Conglomerate Structure in India: Financially Beneficial or Outdated? The Case of the Tata Group

TABLE OF CONTENTS

ABSTRACT

LIST OF TABLES

LIST OF FIGURES

1 Introduction

2 Conglomerate Structure in Emerging Markets
2.1 A Critical Perspective
2.2 Advantages of Conglomerate Structure in India

3 Research Methods
3.1 Sample Selection and Data Sources
3.2 Definitions of variables used in Analysis

4 Empirical Findings and Discussion of Results
4.1 Descriptive Statistics
4.2 Multiple Regression Analysis
4.2.1 Dependent Variables
4.2.2 Independent Variables
4.2.3 Control Variables
4.2.4 Models
4.3 Multiple Regression Analysis – Results
4.3.1 Hypothesis 1
4.3.2 Hypothesis 2
4.3.3 Hypothesis 3
4.3.4 Additional Robustness Tests

5 Summary and Conclusions

REFERENCES

APPENDIX A: Tata Group Ownership Structure

APPENDIX B: Companies Included in the Sample

APPENDIX C: Financial Overview of Sample Tata Group Firms

APPENDIX D: Regression Results of Robustness Tests

LIST OF TABLES

Table 1: Institutional context in the US and India

Table 2: Potential Advantages of Conglomerate Structures; Examples from the Tata Group

Table 3: Tobin’s q Definition – Detailed Overview

Table 4: DOA Drivers and 5-Point Scale

Table 5: Descriptive Statistics and Pearson’s Correlation Coefficients – Total Sample

Table 6: Descriptive Statistics and Pearson’s Correlation Coefficients – Tata Sample

Table 7: Descriptive Stat. and Pearson’s Correlation Coeff. – Benchmark Portfolio Sample

Table 8: Tobin’s q and ROA Multiple Regressions – Total Sample

LIST OF FIGURES

Figure 1: Degree of Affiliation Positively Correlated to mean Tobin’s Q (log)

ABSTRACT

The conglomerate structure is still prevalent in India. Recently, however, consultants and international investors have started pressuring business houses to reduce diversification. Focusing on India’s most diversified conglomerate and a benchmark portfolio of unaffiliated Indian firms, this study examines the impact of Tata Group affiliation on firm performance. Results show a significant positive relation between group membership and performance, both in terms of Tobin’s q and ROA. Differentiating between different degrees of group affiliation (DOA), the analysis further reveals that the higher the influence from the centre, the higher the positive impact on firm performance. From all analyzed DOA factors, the inclusion of senior group level executives or Tata family members in the management of affiliates seems to boost affiliates’ performance the most. A possible interpretation of this finding is that direct managerial involvement from the centre increases firms’ access to group level resources. Furthermore, group level executives are matured professionals and leaders, who bring in valuable business knowledge, thereby increasing the long-term prospects of the affiliate and evoking trust among investors. Overall, the findings of this paper suggest that even in a more liberal and globalized India, the conglomerate structure can still be financially beneficial and is far from outdated. The Tata Group is one such positive example.

1 Introduction

Business groups such as Birla, Reliance, Singhania and Tata still dominate the Indian private sector. However, in a time where emerging markets open up to global competition, consultants and international investors put more and more pressure on business groups to scale back the scope of their business and to focus on their core competencies (Khanna & Palepu, 1997). Under these circumstances, it is more relevant than ever to understand whether or under which circumstances conglomerate structures today still add value in the context of emerging markets.

Khanna and Rivkin (2001, p. 47) define business groups as “a set of firms which, though legally independent, are bound together by a constellation of formal and informal ties and are accustomed to taking coordinated action”. While this definition certainly applies to the Indian context, the following particularities can be added. Firstly, a high proportion of affiliates of Indian business groups are publicly traded and, unlike in other emerging markets (e.g. Goto, 1982), belong to only one group¹. Secondly, Indian business groups are active in a very wide variety of industries and are commonly controlled by a family (Khanna & Palepu, 2000).

The Tata Group is a good example of a highly successful Indian conglomerate. Founded in 1868 by Jamsetji N. Tata, the group has become India’s best reputed and most diversified business house. The 98 group companies (excluding subsidiaries) are active in seven industries – communications and information technology, engineering, materials, services, energy, consumer products and chemicals – and total group revenues for the financial year 2007-08 are estimated at $62.5 billion, of which 60% is from business outside India (Tata Corporate Website, 2008). The strategy of the Tata Group has changed significantly since 1991, the year that marked the end of the “license Raj” era² and when Ratan N. Tata took over as Chairman. He streamlined the group portfolio, increased the competitiveness of the remaining affiliates and introduced initiatives that made the group a more unified corporate entity (Khanna et al., 2008). Mr. Tata, for example, increased the stake Tata Sons, the group’s holding company, had in each affiliate and made group companies pay for the use of the Tata brand. Furthermore, he institutionalized two centralized management organizations that were in charge of overseeing group operating companies. With these initiatives and his visionary leadership style he laid the foundation for the recent high growth rates that Tata group affiliates have been subject to both domestically and abroad. Appendix A provides an overview of the current Tata Group ownership structure.

What differentiates the Tata Group from many other business houses is its heritage to return to society what is earned and its strong adherence to business ethics. 66% of Tata Sons, for example, is owned by two charitable trusts, which frequently fund programs in medicine, economic development, scientific research and education (Khanna et al., 2008). This legacy is further fostered by Mr. Tata, who is commonly referred to as the most successful and ethical Indian top manager of current times and who personifies the values the Tata Group stands for (Robinson, 2008).

This study analyzes the effect of Tata Group affiliation on firm performance relative to a benchmark portfolio of unaffiliated, independent companies. Unlike in other studies (e.g. Khanna & Palepu, 2000), the analysis is focused on one diversified Indian business group. This makes it possible to identify group specific drivers that explain performance differences between Tata affiliates and independent firms. Specifically, this methodology provides a framework to test the impact the above described Tata Group characteristics have on firm performance.

Discussing relevant findings from previous work, the hypotheses of this study are developed in Chapter 2. An overview of the sample selection process and definitions of the variables used in the analysis is given in Chapter 3. Chapter 4 presents the results of the empirical analysis and includes a section that tests the model for its robustness. I conclude in Chapter 6 with a summary of the results.

2 Conglomerate Structure in Emerging Markets

2.1 A Critical Perspective

A number of studies, mainly conducted in the US, have shown a negative relationship between diversification and firm performance (e.g. Lang & Schulz, 1994; Berger & Ofek, 1995; Comment & Jarrell, 1995). A loss of firm value that is associated with diversification is often referred to as “diversification discount”. Scholars have cited a number of factors that explain the negative impact diversification can have on firm value. Diversified businesses have been associated with conflicts of interest between minority and controlling family shareholders. Bertrand et al. (2002), for example, find in the context of Indian business groups that cross holdings across group affiliates motivate the controlling shareholder to tunnel funds from profitable businesses with low ownership rights to affiliates where his ownership rights are dominant. For related reasons, interlocking of directorships³ may also lead to expropriation of minority shareholders (Singh et al., 2007). Furthermore, diversified businesses can underperform due to misallocation of capital (Shin & Stulz, 1998), insufficient internal governance and unsuitable allocation of decision rights (Khanna & Palepu, 2000).

Interestingly, however, the great majority of studies that find a clear negative association between the degree of diversification and firm value were conducted in the US or other developed countries. Fauver et al. (2003) find that the diversification discount only exists in high income countries with developed markets and institutions. In low income countries, on the other hand, their analysis shows no diversification discount and in some cases even a premium for corporate diversification.

In his groundbreaking transaction cost theory, Coase (1937) states that the optimal structure of a firm depends on the institutional context it operates in. To be successful, a company must adapt its strategy to fit a country’s labor, capital and product market, its regulatory system as well as its mechanisms to enforcing contracts (Khanna & Palepu, 1997).

While these markets and mechanisms are well developed and efficient in the United States and western European countries, the same does not (yet) apply to developing countries such as India. Williamson (1975) defines a market failure as a transaction that would be beneficial for all parties involved but fails to take place because the indirect costs outweigh the net benefit. Such market failures are particularly common in developing countries. Capital markets, for example, are still underdeveloped and insufficiently monitored by bureaucrats, making it difficult for independent companies to find investors who are willing to help finance new ventures (Khanna et al., 2005). Furthermore, just as other emerging economies, India suffers from a scarcity of well-trained labor (Khanna & Palepu, 1997), is still subject to high corruption levels and an unpredictable contract enforcement environment. Table 1 summarizes and compares the particularities of the institutional contexts found in the US and India. As will be discussed in Section 2.2, previous research shows that these differences may partly explain why the conglomerate structure is still prevalent in developing economies.

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Table 1: Institutional Context in the US and India (adapted from Khanna & Palepu, 1997, p. 44)

2.2 Advantages of Conglomerate Structure in India

As Khanna and Palepu (1997, p. 41) summarize, business houses can add value by “imitating the functions of several institutions that are present only in advanced economies”. Table 2 provides an overview of potential advantages of the conglomerate structure in the Indian context and lists specific examples from the Tata Group. Below follows a detailed discussion of all aspects.

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Table 2: Potential Advantages of Conglomerate Structures; Examples from the Tata Group (adapted from Khanna & Palepu, 1997, p. 48)

Easier access to capital markets is one of the potential advantages of business group affiliation. Knowing that solvent conglomerates will vouch for their member firms, in emerging markets external capital providers are typically willing to provide financing to business houses (Gopalan et al., 2007). Especially foreign investors find it increasingly attractive to invest in conglomerates, thereby gaining access to fast growing markets without taking too much risk. Furthermore, many conglomerates have put in place mechanisms that allow them to use internally generated capital to support growth of existing affiliates or to enter new businesses. The Tata Group, for example, has a long tradition of diversifying into new businesses with internal capital. The two promoter companies Tata Sons and Tata Industries, functioning as venture capital vehicles, have led the group into new industries as diverse as information technology and oil field services (Khanna et al., 2008).

Moreover, business houses take advantage of internal labor markets to increase and develop the talent pool they need to grow their businesses. This reduces their dependence on inefficient and immobile labor markets prevalent in emerging economies in a way that is not conceivable for independent firms. Tata Administrative Services (TAS), the Tata Group‘s highly selective internal training program, is a good example. Once selected, candidates rotate in several Tata Group companies, have repeated interactive sessions with executives and access to mentoring as well as career planning services (Khanna & Palepu, 1997). After completion of the program, candidates are high potentials for mid level management positions in the Tata Group and have very attractive outside options. With that, TAS enables the group to provide management education and “certification services” in a country where both are very rare (Khanna & Palepu, 1997).

Another potential advantage of conglomerate structures is reputation. By investing in an umbrella brand name and a reputation that stands for strong values and high-quality products and services, all business group affiliates can benefit tremendously. This is particularly true for the Tata Group, whose brand stands for integrity, honesty as well as quality and is appreciated by both the Indian elite as well as the poor. A good reputation is also a way for conglomerates to at least partly mitigate the “contract enforcement” problem that prevails in emerging economies. Many Indian business houses have been able to establish long-lasting partnerships with suppliers and investors. In the case of the Tata Group, the excellent reputation has also led to joint ventures with international heavyweights such as AT&T and Mercedes-Benz (Khanna & Palepu, 2000).

Khanna and Rivkin (2001, p. 50) use the term “coordinated political lobbying” to describe another potential advantage of conglomerate structures. Business houses can function as intermediaries whenever their affiliates or foreign strategic partners need to interact with highly bureaucratic and corrupt government institutions. Khanna and Palepu (1997) even report that large Indian conglomerates maintain industrial embassies in the capital to facilitate these interactions. Also the Tata Group maintains good relationships up to the highest ranks of politicians. Ratan Tata, for example, is Chairman of the Finance Minister’s Investment Commission, composed of three highly respected Indian businessmen and set up to attract foreign direct investment (The Times of India, 2004).

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The discussion above shows how group affiliation can be beneficial for companies. Easier access to capital markets, effective internal labor markets, value from a strong umbrella brand and coordinated lobbying are all factors that may positively influence firm performance. The Tata Group has a strong record of taking advantage of its group structure. Based on this, the first hypothesis is formulated as follows:

H1: Tata Group affiliated companies are characterized by stronger financial performance than a benchmark portfolio of independent, unaffiliated companies from the same business sectors.

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Indeed, a previous study conducted by Khanna and Palepu (2000) is consistent with this proposition. They analyze the performance of affiliates of Indian conglomerates relative to unaffiliated firms and find that even though firm performance initially declines with group diversification, it increases linearly once group diversification exceeds a certain threshold. Thus, according to their results, affiliates of the most diversified business groups outperform unaffiliated firms. Given that the Tata Group is India’s most diversified conglomerate (Gentleman, 2008), their results support H1. One could further argue that differences in the degree of affiliation (DOA)⁴ of member firms to the group may impact firm performance. While affiliates with a high DOA are able to take full advantage of their group affiliation, the same may be possible to a lesser extent in the case of low DOA member companies. Therefore:

H2: Tata Group affiliated companies with high DOA levels are characterized by stronger

financial performance than member firms with low DOA levels and a benchmark portfolio of independent, unaffiliated companies from the same business sectors.

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However, some recent studies conducted in India have found a significant negative relation between the degree of diversification and firm performance, suggesting that the conglomerate structure is not (anymore) beneficial for most business houses. Singh et al. (2007), for example, analyze 889 Indian firms and find that in the case of domestic business group affiliates, high levels of diversification are associated with cost inefficiencies and poor performance. Reed (2002) reports that between 1997 and 1999 many large Indian conglomerates were subject to the greatest decline in profitability. These authors argue that after 1991 and the end of the license raj era (see introduction), India’s institutional context changed dramatically and, therefore, the conglomerate structure would be antiquated. The current trend of reduced regulation, rising capital and labor market sophistication, better information transparency and globalization would have led to an erosion of benefits associated with diversification.

When solely focusing on the Tata Group, though, this reasoning is not sustained. Since 1991, the Group’s total revenues have increased tenfold, profitability levels of most affiliates remain high (Khanna et al., 2008) and on several occasions Ratan Tata personally told me how positive he was about his Group’s future. But what is it that makes the Tata Group special? How does it differentiate itself from other Indian conglomerates?

As already mentioned, a key differentiation factor is the group’s reputation embodied by the Tata brand, which stands for integrity and compliance with the highest ethical standards. Recently, Brand Finance, a consultancy firm based in the UK, valued the Tata brand at $11.4 billion and ranked it 57th in its list of the top 100 brands in the world (Arathoon, 2008). Including “Tata” in the company name, for example, may therefore positively influence firm performance. As Khanna and Rivkin (2001) point out, another key success factor of the Tata Group is its “group level management”. With Ratan Tata, the group has a strong leader and visionary, who is highly respected both domestically and abroad, at its helm. Moreover, members of the central Group Executive Office (see 3.2 for further context) and Tata family members have been placed on Executive Committees and on BoDs of strategically important affiliates, enabling them to impose a coherent strategy across the group.This, in turn, may positively impact affiliates’ performance. Thus, the following hypothesis is formulated:

H3: Tata Group affiliated companies that (1) use “Tata” in their company name and / or (2) include Group Executive Office (GEO) or Tata family members in their Executive Committees or BoDs are characterized by stronger financial performance than member firms without (1) and / or (2) and a benchmark portfolio of independent, unaffiliated companies from the same business sectors.

3 Research Methods

3.1 Sample Selection and Data Sources

For studying the effect of conglomerate affiliation on firm performance, exemplified by the Indian Tata Group, I build a representative portfolio of 14 Tata Group companies and compare their performance to a benchmark portfolio of 28 independent Indian firms.

From a total of 98 Tata Group affiliates (Khanna et al., 2008), the Tata research portfolio is composed according to the following criteria: All Tata sample companies are publicly listed (1), Tata Sons is a major investor of them (2) and neither of the companies is a subsidiary of another firm included in the sample (3)⁵. The first criterion ensures data availability given that listed companies are required to publish a set of financial statements. It is also a prerequisite for using Tobin’s q as a measure of firm performance (see definition in Section 3.2). It can be assumed that Tata Group affiliates with a high level of Tata Sons investment are characterized by a certain degree of group affiliation. Therefore, applying criterion two is a way to shortlist Tata Group companies that are principally exposed to potential advantages or disadvantages of group affiliation and thus are particularly interesting in the context of this study. Criterion three guarantees that all Tata sample companies are separate legal entities that – apart from guidance from the centre – are entitled to perform business decisions independently. Companies included in the sample are listed in Appendix B. Appendix C provides an overview of financial highlights of all sample Tata companies.

The benchmark portfolio consists of 28 companies and is established according to the following criteria:

- Exclusively publicly listed, Indian companies
- For each Tata Group sample company the two major, independent (not part of a conglomerate) competitors are included in the analysis
- Similar size as the respective Tata Group affiliate Taking into account India’s several hundred business groups (Khanna et al., 2000), it is not possible to always fulfill each criterion without reservation. In these cases, the criteria are prioritized in the following order: No group affiliation, Indian headquarters and public listing are regarded as the most important criteria. Where no independent competitors from the same business sectors can be found, companies from other, related industries are included in the sample⁶. In Appendix B, these companies are marked with a star. Only when the above criteria are met is company size taken into account. This becomes apparent when analyzing the descriptive statistics in section 4.1, where the means of total assets, revenues and market value of equity of the benchmark portfolio are higher than those of the Tata sample. Given that this raises questions of comparability, it will be important to perform robustness tests that account for this discrepancy.

Sample companies are identified referring to a number of sources. In case of the Tata Group sample, valuable information is available on the group website⁷. Furthermore, the suitability of the shortlisted group affiliates is reconfirmed with Dr. B. Bowonder, Research Director of the Tata Management Training Centre, as well as the Chairman’s office. In case of the benchmark portfolio, press articles and financial analysts’ reports available on Datamonitor and the web are used to compose the sample.

For all 42 companies financial data of the financial years 2005, 2006 and 2007 are collected from publicly available sources, mainly annual reports. Obtaining data of a three year period reduces the risk that the results are distorted by special circumstances in a given year and thus increases the explanatory power of results.

[...]

¹ This proves to be particularly useful when studying the effect of group affiliation on firm performance.

² In 1991, India’s regulatory and restrictive policy regime which was marked by bureaucracy and protectionism was finally dismantled, industry became open to both domestic and international competition and the government launched a number of far reaching reform and liberalization programs (e.g. Mishra & Akbar, 2007).

³ Interlocking of directorships refers to a situation where directors of different companies sit on each other’s boards.

⁴ Section 3.2 discusses in detail how DOA levels of Tata sample companies are evaluated.

⁵ Nelco, for example, is publicly listed and Tata Sons is the company’s major shareholder. Given that Nelco has become a subsidiary of Tata Power in 2007, however, criterion three is not fulfilled and the company thus not included in the sample.

⁶ Mahindra&Mahindra, for example, is Tata Motor’s main competitor in the heavy vehicles business. However, M&M is also another relatively large Indian conglomerate and therefore can not be part of the benchmark portfolio. Instead, Bajaj Auto, India’s leading Two and Three-wheeler Company is included in the sample. Especially since Tata Motors has showcased its Nano, the cheapest car in the world, this is legitimate because the Nano will directly compete with Bajaj’s motorbikes and three-wheelers (Business Standard, 2008).

⁷ www.tata.com