company cross-holdings: comments

CFA Institute

Company Cross-Holdings: CommentsAuthor(s): Ranjan SinhaSource: Financial Analysts Journal, Vol. 55, No. 3 (May - Jun., 1999), pp. 9-13Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4480162 .

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Letters to the Editor

Table 5. Balance Sheets with Options Company Company

Item A B Consolidated

Cash $ 100 $ 100 $ 200 Fixed assets 100 100 200 Investments 199,999,800 199,999,800 0 Option 100,000,000 100,000,000 200,000,000 Loan 100,000,000 100,000,000 200,000,000

Total equity $200,000,000 $200,000,000 $ 400

The total collateral available for their loans is only the companies' real assets-$400 each. The general rule, although Sinha did not compute it, is that the collateral for one company's loan cannot exceed the total of the two companies' real assets.

On the other hand, there is roughly a 15 percent chance that the options will expire well in the money-say, at double their purchase price. Then, Ferguson and Hitzig really will be multimillion- aires.

Suppose, instead of buying options, Ferguson and Hitzig use the loans to create a valuable business. This use of the loan also makes them really wealthy. They never would have had this opportunity, however, if investors and bankers had evaluated their investments properly.

Cross-holdings provide an extremely valuable benefit, namely, reduced likelihood of losing control. (In the example, the managers cannot lose control to the outside shareholders.) The full economic benefit (ignoring agency costs) of owning both companies can be obtained by buying only the 400 outside shares, but such investors cannot gain control of the two companies this way because the outside shares are only 400 out of 400 million. Sinha appreciated this angle. He missed the point, however, that the reduced likelihood of losing control makes it possible for managers to rape the outside investors, who are the companies' true owners. The beneficiaries are the managers. Agency costs increase tremendously.

In summary, we believe the points Sinha listed in his section called "Basic Issues" are wrong or

irrelevant. Furthermore: * Companies can create cross-holdings either by

transacting with themselves or by transacting with outside shareholders. Transacting with outsiders does not result in an increase in the total market value of the companies involved. It results in a decrease, because each company has paid out cash. Of course, the stated equity of the companies does not change, so it is mis- leading.

* Cross-holdings can be used directly by original investors and managers for self- aggrandizement. The reason cross-holdings have not become more prevalent is probably that they are understood too well. For example, consolidation rules and fraud laws are designed to counter them; cross-holding mis- use cannot be sustained without the chicanery and collusion of managers and government officials, as we believe occurs in the Japanese keiretsu.

* With respect to the stated equities of cross- holding companies, each company appears bigger but is not. Issuing primary shares to outside investors, not other companies, makes the company appear bigger because it is bigger. Cross-holdings are not well-understood by

investors and regulators. Those who do under- stand them too often use them to the disadvantage of shareholders and other innocent civilians. (For example, Japanese managers and government regulators probably know very well that the collateral available to their banks is only the total value of real assets.) We hope our analysis helps change this situation.

Robert Ferguson President

Axiomatic Systems, Inc.

Neal Hitzig KPMG Professor of Finance

Saint Peter's College

Company Cross-Holdings: Comments

In their response to my article "Company Cross- Holdings and Investment Analysis" (September/ October 1998), Robert Ferguson and Neal Hitzig restate their claim that cross-holding arrangements can lead to significant abuse. In their view, bankers will make the mistake that cross-holdings increase debt capacity, which will allow unscrupulous managers to get their hands on the bank's cash. This view is based on an insufficient understanding of

the analysis in my 1998 article. My analysis was from the point of view of a single company in a cross-holding relationship. What the analysis did not consider was the effect on the other company's debt-bearing capacity of the first company's deci- sion to obtain a loan. As any banker understands, "excessive" loans to one company will reduce the debt-bearing capacity of the other companies involved in a cross-holding arrangement. This

May/June 1999 9



Financial Analysts Journal

interdependency eliminates the possibility of abuse.

The analysis in this comment suggests an advantage of the keiretsu structure that has not so far been recognized: Mutual cross-holdings allow companies to share their debt capacities. Although cross-holdings do not increase the overall credit capacity of the economy, they allow banks to "allocate" the credit potential of companies within the group.

The Basic Situation Consider Ferguson and Hitzig's original example: Two identical companies come into existence by issuing 200 shares at $1 a share. A single individual owns each company. The two individuals are friends, and they decide to have a bit of fun. To this end, each company invests $100 in real assets (for analytical convenience, the assumption is that all real investments are in projects with zero net present value) and retains $100 to invest in the other

company. The owners repeat this step a number of times. Panel A of Table 6 shows the original balance sheets of the two companies, Panel B shows the balance sheets after one round of mutual investments, and Panel C shows the balance sheets after two rounds of mutual investments. In each case, the assumption is that once the desired level of mutual investments has been achieved, each company will invest its cash in real assets. By avoiding consolidation, each company reports the balance sheet shown in Table 6. (Consolidation would require the elimination of cross-holdings, but Ferguson and Hitzig showed in their original article, "How to Get Rich Quick Using GAAP" [May/June 1993], that these companies can avoid the consolidation requirements imposed by U.S. generally accepted accounting principles by increasing the number of companies that are part of the cross-holding scheme.) This reporting loophole means that increasing levels of cross-holdings make each

Table 6. Balance Sheets Prior to Bank Loans Item Company A Company B

A. Original balance sheets Assets

Real assets $200 $200

Liabilities and equity Equity $200 $200

Shares outstanding (number) 200 200

B. Balance sheets after one round of mutual investments Assets

Real assets $200 $200 Investments 100 100

Total assets $300 $300


Shares outstanding (number) Original owners 200 200 Held by other company 100 100

Total 300 300

C. Balance sheets after two rounds of mutual investments Assets





Total 400 400

10 ?Association for Investment Management and Research




company appear to be increasingly bigger than it actually is.

Each company appears to get bigger, but note that neither company controls more productive assets in Panel C than it did in Panel A and neither company is larger than it was in terms of annual sales, its ability to hire employees, the avenues for advancement within the corporation, or so on. The market price per share of each company is no more in Panel C than it was before the cross-investments. From each of these points of view, the original owners have achieved nothing, in spite of the fact that each controls a company that is much larger in terms of book and market value.

Borrowing Capacity For the original investors to profit from this game, someone has to be willing to give them control of additional real assets on the basis of the apparent increase in their companies between Panel A and Panel C of Table 6. Ferguson and Hitzig believe that there is a banker out there who will be willing to give them such additional real assets. Ferguson and Hitzig assume that some banker will follow the banking rules mechanically and, assuming that the banking norms indicate an equity-to-debt ratio of 1:1, lend $200 to each company in Panel A, $300 in Panel B, and $400 in Panel C.

In reality, any banker worth her salt will actually look at the asset side of the balance sheet and will know enough to treat the real assets separately from the investments. For example, assume Company A is the first to approach the bank for a loan. In Panel A of Table 6, Company A has real assets worth $200, which will enable it to get a loan of $200. Panel A of Table 7 shows the balance sheets of the two companies after the $200 loan obtained by Company A. If the proceeds of the loan are assumed to be invested in real assets, then after the loan, the companies will control a total of $600 worth of real assets.

In Panel B of Table 6, after one round of mutual investments between these two companies of $100 each, Company A has $200 in real assets and $100 in investments. This balance sheet will allow Company A to borrow $200 on the basis of its real assets plus an additional $67 on the basis of its investments (because Company A holds a one- third share in Company B, which has $200 in real assets). Note here that Company A will not be able to borrow against its one-third share in Company B's investments because those investments are in Company A and the bank will not double-count their collateral value. Therefore, the maximum amount Company A will be able to borrow is $267. Panel B of Table 7 shows the balance sheets after

the cross-investment and, again, with the loan proceeds invested in real assets. Note in Table 7 that the total for real assets controlled by the companies increases from $600 in Panel A to $667 in Panel B.

In Panel C of Table 6, after two rounds of mutual $100 investments between these two companies, Company A has $200 in real assets and $200 in investments. Now, Company A will be able to borrow $300-$200 against its real assets and $100 against its one-half share in Company B's real assets. Panel C of Table 7 shows the balance sheets with the loan proceeds invested in real assets. Now, the companies control real assets with a total worth of $700.

In the limit, after an infinite number of iterations of mutual investments, Company A's borrowing capacity will increase asymptotically to $400, which is the sum of the real assets owned by both companies. At this level of borrowing, Com- pany A will control real assets worth $600 and, together, the two companies will control $800 worth of real assets. That is, cross-holdings do not allow an unlimited increase in the borrowing capacity of Company A. The increase in borrowing capacity is limited by the maximum capacity Company B can "lend" to Company A. This sharing of borrowing capacity was one of the thrusts of my original article, although that article did not specifically consider the limiting case.

Is the banker who lends in the manner described here being taken for a ride? The amount by which the banker can be "fooled" has an upper limit. But is any increase at all in the estimated debt- carrying capacity of Company A spurious? Will such borrowing allow the two friends to exploit the banking system? These questions can be addressed by analyzing the maximum amount of borrowing available to Company B after Company A has obtained the loans shown in Table 7.

Borrowings by Company B First, consider the situation in Panel A of Table 7. Because there is no relationship between the two companies at this stage, Company B will be able to borrow $200 against its real assets. Panel A of Table 8 shows the balance sheets of both companies after each company has borrowed the maximum amount allowed under the norms assumed here. Note that both companies now have $200 in loans, which enables them, together, to control a total of $800 in real assets. This amount is the same as in the limiting case, when Company A was doing all the borrowing.

Now, consider the situation represented in Panel B of Table 7. Will Company B be able to borrow more or less than it would have been able

May/June 1999 11



Financial Analysts Journal

Table 7. Balance Sheets with Maximum Bank Loans to Company A Item Company A Company B

A. Original balance sheets with beginning loan to Company A Assets


Liabilities and equity Bankloan $200 $ 0 Equity 200 200

Total liabilities and equity $400 $200





Liabilities and equity Bank loan $267 $ 0 Equity 300 300



Total 300 300




Liabilities and equity Bank loan $300 $ 0 Equity 400 400



Total 400 400

to borrow in Panel A? The answer is that it will be able to borrow less. First, look at the investment account of Company B. The banker will realize that the $100 in the investment account does not offer any collateral value at all because the bank has already lent money against the real assets (of Company A) to which this investment offers a claim. Next, consider the $200 in real assets owned by Company B. Again, the banker will remember, or discover (if Company B goes to a different banker), that the bank has already lent $67 against these real assets. Therefore, he will now be willing to lend only an additional $133 to Company B. An analysis along similar lines will show that the bank would lend only $100 to Company B in Panel C of Table 7. These results are shown in Panels B and C of Table 8.

Note that in all instances in Table 8, the total value of real assets controlled by the companies after each has taken the maximum amount of loan available to it never exceeds $800. In short, managers will not be able to use excessive bank loans for self-aggrandizement.

This analysis, in fact, illustrates a potentially significant benefit of cross-holdings: They allow companies to share their creditworthiness. That is, although the credit-bearing capacity of the entire group is not affected, cross-holding adds flexibility to the amounts that companies within the group can borrow. As long as bankers apply credit norms intelligently, there is no scope for significant abuse.

This analysis has two potential problems. The first relates to the priority of claims, particularly if different banks lend to the two companies. That is, institutional features may limit a banker's ability to

12 ?Association for Investment Management and Research




Table 8. Balance Sheets with Maximum Bank Loans to Company B Following Maximum Bank Loans to Company A

Item Company A Company B

A. Original balance sheets with beginning loans Assets


Liabilities and equity Bank loan $200 $200 Equity 200 200









Total 300 300







Total 400 400

allocate credit. The second concem is that bankers may not be aware of the exact features of the borrowing arrangements of all members of a group; hence, the bankers may be fooled into making excessive loans. Both concerns appear to be moot in the Japanese context. The keiretsu is generally organized around a "main bank." That is, one bank evaluates the security offered by the real assets in the entire group without worrying about the priority of claims. Also, when deciding on a new loan application from a member of the group, the bank knows all the relevant details about existing loans.

Conclusion Cross-holding arrangements allow companies to

share their credit-bearing capacities, which increases the flexibility with which bank credit can be deployed. There are many valid criticisms of the Japanese keiretsu, but Ferguson and Hitzig's criticism that it allows for managerial self- aggrandizement is not valid. If the salary and perks of U.S. and Japanese managers were compared (after controlling for the value of real assets they control), I would be surprised if the Japanese managers were found to be the ones living off the fat of the land.

Ranjan Sinha Assistant Professor

Leavey School of Business Santa Clara University

May/June 1999 13



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