms that are looser than multidivisional conglom-years after the beginning of the development of
272
domestic intermediation expertise, domestic analysts are still not as skilled as their counterparts
June
from advanced economies (Fisman & Khanna,

1998b; Khanna & Wu, 1998).
Table 1 shows data on 13 contextual variables for
probably facilitated information flows in all markets. Throughout this time period, there is little
evidence of corruption or of rent-seeking behavior
of the sort that is often associated with emerging
markets (Bardhan, 1997; Bhagwati, 1982; Krueger,
which we could construct time series for the
1974).
1988-96 period. These are categorized into capital

market variables, labor market variables, and other
Hypotheses on Changes in Value-Creating

Intermediation by Business Groups
variables. For each variable, we report the values at

the beginning and end of the time series as well as
the estimate (and p-value) of the time coefficient
derived from a regression of each variable on a time

trend. The time trend is statistically significant (at
the 10 percent level or higher) for 10 of the 13
We now consider, sequentially, the implications

of theoretical arguments from economics, political
economy, and sociology for changes in the extent
and type of value creation as a function of changes
variables. Further, the 13 variables are themselves
in institutional contexts.
generally very highly correlated. Thus, a time trend

serves as a reliable proxy for several changes in this
There were several reasons why the development

of intermediaries in capital, labor, and product
markets tended to lag behind primary market deregulation in Chile (Palepu & Khanna, 1998). First,
Chile's policy changes focused on deregulation of
primary markets, but restrictions on the operation
institutional context.
It is worth summarizing the changes in Chile

during 1988-96. Financial markets experienced
significant growth and came to be permeated with
stand-alone specialized intermediaries. Specialized intermediaries were less ubiquitous in product
and labor markets. The post-1990 democratic era
of markets for intermediaries continued to exist.
Second, such intermediaries as did come into exis-
tence could not instantaneously develop the com-
TABLE 1
Changes in Contextual Variables

Coefficient
on Time
Context
Capital
Variable
Data
Source
1988
1996
Trend
marketa
Number of ADRs Standard & Poor's, COMPUSTAT 0 16.00 2.38 0.00
Number of companies covered by analysts Institutional Brokers Estimate System 0 112.00 1.30 0.55
(I/B/E/S)
Number of one-year EPS forecasts made Institutional Brokers Estimate System 0 423.00 74.10 0.02
Market capitalization/GDP International Finance Corporation (IFC) 0 1.98 0.28 0.00
Emerging Stock Markets Fact Book
Capitalization ratio IFC Emerging Stock Markets Fact Book 0 3.21 0.36 0.00
Value of share volume traded/GDP Datastream 0 0.01 0.00 0.13
Labor marketb
Education enrollment ratio, tertiary level UNESCO Statistical Handbook 0 30.30 1.45 0.00
Education enrollment ratio, primary or UNESCO Statistical Handbook 0 93.00 -0.18 0.50
secondary level
Other
Number of privatizations Securities Data Corporation 0 6.00 0.67 0.04
Value of pension fundsc Superintendencia de Administradoras 0 11.72 3.54 X 10-9 0.00

de Fondos de Pensiones de Chile
Country risk Political Risk Services (PRS) 0 79.50 2.31 0.00

International Country Risk Guide
18-month forecast of regime stabilityd PRS International Country Risk Guide 0.75 0.85 0.04 0.01
Number of terrorist incidents Pinkerton Risk Assessment Services 40 0 -23.04 0.00
a ADRs are American depository receipts. EPS is earnings per share. GDP is gr
as (domestic credit + market capitalization)IGDP at constant prices.
b The primary level refers to elementary and primary schools; the secondary
or technical schools, and teacher training schools; and the tertiary level, to
completion of secondary education. The enrollment ratio is calculated as gro
c In trillions of pesos.
d Data were available for a subset of years.
2000
273
Khanna and Palepu
petencies required to perform their intermediation

function. There was thus a monitoring vacuum
similar to those created in China (Qian, 1995), India
(Khanna & Palepu, 2000b), and Russia (Frydman,
Phelps, Rapaczynski, & Shleifer, 1993) by the withdrawal of the state from the business of monitoring
its firms and by the failure of newly emergent or
existing commercial banks to adequately perform

such a function. Third, institutions developed
slowly because of their interrelationships with
other institutions (Aoki, 1994; Aoki & Kim, 1995).
Political economy considerations, especially the
advent of democracy, as occurred in Chile in 1990,
generally buttress the likelihood of information
flowing more freely and of intermediaries gradually
emerging in an economy. Thus, economic arguments lead us to expect Chile to be characterized by
a gradual emergence of intermediaries and a grad-
d'etre of the groups. We were thus led to advance

the following hypotheses:
Hypothesis 3. The threshold above which marginal increases in unrelated group diversification result in marginal increases in firm performance will rise as market institutions evolve
over time.
Hypothesis 4. After group diversification is

controlled for, the performance effects of group
membership will decrease as market institutions evolve over time.
METHODS
Sample
Our sample has 34 group affiliates, firms that a

members of ten groups, and 80 unaffiliated firm
fore, we expect that it becomes progressively more for a total of 114 firms each with nine years of d
difficult for groups to create value through runningAccounting data (balance sheet and income stateinternal (labor and capital) markets across their
ment data) for all publicly traded companies were
diverse affiliates. Stated equivalently, there is a rise
obtained from the Superintendencia de Valores y
in the threshold level of group diversification
Seguros (SVS) in Santiago, Chile. Stock market
above which groups have an incentive to invest in
data, used only in our robustness checks, were
creating internal intermediation systems. Further,
obtained from Datastream International. Finally,
we expect that as information flows progressively
the data on group affiliation, which are the most
more freely in an economy, and as contracts are
difficult to uncover, were obtained from a departenforced progressively more efficiently, it also bement within the SVS, after multiple visits revealed
their existence.
comes more difficult for groups to generate nondiversification-related benefits relative to the shiftMuch effort was expended in merging the three
ing contextual benchmark.
data sources, especially in cases in which slightly
In contrast to these economic arguments, some
different company names were used in the different
sociological arguments, such as those for the posidata sources; we had to rely on conversations with
the collectors of the data and on miscellaneous
tive performance effects of a moral community
(Granovetter, 1994) within groups, appear much
knowledgeable observers in Chile to match the
names in some instances. Since firms that own
more uniformly applicable over the entire time period in question here. Stated simply, it is difficult
more than 50 percent of another firm are requir
to imagine deep-seated sociological changes over
to report both individual and consolidated finanthe mere nine-year time span in consideration here.
cial statements, we had to make some adjustments
Therefore, to understand the performance implito avoid double-counting in the process of combincations of all these theories across our distribution
ing some firm-level data into group-level aggreof firms, it appears reasonable to start with the
gates, which were used in our robustness checks.
premise that the various economic and sociological
We also obtained data from a variety of sources to
arguments apply to differing extents to each of the
help us characterize changes in the institutional
context (Table 1).
groups in our data. Since the economic arguments
predict changes in performance effects and the soBusiness group affiliation is tracked by regulaciological arguments do not, we should expect to
tory authorities in Santiago because the economic
see milder support for the predictions grounded in
crisis in the early 1980s in Chile was believed to
the economic theories than we would expect if
have been partly caused by banks' indiscriminate
groups were driven entirely by economic considerlending to companies with which they were closely
affiliated. Thus, unlike Central American business
ations. Support for the economic theories would be
stronger the greater the role of economic considergroups (Strachan, 1976) and small Japanese groups
ations in groups. Support for the predictions of the (Goto, 1982), Chilean business groups have a forual reduction in ambient transaction costs. There-
economic theories would be lacking if sociological
mal definition: "[A business] group is a set of com-
considerations constituted the primary raison
panies which present such a sort of relationship
274
and linkages in their property, management, administration, or credit responsibilities, that there is
ground to believe that the economic and financial
decisions of those companies are guided by or subordinated to the shared interest of the group, or that
there are common financial risks in the credits ob-
June
Second, a lot of variation in performance would

have been lost if we had aggregated firm measures
into group measures. Indeed, industry-adjusted

performance varied substantially among the mem-
bers of groups. Third, using group-level performance measures rests on the assumption that the
tained or in the financial instruments used" (Artiextent of social and economic interlocks among
cle 96, Title XV, Law 18045, Mercado de Valores;
affiliates is similar for all groups, when this might
not be the case. Instead, we used an estimation
cited and translated by Majluf, Abarca, Rodriquez,
and Fuentes [1995: 2]). We checked these data
approach that let us control for group-level unobservables.
against independent sources (often in Spanish) and
by showing random samples to knowledgeable ob- Independent variables. The SVS assigns indusservers in Chile (including academics, regulators,try designations to each firm following the Internaand managers). Our sample consists of firms for
tional Standard Industrial Classification (ISIC) syswhich we had a nine-year data series and for which
tem developed by the United Nations. The vast
group affiliation was stable over the nine years. We
majority of firms have a primary two-digit ISIC
concentrated on this sample, though we considered
code and very little activity in other two-digit ISIC
broader samples in our robustness checks.
codes. The simplest group diversification measure
is a count of the number of industries in which a
group is involved (note that this is not synonymous
Analysis
with the number of firms in the group, because
We tested Hypotheses 1 and 2 using multivariate

regression techniques modeling firm performance
as a function of firm size, group membership, group
diversification (including a quadratic term), group
size, and industry fixed effects. The regression was
estimated for every year in the sample. We also
carried out panel estimations using the entire sample. Since our hypotheses suggest that the effects
related to group diversification might offset the
non-diversification-related effects (with group diversification being costly for groups below some
threshold level of diversification, and non-diversification-related effects being positive), we were
careful to include variables to capture both effects.
The high correlation between group size and group
diversification suggests that not including group

size would have led to spurious inferences attributed to group diversification.
We tested Hypotheses 3 and 4 by examining the
variation over time of the estimated coefficients on
the group diversification and the group dummy

variables in the year-by-year regressions and by
inserting time trends in the panel regressions.
Dependent variables. We used firm return on
assets (ROA) as our measure of performance, defining ROA as follows: [net income + interest X (1 tax rate)]/[total assets], where an average tax rate is
estimated for each firm (Berger & Ofek, 1995; Caves
& Uekusa, 1976; Khanna & Palepu, 2000a). We preferred this to a measure of group performance for
several reasons. First, each firm was a legally separate and publicly traded entity that published its
own statements and was responsible to its own
shareholders, like the members of Japanese keiretsus (Kim & Hoskisson, 1996; Lincoln et al., 1996).
there are often multiple firms within a group in the

same ISIC category). We included in this calculation the industries of all group members, including
those that were not in our sample, on the grounds
that this inclusion provided a more complete picture of the total unrelated diversification of a group.
The results we report are all based on this simplest
measure. For U.S. data, some studies indicate that
product count measures of diversification are as

good as others that require more detailed data (Lubatkin, Merchant, & Srinivasan, 1993), and others
suggest that the latter are superior (Chatterjee &
Blocher, 1992; Hoskisson, Hitt, Johnson, & Moesel,
1993). In our case, poor quality of the sales and
assets data outside our sample precluded the accurate construction of group Herfindahl or entropy
indexes. We measured group size as the number of
companies in a group (including those group members that were not in our sample because they did
not meet our sampling criteria). Industry fixed effects were specified using the primary ISIC categorization.
Regression specification. Following Moulton

(1990), we noted that observations sharing an observable characteristic like group membership may
also share unobservable characteristics that may
cause the error terms to be correlated. Such correlation would cause understatement of the standard
errors obtained using ordinary least squares (OLS)

analysis, leading to potentially spurious claims of
statistical significance, with the problem being
more acute the greater the extent of within-group
unobservable correlations (Moulton, 1986). Accordingly, we used an estimation approach in
which it is assumed that observations are indepen-
Khanna and Palepu
2000
275
group diversification rows in Table 2 display the
dent across groups but may not be independent

within groups. Additionally, the standard errors
reported are also heteroscedasticy-consistent White
total number of two-digit ISIC-equivalent indus-
tries in which a firm was present for unaffiliated

firms, and for group affiliates they show the total
number of industries in which the group was
present (aggregated across all group affiliates). Note
that the increase in mean group diversification be-
standard errors.
By restricting our regression results to those

firms that had not experienced changes in group
affiliation, we avoided possible endogeneity problems regarding group membership that might have
tween 1988 and 1996 is based on all firms known to
arisen if we had also considered firms that
be members of a group at each point in time and not

only on the firms in our sample. The Pearson
switched groups or that switched between the

group and nongroup categories (Hoshi, Kashyap, &
correlation coefficients for the main variables
Scharfstein, 1991). Our focus on firms for which we
(Table 2) suggested that multivariate techniques
had reliable accounting data for all nine years ensured that changes in the effects of group affiliation
that we identified over our sample period were not
driven by changes in the sample of firms that we
were needed to sort through the effects of different

group attributes.
used.
Regression Analysis Results
We sequentially present results for a year-by-year
regression analysis, a panel regression analysis,
RESULTS
and robustness checks.
Descriptive Statistics
Year-by-year regressions. The results (Table 3)
Table 2 reports means and standard deviations

for group affiliates and unaffiliated firms for both
1988 and 1996. In 1988, the mean ROA for group
showed curvilinear dependence of ROA on group

diversification in every year. The effects are always
statistically significant at conventional levels (except in 1990, when only the quadratic term is thus
significant). Consistent with Hypothesis 1, the benefits of greater diversification do not kick in until
after a threshold group diversification level is exceeded. Group size has a positive regression estimate in seven of the nine years, though it is never
significant at conventional levels.
The table displays two values inferred from the
magnitudes of the regression estimates on the
affiliates was significantly higher (p < .01, two-
tailed t-test) than the mean ROA for unaffiliated

firms. This is also true in 1996, though the magnitude of the difference is considerably less than in
1988. In each year, the group affiliates were significantly larger than the unaffiliated firms. The group
size rows in Table 2 display the total number of
companies in the group in question for group affiliates, and it is set to 1 for unaffiliated firms. The
TABLE 2
Descriptive Statistics and Pearson Correlation Coefficients for 1988 and 1996a
Group Affiliates Nonaffiliates
Variable
Mean
s.d.
Mean
s.d.
1988
1.
ROAb
2.
SalesC
3.
Group
4.
15.05
9.53
15.21
2.06
4.68
membership
Group
size
16.70
11.76
9.26
4.15
4.78
0
1
0
0
.44
.31
.23
.41
.36
.85
5. Group diversification 6.53 3.79 1.20 0.52 .20 .34 .76 .96
1996
1.
ROAb
8.11
9.17
3.31
9.35
2. Salesc 16.78 2.22 12.93 4.64 .32

3. Group membership 1 0 0 0 .23 .41
4. Group size 13.26 8.08 1 0 .20 .32 .81
5. Group diversification 8.35 4.98 1.19 0.53 .17 .30 .77 .94
a N = 114 (n = 34 for group affiliates, n = 80 for nonaffiliates).
than .30 are significant at p < .01.

b Expressed as a percentage.
c Logarithm.
276
June
TABLE 3
Results of Year-by-Year Regression Analysis with ROA as the Dependent Variablea

Variable 1988 1989 1990 1991 1992 1993 1994 1995 1996
Salesb 0.010** 0.012* 0.009*** 0.013*** 0.014*** 0.015*** 0.014*** 0.008** 0.009***
(3.093) (2.320) (3.387) (3.294) (4.727) (5.459) (4.616) (3.055) (3.386)
Group membership 0.138* 0.084 0.088* 0.141* 0.131t 0.077 0.039 0.082t 0.041
(2.082) (1.446) (2.201) (2.221) (1.647) (1.599) (0.789) (1.755) (1.032)
Group size -0.010 0.001 -0.006 0.007 0.014 0.005 0.018 0.005 0.004
(-0.874) (0.155) (-0.692) (0.645) (1.228) (0.653) (1.319) (0.531) (1.344)

Group diversification -0.034t -0.055*** -0.023 -0.087* -0.093** -0.057* -0.065t -0.035* -0.034*
(-1.775) (-3.481) (-1.232) (-2.551) (-2.605) (-2.314) (-1.829) (-2.108) (-2.614)
Group diversification 0.003** 0.004*** 0.002* 0.005** 0.005** 0.003** 0.003* 0.002* 0.002***
squared (2.965) (4.139) (2.542) (3.080) (2.948) (3.014) (2.070) (2.529) (3.401)
Industry fixed effects Included Included Included Included Included Included Included Included Included
Constant -0.126* -0.055 -0.065t 0.007 -0.023 -0.036 -0.065 -0.060 -0.066
(-2.350) (-0.995) (-1.799) (0.138) (-0.431) (-0.687) (-1.102) (-1.485) (-1.582)

Number
of
114
114
114
114
114
114
114
114
114
observations
F 13.69*** 12.55*** 17.56*** 10.68*** 18.05*** 9.68*** 10.02*** 23.66*** 13.26***
R2 0.275 0.224 0.305 0.390 0.451 0.359 0.291 0.316 0.292

Threshold
above
5.1
6.7
5.7
8.6
9.7
8.6
11.1
8.2
9.4
which group
diversification
ceases to destroy
value
Threshold above 10.2 13.4 11.4 17.1 19.5 17.3 22.1 16.5 18.9
which group
diversification
creates value
a We used year-by-year estimations using least squares estimation techniques with nonzero correlations across the error terms for all
members of a particular group, following Moulton (1986, 1990). Heteroscedasticy-consistent standard errors were used to compute
t-statistics, which are reported in parentheses. The two threshold values were calculated from the regression estimates of the gro
diversification and group diversification squared regressors.
b Logarithm.
tp < .10
* p < .05
** p < .01
***p < .001
linear and quadratic group diversification terms.

1991, 1992, and 1995, consistent with Hypothesis
First, we indicate the level of group diversifica-
2. The estimate varies from a high of 0.14 in 1988

and 1991 to a low of 0.04 in 1994 and 1996. Group
affiliation's non-diversification-related 14-percentcreases in firm ROA. Second, we indicate the
age-point ROA increment in 1988 seems nontrivial
level of group diversification above which the net
compared to the 1988 mean sample ROA of 7.78
performance effects of group diversification (as
percent.
compared to a benchmark of no affiliation with a
The 1988 net effect of group affiliation is the sum of
the diversification-related effect evaluated at the
group) are positive. For example, in 1988, we find
that these two threshold group diversification
mean group diversification level (6.53 industries),
levels are 5.1 industries and 10.2 industries, reand the coefficient on the group membership
spectively. Thus, 60 percent of our sample of
dummy, or 5.91 percentage points, against a 1988
group affiliates were members of groups whose
sample average ROA of 7.78 percent. Affiliates of the
diversification levels exceeded 5 industries, and
most diversified group in 1988 (11 industries) have
10 percent were members of groups whose diveran extremely large overall net effect of 16.75 percentsification levels exceeded 10 industries.
age points. Similar calculations show that the net
We also find that the regression estimate on the
effect of group membership, evaluated at the average
group membership dummy variable is always pos-group diversification level for the year, is positive for
itive and is statistically significant in 1988, 1990, the first half of the years in our sample.
tion above which marginal increases in group

diversification are correlated with marginal in-
Khanna and Palepu
2000
Figure 1 shows a rise over time of the threshold

above which marginal increases in diversification
are correlated with marginal increases in firm ROA.
The figure plots the actual threshold and a predicted threshold. (The latter, based on a simple
model in which the threshold is regressed as a
function of year, has a multiple squared correlation
[R2] of .58, with the year variable significant at the
.01 level.) These thresholds, which support Hypothesis 3, suggest that the net diversificationrelated benefits of group affiliation become more
difficult to attain as time passes. Until and through
1994, there are groups in our sample whose diver-
277
(Hypothesis 2), are both in evidence, with the effects significant at the 1 percent level. These results
remain in model 2, in which the group dummy is
interacted with a time trend. The non-diversifica-
tion-related group effect declines at approximately

0.5 percentage points per year, consistent with Hypothesis 4. Interacting the other group variables
with a time trend does not show a significant trend,
inconsistent with Hypothesis 3.
We also estimated several similar panel regression
specifications in which we replaced the time trend by
an appropriate time series of each of the contextual
variables listed in Table 1, and in which we included
sification levels exceed the first threshold. How-
a group dummy interacted with the contextual variever, starting in 1991, there are no groups whose able in question. This procedure allowed us to partially identify which of the contextual change varidiversification values are high enough that their
affiliates earn net diversification-related ROA benables were driving our support for Hypothesis 4.
Estimations based on the following 4 measures (of the
efits. Figure 2 suggests that the regression estimate
of the group dummy variable declines with time. 13 in Table 1), reported as models 3 through 6 in
Table 4, show statistically significant effects: tertiary
The predicted group effect (based on a model in
education enrollment level, value of pension funds,
which the actual group effect is regressed on the
country
risk, and probability of regime stability. The
year variable, with an R2 of .36 and the year varidiversification-related curvilinear group effects alable significant at the .05 level) has a negative
ways remain strongly in evidence, with the regression
slope, thus supporting Hypothesis 4.
estimates of the relevant terms not altered much (exPanel regressions. We report the results of a
cept in model 6, which uses the much smaller data
random-effects generalized least squares panel essample for which the relevant variable was available).
timation over the entire nine-year data set in Table
The regression estimate of the non-diversification4. All estimations include controls for industry efrelated group effect is much larger in models 3-6
fects and year effects. A chi-square test revealed the
than in model 1, which uses only a time trend. Fijoint significance (p < .01) for all specifications
nally, we note that the time trend regressions have the
reported in Table 4.
In model 1, the curvilinear dependence of ROA
best overall chi-square values, suggesting that a proxy
for an ensemble of changes fits the data better than
on group diversification (Hypothesis 1), and the
changes along any individual contextual dimension.
positive non-diversification-related group effect
FIGURE 1
Threshold above Which Group Diversification Creates Value

12 -
10 -
8-
Actual and Predicted -
Group Diversification 6 -Thresholds
1988
1990
1992
1994
1996
Year
|---- Actual Threshold ----- Predicted Threshold
278
June
FIGURE 2
Non-Diversification-Related Group Effect

0.16-
Actual and
Predicted
Group Effect
1988 1989 1990 1991 1992 1993 1994 1995 1996
Year
- Actual Group Effect ----- Predicted Group Effect
which we had less than nine years of data, and

including those that shifted group affiliation, did
not change the results.
authors. First, our results held for a battery of alternative specifications using different functional
forms for group size and group diversification, including group fixed effects and a control for firm
DISCUSSION
age, and using alternative measures of group size.
Hypothesis 1 is robustly supported by both
Second, we investigated alternative performance
specific
and panel estimation techniques. The c
measures, since ROA has important limitations, invilinear relationship between firm performance
cluding susceptibility to business cycle effects and
and (unrelated) group diversification in Chile, and
no consideration of differences in systematic risk
the fact that affiliates of the most extensively unreand temporary disequilibrium effects (Benston,
lated diversified groups outperformed focused un1985). We considered Tobin's q, defined as follows:
affiliated firms in the early years of our sample,
(market value of equity + book value of preferred
stand in contrast to results on the performancestock + book value of debt)/(book value of assets).
diversification relationship in the United States
Though this performance measure's forward-look(Berger & Ofek, 1995; Lang & Stulz, 1994). The
ing nature, and the fact that the accuracy with
simple view that unrelated diversification is alwhich it capitalizes future costs and benefits
ways costly thus finds no support in our data. The
changes as Chilean capital markets develop, made
relationship we identify is also different from that
it less appropriate as a measure of performance
in Japan, where one sees risk reduction as the prieffects at one point in time, our results continued to
mary benefit of keiretsu affiliation, rather than the
hold. Our results also held using an industryenhancement of returns (Caves & Uekusa, 1976;
adjusted group ROA performance measure (the
Lincoln et al., 1996; Nakatani, 1984). We have arweighted average of the ROAs of group affiliates
gued (Khanna & Palepu, 1997) that groups may
minus the corresponding weighted average of a
compensate for a variety of missing institutions in
measure of industry ROAs). Third, we investigated
an environment, so that such benefits of group afthe issue of sample selection bias in several ways.
filiation as do exist may manifest themselves in
Our results are not driven by outliers (Belsley, Kuh,
quite different ways in different contexts and at
& Welsch, 1980). Limiting ourselves to only group
different times. The institutional voids filled by
firms continued to show the curvilinear depenJapanese keiretsus appear quite different from
dence of firm performance on group diversificathose filled by the most diversified Chilean and
Indian groups (Khanna & Palepu, 2000a) and by the
tion. Expanding our sample to include firms for
Robustness of the basic results. Details of a se-
ries of robustness checks are available from the
Khanna and Palepu
2000
279
TABLE 4
Results of Panel Estimationa

Model 1, Model 2, Model 3, Model 4, Model 5, Model 6,
ROA
ROA
ROA
ROA
ROA
ROA
Dependent Variable 1988-96 1988-96 1988-96 1988-96 1988-96 1990-94

Salesb
0.011***
0.011***
(6.206)
Group membership
0.061**
(2.618)
Group membership x year
(6.315)
0.010***
0.011***
(5.936)
(6.320)
10.625*
0.158**
0.071**
(2.045)
(3.112)
(2.912)
0.011***
(6.408)
0.013***
(5.489)
0.212**
(2.633)
0.187**
(2.713)
-0.005*
(-2.033)
Education enrollment ratio,
tertiary level
-0.003**
(-2.609)
Group membership x education
-0.004**
enrollment ratio, tertiary level
(-2.053)
Value of pension funds
-1.6 x 10-6***
(
Group membership x value of
-4.193)
-1.2 X 10-6t
pension funds
( -1.635)
Country risk
-0.002***
(-3.968)
Group membership x country risk
-0.002*
(-1.978)
18-month forecast of regime stability
-0.157*
(-2.518)
Group membership X 18-month
-0.328**
forecast of regime stability

Group size
Group diversification
(-2.669)
-0.000
0.001
0.001
0.001
(-0.003)
(0.381)
(0.189)
(0.441)
-0.025**
(-2.828)
Group diversification squared

Industry dummy variables
Year dummy variables
Constant
Number of observations
Chi-square
0.002**
-0.028**
(-3.157)
0.002***
(3.294)
-0.027**
(-2.976)
0.002**
-0.027**
(-3.087)
0.002**
0.001
(0.274)
-0.026**
(-2.979)
0.002**
0.007
(0.270)
-0.045**
(-2.870)
0.003**
(2.966)
Included
Included
Included
Included
Included
Included
Included
Included
Included
Included
Included
Included
-0.064'
-0.622*
(-1.863)
(-1.801)
1,026
123.13***
1,026
127.10***
(3.090)
-0.014
(-0.341)
1,026
96.30***
(-3.130)
-0.057*
(-1.721)
1,026
109.31***
(3.110)
0.083
(1.616)
1,026
109.64***
(3.139)
0.004
(0.063)
456
84.00***
a The table reports the results of a random-effects generalized least squares panel estimation. Heteroscedasticy-co
errors were used to compute the t-statistics reported in parentheses.
b Logarithm.
tp < .10
* p < .05
** p < .01
*** p < .001
most diversified Korean groups (Chang & Choi,

1988).
The curvilinear relationship between firm performance and group diversification is consistent with
the existence of fixed costs of intermediation. It is
also consistent, however, with a model of rentseeking behavior that suggests the most diversified
groups bid the most for bureaucrats' scarce favors,
because these groups have the most opportunities
to use the favors. This latter interpretation, however, appears less likely to hold in a relatively
corruption-free country than in countries like India
or Indonesia (Bardhan, 1998; Fisman, 2000;
Khanna & Palepu, 2000a). The Chilean results sug
gest that groups are probably not purely rent-seek

ing devices.
It is possible that biases were introduced into the
analysis because we used data on publicly traded
280
June
firms only. However, one would have to believe

that these biases vary systematically with group
diversification to explain the robust curvilinear
phenomenon that we found. In fact, one would
have to believe that the biases operate in a different
direction for less diversified groups than they do
for extensively diversified groups.
Hypothesis 2 is also robustly supported by both
the year-specific and panel estimation techniques.
The results are consistent with sociological arguments that suggest that groups may be characterized
by a moral community or a principle of solidarity
(Granovetter, 1994), both facilitating economic per-
ture's primary focus on groups as an efficient response to capital market imperfections may not be
entirely justified.
In contrast to the interpretation of Hypothesis 2,
the results regarding Hypothesis 4 are not supportive of the sociological thesis if one assumes that
factors like a moral community and a principle of
solidarity take rather longer than the nine-year time
span considered here to atrophy. However, much
caution should attend such a tentative conjecture
as this. First, measuring constructs like moral community is fraught with difficulties. Second, sociological and economic arguments may play differenformance. The results are also consistent with these
tially important roles in different groups.
characteristics playing a role in reducing withinAn alternative argument would be that the degroup transaction costs, relative to the ambient
cline in the group effect has to do with a process of
costs of market transactions. There is no evidence
mean reversion, whereby any splitting of a sample
for an alternative theory under which the nondiver-into an initially high-performance subset and an
sification effect could have been negative. Such a
initially low-performance subset ultimately shows
reduced differences between these subsets. When
theory would aver that groups, characterized as
they often are by equity interlocks, are immune to
we consider the overlapping portions of the 1988
disciplinary action from outside monitors and are
performance distributions of group-affiliated and
non-group-affiliated firms, however, we find that
thus more likely to be able to tolerate lower performance. The non-diversification-related group benthe mean returns of this subset of group firms falls
efits could also have been nonexistent, as with
by more than that of the subset of nongroup firms.
Indian business groups (Khanna & Palepu, 2000a).
Under mean reversion, we would have expected
Hypothesis 3, which predicts an increase with
the mean returns of these subsets of group and
nongroup firms to fall to similar extents. A related
time in the threshold above which marginal increases in unrelated group diversification result in
argument says that groups may have been the remarginal firm performance improvements, is supcipients of lucrative privatization contracts early in
ported in the year-by-year estimations but not in
our sample period; if groups proved incompetent at
managing these, the group effect would decline. We
the panel estimations. There is thus weak support
for the idea that, as intermediaries emerge, and as
note that the general success of the privatization
the transaction costs of operating through markets
program is inconsistent with the idea of groups
decline, the net benefits of group affiliation desystematically destroying value through this process.
cline. Thus, the level of group diversification above
which it becomes profitable to be a group member
increases as such intermediaries emerge.
Hypothesis 4, which predicts the decline in the

non-diversification-related group benefits, is supported in both the year-specific and panel estimations. Our panel regressions using specific measures
of contextual change suggest that the development
of markets and the advent of political stability and
democracy, which themselves play important roles
in facilitating the free flow of information and the
development of markets, lead to the reduction in
the group effect. An interpretation is that the development of efficient external markets results in
less need for the internal markets that groups can
create and therefore lowers the performance effects
of group affiliation. Note that the measures of capital market contextual changes (Table 1) are not the
most successful in explaining changes in the per-
Directions for Future Research
The trade-off involved in assembling a largesample data set for our estimations was that we
employed simple measures as proxies for the pros
and cons of group affiliation. In contrast, in previous research (Khanna & Palepu, 1999), we used
detailed, field-collected data to show that large
Chilean groups increased the extent of their intermediation activities over a similar time period, and
they did so in a value-creating way. These contrasting results suggest that there may be some payoff to
developing better measures of what groups do in
order to reveal whether some subset of them con-
tinues to create value.
formance effects of group affiliation (Table 4). This
Data limitations prevent us from fully identifying

which of several possible changes in the Chilean
context were most responsible for the changes in
finding suggests that the transaction cost litera-
the performance effects of group affiliation. Re-
Khanna and Palepu
2000
281
searchers lack a model of how contextual change
one society will yield the same results in another"
interacts with changes in group strategy and structure. In future work, they might seek to exploit both
(1994: 944). Our theory of institutional voids

(Khanna & Palepu, 1997) and the idea that institutional voids may differ across countries can help
variations in the extent to which different indus-
tries are affected by different kinds of institutional provide a unified framework for appreciating crosschanges, and the fact that group membership varies country differences in the role of groups.
over time. Information contained in firms' reWe also demonstrate the existence of group ben-
sponses to surprise events can also be exploited, efits that are unrelated to diversification. These
might have multiple causes. We conjecture that
(stock market) response of group-affiliated and
these might be related to the benefits of having
non-group-affiliated firms to surprise events affectstronger social links among firms that may have
ing the viability of groups' rent seeking in Indotheir origins in family, ethnic, or kinship networks.
much as Fisman (2000) focused on the differential
nesia.
Combining the diversification and non-diversifica-
Finally, we note that our results provide a datation-related effects, we found that an affiliate of the
point in the quest to understand the rate at which average group in our sample benefited from group
group effects might atrophy. We interpret our re-membership in approximately the first half of our
sults as suggesting that there is only weak evidencesample years.
of rapid change in the performance effects of group As context changes, the benefits of group affiliaaffiliation. It should be kept in mind that Chile tion change. There is mild evidence that benefits
underwent a sustained burst of promarket reforms,
from unrelated group diversification become proand a sustained corollary withdrawal of the state, gressively harder to attain as time passes. There is
from the mid 1980s to the end of our sample period.stronger evidence of the decline in the extent of
Chile is unusual in the duration of this sustained
non-diversification-related group benefits. Since
burst of promarket reforms. More polarized societ- the passage of time is correlated with the emeries might find it more difficult to sustain consensus gence of an array of specialized intermediaries, we
about the direction of change (Easterley & Levine,conjecture that such decline in benefits as we ob1997). Further, in more corrupt societies, one mightserved is due to there being a lowering in the costs
easily expect to find more resistance from politi-of transacting through the market. Since the nine
cally entrenched business groups to the kinds of years for which we have data probably constitute
market reform that might cause group advantages to too short a period for significant changes to have
atrophy. These factors suggest that the rate at which occurred in some of the (unmeasured) sociological
group advantages atrophy might be even slower in variables that might underlie these benefits, we
other countries than estimated in the case of Chile.
conjecture that these variables do not account for
This is, however, a conjecture that awaits data col-
the non-diversification-related group benefit. Fi-
lection and systematic analysis.
nally, since the decline is not very sharp, our conclusion is that the mere deregulation of economies
does not automatically lead to immediate reduction
CONCLUSION
in transaction costs. Institutional voids are unlikely
In a longitudinal study of diversified business
to be mandated away. Thus, the wave of deregulagroups in Chile (1988-96), we demonstrated varition currently sweeping through the world's econation over time in the extent to which firms beneomies need not lead to the proximate decline in the
fited from their affiliation with business groups. performance effects of business group affiliation.
We demonstrated a curvilinear relationship be-
tween firm performance and the extent of unrelated

group diversification. In the early years of our data,
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APPENDIX
Major Policy Changes in Chile, 1988-96

This information was obtained from public sources,
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and from field work, especially that reported in Khanna
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Capital Market Changes
Pension funds (Administradoros de Fondos de Pensiones [AFPs]). A nascent pension fund industry develops.
Restriction on AFPs' investments gradually removed, so
that they can invest in domestic equities and then in
international equities and finally in domestic projects
without track records (often risk capital). Privatization of
pension funds and a law enforcing that a certain percentage of monthly earnings be invested in pension funds
ensures that there is capital inflow into the pension fund
industry. This, in turn, fuels the development of financial markets.
Minority shareholder protection legislation. Series of

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Mutual funds. Emergence of mutual fund industry
with funds
Strachan, H. 1976. Family and other business groups
in gradually made available to domestic and
foreign investors.
economic development: The case of Nicaragua.
Removal of foreign exchange regulations. All foreign
New York: Praeger.
exchange operations following general guidelines perTeece, D. 1980. Economies of scope and the scope of the
mitted unless explicitly prohibited.
enterprise. Journal of Economic Behavior and OrADR market accessible. Several companies issued
ganization, 1: 223-247.
American depository receipts (ADRs), opening up access
Teece, D. 1982. Toward an economic theory of the multo international capital markets.
tiproduct firm. Journal of Economic Behavior and
Development of analysts. Local and domestic analysts
Organization, 3: 39-63.
become more prominent following ADR market developSpence, M. 1973. Job market signaling. Quarterly Journal of Economics, 87: 355-374.
ment. Analyst capabilities gradually enhanced.

Weinstein, D., & Yafeh, Y. 1998. On the costs of a bankInternational bond rating. Chile obtains international
centered financial system: Evidence from the changbond rating, thus facilitating access to international caping main bank relations in Japan. Journal of Finance, 53: 635-672.
ital markets.
2000
Khanna and Palepu
Labor Market Changes

Unionization. Enhanced right to unionize amidst tri-
partite agreement between government, business, and

labor. New social contract calls for growth with equity.
Exit barriers. Right of employers to suspend workers
suppressed to some extent.
Product Market Changes
Tariff barriers. Lowered to 11 percent in 1991.

Nontarriff barriers. Banned. Removal of executive discretion in setting nontariff barriers.
Regional integration. Chile builds closer links with
Mercosur countries (including Argentina, Brazil, Paraguay, and Uruguay) and seeks association with the North
American Free Trade Agreement (NAFTA) countries.
285
Tarun Khanna (Ph.D., Harvard University) is an associate professor in the competition and strategy area at the
Harvard Business School. He researches the strategy and
structure of business groups in emerging markets in Asia,
Latin America, and Africa and is interested in under-
standing how the institutional underpinnings of efficient

markets emerge.
Krishna Palepu (Ph.D., Massachusetts Institute of Technology) is the Ross Graham Walker Professor of Business
Administration at the Harvard Business School. His re-
search focuses on analyzing firms' business strategies

and the process used to communicate their effectiveness
to investors. He currently studies capital market development, corporate governance, and business strategies in
emerging markets.
Other Policy Changes

Privatization. Crisis in 1982 resulted in government
takeover of a number of recently privatized entities,
which came to be called the odd sector. These are reprivatized and are followed by privatization of the so-called
core state-owned enterprises (hitherto meant to be left
under state control). Privatization of social services also
occurs extensively during this period.
Central bank. Independent central bank established.
Democracy. Democracy is restored with handover of
power from Pinochet to center-left government of Aylwin
and is reaffirmed when Frei takes over as president in 1994.

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The Future of Business Groups in Emerging Markets: Long-Run Evidence from Chile

Author(s): Tarun Khanna and Krishna Palepu

c Academy of Management Journal

THE FUTURE OF BUSINESS GROUPS IN EMERGING

MARKETS: LONG-RUN EVIDENCE FROM CHI.E

madjiam, 1996). Our conceptual contribution is to

the effects of the institutional context on the rela-

tive values of different organizational forms (North,

Chile offered an ideal setting for our analysis, for

1994; Ghemawat & Khanna, 1998; Granovetter, 1994;

Guillen, 1997; Khanna & Palepu, 1997; Leff, 1976,

group owners in China, India, Malaysia, Mexico,

on groups in several countries is rich in historical

particular from Professor Carlos Caceres. We are grateful

THEORY AND HYPOTHESES

Division of Research at the Harvard Business School

Khanna and Palepu

sponses to market imperfections. This line of work

institutional context changes, whereas existing

markets and, to a lesser extent, in the market for

[1996] used time series data). We derived and ex-

etsu affiliates. In other recent research (Khanna &

Palepu, 1997, 2000a), we have argued that there is

Institutional Voids Framework: Hypotheses on

Value Creation by Business Groups

to view institutional contexts primarily in terms of

Teece, 1980, 1982; Williamson, 1975, 1985) suggest

acterized by efficient intermediation, it is less

likely to exceed any potential benefits. Several re

1999; Schwartz, 1992).

Our current article is an attempt to overcome two

tries (Rumelt, 1974), support this assessment of the

transaction costs imply that an enterprise can oft

Academy of Management Journal

flows, such benefits are likely to increase with the

ensure access to internal finance in an environment

market increase with the extent of unrelated diver-

in which external finance is even more costly than

sification. It follows that only groups that exceed

intermediaries leads to institutional voids in labor

take such investments.

and product markets. We have argued (Khanna &

Oft-studied problems of unrelated diversification

wise comparable unaffiliated firms.

nesses across which to collectively smooth cash

Such a threshold effect of diversification can also

be generated by an explanation grounded in political economy, emphasizing a rent-seeking view of

dustrial embassies" set up by the largest diversified

cussed the "politico-economic" empires that take

and would thus trade off this cost of dispensing more

Hypothesis 1. The net performance effects of

affiliation with a diversified business group

Khanna and Palepu

ethnic ties among a group's members. Pointing to

of contractual disputes, and providing a low-cost

problems, in much the same way emphasized by

erates, like business groups, ought not to survive,

broader theoretical question concerns changes in

subsequent examination of associated changes in

ban, 1994; Cortazar, 1997). The Appendix provides

tracts in Confucian economies. These ideas lead to

our second hypothesis:

The third phase, triggered by the introduction of

Hypothesis 2. After group diversification is