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Journal of Banking & Finance 32 (2008) 2178–2187

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Tunneling and propping: A justification for pyramidal ownership q

Yohanes E. Riyanto a,*, Linda A. Toolsema b
a
Department of Economics, National University of Singapore, AS2 1Arts Link, Singapore 117570, Singapore
b
COELO, University of Groningen, P.O. Box 800, 9700 AV Groningen, The Netherlands

Received 6 July 2007; accepted 20 December 2007

Available online 26 January 2008

Abstract

This paper links existence of the pyramidal ownership structure to tunneling and propping. Tunneling refers to a transfer of resources
from a lower-level firm to a higher-level firm in the pyramidal chain, whereas propping concerns a transfer in the opposite direction
intended to bail out the receiving firm from bankruptcy. We show that tunneling alone cannot justify the pyramidal structure unless out-
side investors are myopic, since rational outside investors anticipate tunneling and adjust their willingness-to-pay for the firm’s shares
accordingly. With propping, however, they may be willing to be expropriated in exchange for implicit insurance against bankruptcy.
Ó 2008 Elsevier B.V. All rights reserved.

JEL classification: G32; L22

Keywords: Tunneling; Propping; Pyramids; Ownership structure; Business groups

1. Introduction controlling shareholder with incentives to engage in self-

Empirical evidence shows that in large parts of the world
many firms belong to business groups characterized by
complex ownership structures, which often take the form
of a pyramid (La Porta et al., 1999; Claessens et al.,
2000). These firms are controlled through a chain of compa-
nies, where firm A holds part of firm B’s shares, which in
turn holds part of firm C’s shares, etc. The ultimate control-
ling shareholder, who is in control of firm A and thereby of
‘lower-level’ firms B, C, etc., is often a wealthy family. The
family uses indirect ownership to exert control over the
firms belonging to the pyramidal chain. This implies that
she is able to maintain control of the lower-level firms with-
out a majority of cash-flow rights, thus creating a separa-
tion between control rights and cash flow rights. This
separation between ownership and control provides the
q
This paper was reviewed and accepted while Prof. Giorgio Szego was
the Managing Editor of The Journal of Banking and Finance and by the
past Editorial Board.
*
Corresponding author.
E-mail addresses: ecsrye@nus.edu.sg (Y.E. Riyanto), l.a.toolsema@
rug.nl (L.A. Toolsema).
dealing transactions at the expense of minority sharehold-
ers. That is, the controlling shareholder may find it profit-
able to transfer resources from a firm in the pyramidal
chain to herself or to another (usually a higher-level) firm,
at the expense of the minority shareholders of the former
firm. Examples of these transactions are abound and
include internal asset sales, equity sales, transfer pricing
contracts that benefit other firms in the pyramid, and out-
right cash appropriation.1 In this paper, we analyze whether
such self-dealing transactions provide a justification for the
existence of the pyramidal ownership structure.
Outright cash appropriation and other resource transfers
directly to the family’s own pockets are generally considered
illegal and face severe punishments.2 However, interfirm
transfers of resources within a business group, generally
known as related-party transactions, are often considered
legal, at least under some countries’ jurisdictions. Djankov
1
For more real world examples of related-party transactions see
Johnson et al. (2000), Bae et al. (2002), Friedman et al. (2003), Jian and
Wong (2006), Gopalan et al. (2004), and Cheung et al. (2006).
2
The infamous Enron and Parmalat cases are good examples of these
illegal activities.

0378-4266/$ - see front matter Ó 2008 Elsevier B.V. All rights reserved.
doi:10.1016/j.jbankfin.2007.12.044
 Y.E. Riyanto, L.A. Toolsema / Journal of Banking & Finance 32 (2008) 2178–2187
et al. (2008) define these legal related-party transactions as
actions taken by controlling shareholders which ‘may bene-
fit them at the expense of other investors, but follow the law
regarding disclosure and approval procedures.’ The differ-
ent legal treatments of related-party transactions across
countries reflect differences in their legal systems and court
interpretations.3
In this paper we focus on legal related-party transactions,
thus excluding outright expropriation or looting by the ulti-
mate controlling shareholder. We are interested in the ques-
tion whether legal related-party transactions provide a
justification for the emergence of pyramidal business
groups. There are two reasons for ignoring illegal actions.
First, the aim of the criminal punishment against such
actions is to prevent them, so the expected payoff taking into
account possible discovery and punishment will usually be
lower than that of the outside option (i.e., the optimal legal
action). Second, whereas there is a critical difference
between a pyramidal structure and an independent horizon-
tal-structure with respect to the possibility of legal interfirm
transactions (which are allowed only between related par-
ties, i.e., in the pyramidal but not the horizontal structure),
there is no such difference for illegal transactions. Thus, in
this paper we take as a starting point a legal framework
which allows related-party transactions in a pyramidal
structure (at least to some extent) and ask whether this char-
acteristic of the pyramidal structure may justify its exis-
tence.4,5 Indeed, Johnson et al. (2000, p. 26) speculate that
the reason why the pyramidal structure is relatively rare in
the US and the UK may be that related-party transactions
are often challenged on legal grounds in those countries.
When related-party transactions are more difficult to imple-
ment, it seems that the attractiveness of the pyramidal struc-
ture for the ultimate controlling shareholder diminishes.
Several justifications for existence of pyramidal structures
have been advanced in the literature (see Almeida and Wol-
fenzon, 2006; see also Morck et al., 2005, who compare the
pyramidal structure to a single conglomerate rather than
to a horizontal structure as we do). First, in the presence
of private benefits of control clearly the pyramidal structure
is attractive because one can obtain large control rights with
limited financial means. However, this explanation suggests
3 When the pyramidal structure does not only involve
See Djankov et al. (2008) and Johnson et al. (2000).
4
For empirical studies on related-party transactions in pyramidal
business groups, see for example Bae et al. (2002), Bertrand et al. (2002),
Friedman et al. (2003), Claessens et al. (2000), Jian and Wong (2006), and
Cheung et al. (2006).
5
Even if interfirm transactions were possible in the horizontal structure,
they would be more prevalent in the pyramidal structure because the
separation of ownership and control enhances the incentive to engage in
self-dealing. Claessens et al. (2002) provide empirical evidence on this,
arguing that the controlling shareholder of a pyramidal group faces a
trade-off between an incentive effect and an entrenchment effect when
deciding on appropriation. The incentive effect induces the shareholder to
maximize firm value, whereas the entrenchment effect refers to the
temptation to engage in self-dealing. The authors show that the
entrenchment effect dominates the incentive effect when the degree of
separation between control rights and cash-flow rights increases.
2179
that pyramids should be characterized by maximum separa-
tion of ownership and control but empirical evidence indi-
cates that this is not always the case. Also, the same
separation can alternatively be obtained by issuing dual-
class shares. Second, business groups may provide a firm
with a substitute for poorly functioning financial markets.
This argument is formalized for the pyramidal structure by
Almeida and Wolfenzon (2006). In their model, a family
owns a firm A which already generated cash flow in the past.
When setting up a new firm B, funds need to be acquired to
pay for the setup cost. This can be done by selling part of the
new firm B and by using the full firm-A cash flow in the pyra-
midal structure, but only her own share of firm A’s cash flow
in an independent, horizontal structure. That is, under the
pyramidal structure more funds are available ex ante, since
the family can let firm A set up firm B and let outside inves-
tors of firm A ‘pay’ part of the establishment of firm B.
In the current paper, we also consider the establishment
of a new firm but ignore this past-cash-flow effect. Instead,
we focus on (legal) related-party transactions to analyze
whether these may provide an alternative – or additional –
justification for the pyramidal structure. We distinguish
two types of related-party transactions in our analysis. Tun-
neling refers to related-party transactions which move funds
from a lower-level firm to a higher-level firm in the pyrami-
dal chain, and propping refers to transfers of funds in the
opposite direction (Friedman et al., 2003). Tunneling clearly
involves expropriation of minority shareholders of the
lower-level firm. Propping, however, is only optimal to the
controlling shareholder when it is used to guarantee future
cash flows, say to save the lower-level firm from bankruptcy,
and thereby usually benefits minority shareholders as well.
Our results show that when investors are rational, tun-
neling alone does not justify the pyramidal structure.
Rational shareholders anticipate the expropriation and
adjust their willingness-to-pay for the firm’s shares accord-
ingly. This fully eliminates the potential benefit to the fam-
ily of self-dealing in the pyramidal structure, and the family
will prefer the independent, horizontal structure. Empirical
evidence indicates that investors may be myopic and under-
estimate the extent of tunneling.6 However, a justification
for pyramidal ownership relying on myopic investors may
not be very attractive from a modelling perspective.
tunneling but also propping, we find that the family may
indeed prefer to use the pyramidal ownership structure.
The possibility of propping in pyramidal business groups
implicitly provides outside investors with an intercorporate
insurance in case of financial distress. In this case, rational
outside investors are willing to be expropriated to some
extent via tunneling in exchange for a larger probability
of realizing positive returns from their investment in the
future. This explanation is consistent with Morck et al.
6
See e.g., Bertrand et al. (2002) and Bertrand and Mullainathan (2003).
Cheung et al. (2006, p. 384) also mention ‘overoptimistic’ investors as a
possible explanation for their empirical results.
2180 Y.E. Riyanto, L.A. Toolsema / Journal of Banking & Finance 32 (2008) 2178–2187
(2005), who argue that the benefit of intercorporate insur-
ance is one of the factors that underlies the creation of
pyramidal business groups. Cheung et al. (2006) analyze
a sample of 328 filings of related-party transactions
between Hong Kong publicly listed companies and their
controlling shareholders during the period 1998–2000,
and find evidence that market participants do not a priori
discount firms with potential for expropriation. This indi-
cates that investors may deliberately accept tunneling in
exchange for the insurance against financial distress.
Finally, it is worth mentioning that Friedman et al.
(2003) also present a model of propping, albeit in a dynamic
setting. Their study, however, does not consider the estab-
lishment of the ownership structure, so their model cannot
explain the choice of ownership structure, as ours does.
The remainder of this paper is structured as follows.
Section 2 presents the model. In Section 3 we solve the
model and derive the controlling shareholder’s payoffs
under the two ownership structures. In Section 4 we com-
pare these payoffs and derive the optimal ownership struc-
ture. Section 6 concludes.
2. The model
Suppose that, initially, a payoff-maximizing family owns
a controlling fraction a of the shares of a firm A, 0 < a < 1.
At t ¼ 0 the family wants to set up a second firm, firm B,
either as an independent firm (horizontal structure) or as
a pyramidal firm controlled by firm A (pyramidal struc-
ture).7 In the latter case, the family lets firm A establish firm
B. The two firms yield cash flows pA > 0 and pB > 0 for
two periods, t ¼ 1 and t ¼ 2 – unless firm B is in financial
distress. For simplicity we assume that there is no discount-
ing, and that after t ¼ 2 both firms are worthless.
The establishment of firm B requires an investment of size
I B > 0. The family has no initial cash available, so a fraction
of firm B’s equity must be sold to outside investors.8 That is,
at t ¼ 0 the family not only chooses the ownership structure,
but also decides what fraction of firm B to sell. We generally
7
We implicitly assume here that firm B is a startup firm. Our results do
not qualitatively change if we assume that firm B is not a startup but
instead is an acquisition, as long as the acquisition is done in the following
manner. The family can initially (and temporarily) finance the acquisition,
say the amount I B , using either personal cash or debt. Upon acquiring
100% of firm B’s shares, the family can then sell some of firm B’s shares to
outside investors to recover the amount I B and establish either the
horizontal or the pyramidal structure as discussed in our analysis.
8 9
Adding initial cash of the family into the model is straightforward,
however it will not change the qualitative aspects of our results. Thus, for
the sake of simplicity we assume that there is no initial cash available.
Other than cash, debt can also be a source of funds. However,
incorporating debt requires us to explicitly take into account uncertainty
and to deal with the issue of optimal capital structure. This is clearly
beyond the scope of our paper. As yet another alternative, the family can
also sell a fraction of firm A (see Almeida and Wolfenzon, 2006).
Incorporating this into our model will seriously complicate our analysis
and make it difficult to compare the two structures. We therefore leave this
for future research.
assume that outside investors are rational, unless explicitly
stated otherwise. We denote by bH the fraction of firm B’s
shares held by the family in the horizontal structure,
0 < bH < 1, and by bP the fraction of firm B’s shares held
by firm A in the pyramidal structure, 0 < bP < 1. The
remaining fraction of firm B’s shares is sold to outside inves-
tors in order to generate funds for the required investment
I B . We assume that investors have an outside option that
yields a net return of zero. Also, we assume that indeed the
family wants to set up firm B, that is, the family’s net
expected payoffs will be greater with firm B than without it.
Notice that for the pyramidal structure this would imply
that the controlling family is entitled to a fraction abP of
firm B’s cash flow, while firm A’s minority shareholders
are entitled to a fraction ð1  aÞbP of firm B’s cash flow.
Thus, effectively the controlling family ‘grants’ firm A’s
minority shareholders some cash flow from firm B. Indeed,
in our model, the controlling family has an incentive to do
so because this enables the family to establish the pyrami-
dal structure and to benefit from it. Moreover, from the
legal point of view, firm A’s minority shareholders are leg-
ally entitled to receiving their share of firm B’s cash flow.
At t ¼ 1, the family decides on related-party transac-
tions. That is, the family decides whether or not to tunnel
or to prop, and in case of tunneling chooses the amount
of funds to be tunneled. For tunneling and propping to
be feasible, we require that a and bP are controlling shares.
That is, using the so-called weakest-link approach9 we will
focus on the case where minða; bP Þ P w for some w > 0
which represents the smallest possible share ownership that
enables a shareholder to exert control. Tunneling and
propping are discussed in more detail below.
Fig. 1 below summarizes the sequence of events of our
model.
2.1. Tunneling
In the pyramidal structure the family has the possibility
to tunnel at t ¼ 1. We focus on legal related-party transac-
tions and exclude looting, i.e., tunneling of funds directly
to the family’s pockets. Thus, tunneling here means that
the family moves part of the cash flow of firm B to firm
A. The tunneled money S is then invested in a project in
firm A and yields an additional cash flow of lS at t ¼ 2
for firm A.10 Here, l represents the productivity parameter
of the reinvested funds, and we assume that this is the same
In many empirical studies the weakest link of ownership in the
pyramidal chain is used as a measure of control rights (see La Porta et al.,
1999; and Claessens et al., 2000). A lower bound for controlling shares is
somewhere around 10% or 20% (see the references above, and Lemmon
and Lins, 2003).
10
This is of course a simplified interpretation of tunneling. Alternatively
one can think of the following example of an asset sale. Firm A forces firm
B to acquire some of its assets at an inflated price. In this case, the money
spent for asset purchase will reduce the cash flow of firm B, while the
proceeds from the purchase will increase the cash flow of firm A and
enable firm A to invest in a profitable project.
 Y.E. Riyanto, L.A. Toolsema / Journal of Banking & Finance 32 (2008) 2178–2187
Fig. 1. Timing.
for funds coming from firm A and firm B. We assume that
0 < l 6 1, implying that the family has no incentive to
reinvest funds from firm A back into the same firm A.
But as we will show below, for these values of l, the con-
trolling family may indeed have an incentive to tunnel
and reinvest funds from firm B into firm A. In particular,
tunneling is profitable if l > bP . Since the case with tunnel-
ing is the one we are interested in, we focus on parameter
values for which this inequality holds for the equilibrium
value of bP in our model (to be derived in the next sec-
tion).11 With tunneling, the cash flow from firm B at
t ¼ 1 will be pB  S and the cash flow from firm A at
t ¼ 2 will be pA þ lS. These cash flows will be distributed
as dividends among the firms’ shareholders according to
their respective equity ownership. The family chooses S
in order to maximize her total payoffs.
Although we argued above that tunneling may be legal,
this does not necessarily mean that all available resources
in a pyramidal firm can be tunneled away. First, the extent
of legal minority shareholder protection in a country will
limit the amount of resources that can be tunneled.12 Sec-
ond, there may be transaction costs and some assets may
be hard to take away from a firm in the short run, or,
finally, a firm may have strategic reasons to limit tunneling.
So, we assume that tunneling is limited by legal conditions,
transaction costs, and other issues (e.g., concern for repu-
tation). We describe this using a parameter s to denote
the maximum fraction of firm B’s cash flow pB that can
be tunneled to firm A, 0 < s 6 1.13
2.2. Propping
As we mentioned above, with some probability q,
0 6 q < 1, firm B will be in financial distress at t ¼ 1 and
11
This assumption allows us to focus on interior solutions for exposi-
tional convenience.
12
See Djankov et al. (2008).
13
Clearly, this is a very simple modelling approach where tunneling is
costless up to some amount and infinitely costly beyond that amount. For
our purpose, this simple specification suffices. One could of course think of
using a convex function (say, a quadratic one) to describe the costs of
tunneling. However, this would seriously complicate the analysis without
qualitatively changing the results.
2181
needs an additional investment in order to survive and yield
positive cash flow in the future ðt ¼ 2Þ.14 For example, con-
sider a situation where advertizing is required to draw con-
sumers’ attention to the new firm’s product and with
probability q the original campaign is unsuccessful so that
additional advertizing is required. We assume that limited
liability prevents the controlling shareholder from earning
negative profits, so in case of bankruptcy the cash flow of
firm B at t ¼ 1; 2 is 0. If firm B is propped up, it still yields
a cash flow of 0 at t ¼ 1 – so tunneling is not possible – but it
does yield pB > 0 at t ¼ 2. The amount of funds needed to
prop up firm B and save it from bankruptcy is exogenously
given as F > 0.
In the pyramidal structure the family can use firm A’s
first-period cash flow pA to prop up firm B. Note that it
seems reasonable to assume that if it is legal to tunnel funds
from B to A in the pyramidal structure, it is also possible to
shift funds from A to B. Under normal circumstances, the
family has no incentive to do this. But if firm B is in finan-
cial distress the family may find it optimal to prop firm B in
order to safeguard future cash flow streams. As in the tun-
neling case, we let the parameter s limit the share of a firm’s
cash flow that can be used to prop up another firm. That is,
at most spA can be used to prop up B,15 and we assume for
convenience that F 6 spA .16 After transferring the amount
F to firm B, the remainder of firm A’s cash flow, pA  F , is
distributed as dividends among firm A’s shareholders
14
In our analysis we abstract from the possibility that the old firm A
itself may be in distress. Our model could be extended to allow for this.
However, this will not qualitatively affect our results. The only difference is
that funds will move from B to A for a wider range of parameter values.
15
Note that in the pyramidal structure as we model it, it is in the interest
of outside investors of firm A to prop up firm B. Therefore, if we interpret
s as legal protection it should not appear here. However, if we interpret it
as transaction costs, it should, and therefore we leave it in. Ignoring this
and replacing s by 1 here would only strengthen our results.
16
In addition to the amount spA , the family could use her own funds
from dividends to prop up firm B. Since using funds from firm A implies
that minority shareholders of A effectively pay part of the propping, it is
always more profitable to the family to use those funds first. For
expositional convenience, we therefore ignore propping with own funds in
the pyramidal structure. Including this possibility relaxes the financing
constraint, and in that sense it would strengthen our results.
2182 Y.E. Riyanto, L.A. Toolsema / Journal of Banking & Finance 32 (2008) 2178–2187

according to their respective equity ownership. Thus, the  IB

bH
prop ¼ 1  ; ð1Þ
controlling family gets aðpA  F Þ at t ¼ 1. ð2  qÞpB
In the horizontal structure, the family can use its own
where we use the superscript * to denote equilibrium val-
share of the cash flow obtained from firm A, i.e., apA , to
ues.18 Substituting (1) into the maximand yields the equilib-
prop up firm B. It is not possible for the family to use
rium expected payoff
the remaining cash flow of firm A. Since firm A’s outside 
investors are not involved in firm B in any way, transfer- PH
prop ¼ 2apA þ ð2  qÞpB  qF  I B : ð2Þ
ring their funds to firm B does not serve their interest. Such H
Now suppose that F > minfapA ; b pB g, so that propping
an action would therefore be considered as looting and is
will not occur. This implies that firm B will not be bailed
illegal. Thus, in the horizontal structure propping will be
out in the event of financial distress. The family’s expected
possible only if F 6 apA , and if propping occurs the family
payoff at t ¼ 0 is given by
has a cash flow of apA  F at t ¼ 1.
H
PH
no prop ¼ ð1  qÞð2apA þ 2b pB Þ þ 2qapA
3. Solution of the model
¼ 2apA þ 2bH ð1  qÞpB :
In this section, we solve the model using backward The controlling shareholder thus faces the following
induction. maximization problem:
max 2apA þ 2bH ð1  qÞpB
3.1. Horizontal structure bH

s:t: 2ð1  qÞð1  bH ÞpB P I B ;

As we argued above, in the horizontal structure prop-
ping will be feasible (i.e., possible) only if the family has
sufficient cash available, F 6 apA , but for propping to actu-
ally occur in equilibrium we also require it to be efficient
(i.e., optimal, profit-maximizing), i.e., we require parame-
ters to be such that in equilibrium F 6 bH pB . If the latter
condition is violated, it is not worthwhile to prop up firm
B because the additional payoffs from saving the firm,
where the LHS of the financing constraint represents the
amount that outside investors are willing to pay for a frac-
tion ð1  bH Þ of the shares of firm B. The value of bH that
will make the financing constraint satisfied with equality is
 IB
bH
no prop ¼ 1  : ð3Þ
2ð1  qÞpB
 

i.e., cash flows of bH pB at t ¼ 2, do not outweigh the cost Note that bH H

no prop is smaller than bprop . Since now firm B

F involved at t ¼ 1. Thus, in order to make propping occur
in case of financial distress we require that
F 6 minfapA ; bH pB g, where the value of bH is to be derived
below. The family’s expected payoff at t ¼ 0 from the hor-
izontal structure is then given by
H H
PH
prop ¼ ð1  qÞð2apA þ 2b pB Þ þ qð2apA  F þ b pB Þ
¼ 2apA þ bH ð2  qÞpB  qF :
The controlling shareholder faces the following maximi-
zation problem:
max 2apA þ bH ð2  qÞpB  qF
bH
s:t: 2ð1  qÞð1  bH ÞpB þ qð1  bH ÞpB P I B ;
where the left-hand side (LHS) of the financing constraint
represents the amount that outside investors are willing to
pay for a fraction ð1  bH Þ of firm B’s shares sold, taking
into account that firm B will be propped up in case of
financial distress. The expected payoff clearly is increasing
in the fraction of firm B’s shares owned by the controlling
family, bH . Hence, the controlling family will just sell en-
ough shares to outside investors to satisfy the financing
constraint with equality.17 The value of bH that will make
the financing constraint satisfied with equality is
17
The same argument holds for the other cases we consider below.
will not be saved in case of financial distress, outside inves-
tors are willing to pay less per share and a larger part of
firm B needs to be sold to meet the required amount
I B .19 Using (3) the equilibrium expected payoff is

PH
no prop ¼ 2apA þ 2ð1  qÞpB  I B : ð4Þ
3.2. Pyramidal structure
In the pyramidal structure, it can easily be verified that
whenever tunneling is profitable it is optimal for the family
to tunnel the maximum amount S  ¼ spB . We assume that
there is sufficient cash available to prop up firm B when it is
in financial distress, so F 6 spA . But for propping to be effi-
cient, we also require parameters to be such that F 6 bP pB
in equilibrium. Thus, we require that F 6 minfspA ; bP pB g
to make propping occur in case of financial distress.
We start with the case in which propping occurs in the
pyramidal structure. We assume that propping is efficient
in the equilibrium derived below, which will allow us to
focus on interior solutions. At t ¼ 0 the family’s expected
payoff can be expressed as
18
We assume that the family’s expected revenues with firm B exceed
those without it. For the case under consideration here, this condition can

be rewritten into 2apA þ bHprop ð2  qÞpB  qF P 2apA , which can be
simplified into ð2  qÞpB  qF P I B :
19
The condition for the family’s expected revenues with firm B to exceed
those without it can be written as 2ð1  qÞpB P I B .
 Y.E. Riyanto, L.A. Toolsema / Journal of Banking & Finance 32 (2008) 2178–2187
PP ¼ ð1  qÞð2apA þ 2abP pB þ aðl  bP ÞspB Þ
P probability that firm B will be in financial distress and
þ qðað2pA  F Þ þ ab pB Þ
¼ 2apA þ abP ð2  qÞpB þ ð1  qÞaðl  bP ÞspB  qaF :
The difference between this case and the case of horizontal
structure with propping is that now F is multiplied by
a < 1. That is, the outside investors of firm A carry part
of the burden of propping up B. Outside investors are will-
ing to pay
ð1  qÞð1  bP Þð2  sÞpB þ qð1  bP ÞpB ð5Þ
for a fraction ð1  bP Þ of firm B. Note that rational inves-
tors discern the extent of tunneling and take it into account
in their share valuation. This lowers the amount of money
that can be raised by the family. The family thus faces the
following maximization problem:
max 2apA þ abP ð2  qÞpB þ ð1  qÞaðl  bP ÞspB  qaF
bP
s:t: ð1  qÞð1  bP Þð2  sÞpB þ qð1  bP ÞpB P I B :
The value of bP that will make the financing constraint sat-
isfied with equality is
 IB
bP ¼ 1  : ð6Þ
ð2  q  ð1  qÞsÞpB
Finally, using (6), the equilibrium payoff under the pyrami-
dal structure20 can be rewritten as

PP ¼ 2apA þ ð2  q  ð1  qÞð1  lÞsÞapB  qaF  aI B :
ð7Þ
4. Optimal ownership structure
In this section we study the choice of ownership at t ¼ 0 in
more detail. Our aim is to find out whether tunneling and
propping may provide a justification for selecting the pyra-
midal ownership structure. First, we consider the general
model in which both tunneling and propping may occur in
equilibrium. Second, we analyze a special case with tunneling
only, where propping is ruled out by assumption.
4.1. Tunneling and propping
First suppose that propping is feasible and efficient in
both the horizontal structure and the pyramidal structure,
i.e.,21
n 
o 22
P
F 6 min apA ; bH p
prop B ; sp A ; b pB :
In order to derive the optimal ownership structure we com-
pare the family’s payoffs under the two structures.
20
The condition for the family’s expected revenues with firm B to exceed
those without it can be written as ð2  q  ð1  qÞð1  lÞsÞpB  qF P I B :
21
We abstract from corner solutions in which the equilibrium value of b
does not satisfy the expressions for b as derived above.
2183
Proposition 1. In our model, if there is a strictly positive
parameters are such that propping will occur in case of
financial distress in both structures, then the pyramidal
structure can never be strictly preferred over the horizontal
structure.
Proof. See appendix. h
Propping may occur only when there is financial dis-
tress, which happens with probability q. Even then, if

F > minfapA ; bH p ; sp P
A ; b pB g there will not be
prop B
propping in both structures because it is not feasible or
not efficient in at least one setting. If instead propping
is feasible and  efficient in  both structures, that is if
F 6 minfapA ; bHprop pB ; spA ; bP pB g, then the pyramidal
structure is never the optimal ownership structure.
Although to the family propping up firm B is cheaper in
the pyramidal structure – since outside investors share in
the burden – to outside investors the main difference
between the two structures is the tunneling. They take this
into account in their investment decision and adjust their
willingness to pay for firm B’s shares accordingly (as sug-
gested by Bertrand et al., 2002, p. 146). From the family’s
point of view, this negative effect turns out to dominate,
and the pyramidal structure cannot yield higher payoffs
to the family than the horizontal structure does.
Now suppose that propping is not feasible in the hori-
zontal structure because the family’s cash flow from firm
A is insufficient, i.e., F > apA ,22 but is feasible as well as
efficient in the pyramidal structure, that is,
F 6 minfspA ; bP pB g.23
Proposition 2. In our model, if there is a strictly positive
probability that firm B will be in financial distress and
parameters are such that propping will occur in case of
financial distress in the pyramidal structure but not in the
horizontal structure, then the pyramidal structure can be
strictly preferred over the horizontal structure.
Proof. See appendix. h
In this case, the pyramidal structure yields a benefit
to outside investors: firm B can be saved from bank-
ruptcy. This acts as a kind of insurance, and investors
are willing to pay a premium for it. Rational outside
investors are willing to be expropriated to some extent
Alternatively, we could assume that propping in the horizontal
structure is feasible but not efficient from the point of view of the family,

i.e., bHprop pB < F 6 apA . However, to analyze this situation in detail we
would have to study corner solutions. We abstract from this.
23
Recall that we ignore propping with the family’s own funds in the
pyramidal structure. In a more general model where the family can use her
own funds the total amount available for propping is spA þ að1  sÞ
pA ¼ apA þ ð1  aÞspA . Clearly, this exceeds the amount available in the
horizontal structure, apA . Thus, in this more general model, whenever
propping is feasible in the horizontal structure, it is so too in the pyramidal
structure.
2184 Y.E. Riyanto, L.A. Toolsema / Journal of Banking & Finance 32 (2008) 2178–2187

via tunneling in exchange for a larger probability of  2s

PPmyopic ¼ 2apA þ að2  ð1  lÞsÞpB  aI B : ð9Þ
realizing positive returns from their investment in the 2
future. In that case, from the point of view of the
Comparing this payoff to that of the horizontal structure
controlling family, the pyramidal structure may indeed be
(with q ¼ 0), we can establish the following proposition.
optimal.
Proposition 4. In our model with tunneling only and without
4.2. Tunneling only financial distress ðq ¼ 0Þ, if investors are myopic and do not
take tunneling into account in their investment decision, then
The above analysis suggests that the possibility of prop- the pyramidal structure can be strictly preferred over the
ping is important in determining which structure is the horizontal structure.
optimal one. In order to verify this, we now consider a ver-
sion of our model in which propping is absent by assump-
Proof. See appendix. h
tion because firm B never faces financial distress (q ¼ 0)
and evaluate whether tunneling alone can provide a justifi- Thus, tunneling alone may lead to the pyramidal struc-
cation for pyramidal ownership. ture being optimal only if investors are myopic and do not
realize that there will be tunneling. Admittedly, in the
Proposition 3. In our model with tunneling only ðq ¼ 0Þ the
above analysis we have used an extreme assumption – that
pyramidal structure can never be strictly preferred over the
investors do not take tunneling into account at all ðs0 ¼ 0Þ.
horizontal structure.
It can, however, easily be verified that our result continues
to hold even if investors do realize that there will be tunnel-
Proof. See appendix. h ing, but underestimate the extent of it ð0 < s0 < sÞ.
This proposition shows that in our model tunneling can-
5. Discussion
not be the sole reason for the controlling family to choose
the pyramidal ownership structure. Again, this is due to the
Our model has several empirical implications which can
fact that rational outside investors of firm B anticipate that
be compared to the existing empirical literature or which
they will be expropriated through tunneling and adjust
can be tested in future research. For example, in construct-
their willingness to pay (5) for firm B’s shares. From the
ing the model, we argue that the controlling shareholder
point of view of the controlling family, this effect domi-
may tunnel resources out of a firm that has good perfor-
nates the benefit of tunneling, and the horizontal structure
mance and may instead prop up a firm that is having finan-
is preferred.
cial difficulty. This argument is in line with the recent
However, as we discussed in the introduction, there is
empirical evidence presented by Bertrand et al. (2002)
empirical evidence suggesting that outside investors do
and Cheung et al. (2006).
not fully anticipate the tunneling. If outside investors
Further, with the possibility of propping, the pyramidal
underestimate the extent of tunneling by the control-
structure is optimal only if the probability of financial dis-
ling family (i.e., if they use some s0 < s in their calcula-
tress q is sufficiently large. One can actually derive the crit-
tions) then under some conditions the pyramidal
ical value q of the probability of financial distress that will
structure may be optimal. To see this, consider the
make the controlling shareholder indifferent between the
following modification of the model. Suppose that inves-
pyramidal structure and the horizontal structure. This
tors are myopic. For simplicity, we assume that investors
model can be calibrated using actual data on ownership
completely ignore the possibility of tunneling, that is,
structure and related-party transactions.
they believe that the amount tunneled is s0 ¼ 0. We can
Also note the following. We have shown that the pyra-
rewrite the maximization problem of the controlling
midal structure can be optimal if outside investors of firm
family as
B are myopic and underestimate the extent of tunneling,
max 2apA þ 2abP pB þ aðl  bP ÞspB or if propping up firm B in the event of financial distress
bP
is feasible. An alternative explanation for the optimality
s:t: 2ð1  bP ÞpB P I B : of the pyramidal structure in this context could be the
failure of firm B’s outside investors to estimate the proba-
The value of bP that will make the financing constraint sat- bility of financial distress accurately, due to asymmetric
isfied with equality is information. For instance, if they overestimate the proba-
 IB bility of financial distress, they would be willing to pay
bPmyopic ¼ 1  : ð8Þ more for firm B’s shares in the pyramidal structure. Conse-
2pB
quently, this would make the pyramidal structure more
Using (8), equilibrium payoffs24 can be rewritten as attractive from the point of view of the controlling
shareholder.
24
The condition for the family’s expected revenues with firm B to exceed Next, we evaluate the relationship between the parame-
those without it can now be written as 2s2
ð2  ð1  lÞsÞpB P I B . ter s, which represents the ease with which funds can be
 Y.E. Riyanto, L.A. Toolsema / Journal of Banking & Finance 32 (2008) 2178–2187
moved around, and the relative desirability of the pyrami-
dal structure. First consider the point of view of firm B’s
outside investors. From our previous discussion we know
that with rational outside investors the pyramidal structure
may be optimal only if propping is not feasible or not effi-
cient in the horizontal structure. Hence, for the purpose of
our discussion here, we focus on this case. We know that in
H
equilibrium

the controlling shareholder will set b no prop and
bP to satisfy the financing constraint with equality. Conse-
quently, the value of the shares that outside investors of
firm B obtain will always be equal to I B , and outside inves-
tors earn zero which is the value of their outside option.
Outside investors’ incentive to invest in firm B is indepen-
dent of the value of s. Obviously the size of bP will depend
on s.25 In the pyramidal structure, when s is high, the value
of firm B’s shares will be relatively low because outside
investors anticipate that there will be tunneling. This
implies that the controlling shareholder will have to sell a
larger fraction of firm B’s shares to satisfy
the financing
constraint. There is a critical value of bP (and therefore
of s) that will make the controlling shareholder indifferent
between establishing a pyramidal structure and a horizon-
tal structure.
For the controlling shareholder, our model suggests an
inverted U-shape relationship between s and the attractive-
ness of the pyramidal structure. The attractiveness is highest
for intermediate values of s. This can be explained as fol-
lows. If both tunneling and propping are difficult (e.g.,
due to high transaction costs or strong legal protection),
the benefits of the pyramidal structure cannot be exploited.
However, if tunneling and propping are easy (e.g., low
transaction costs or weak legal protection), the benefits of
propping will be outweighed by the negative effect of tun-
neling on the willingness to pay of outside investors, and
consequently the horizontal structure may be preferred.
Only in intermediate cases the benefit of propping may out-
weigh the negative effect of tunneling, and the family may
prefer the pyramidal structure over the horizontal structure.
6. Conclusion
We have presented a formal model of tunneling and
propping that explains the existence of the pyramidal own-
ership structure. We defined tunneling as a transfer of
resources from a lower-level firm to a higher-level firm in
the pyramidal chain, and propping as a transfer of
resources in the opposite direction. In the model, a family
establishes a new firm either as a subsidiary of another firm
under her control, thereby forming a pyramidal ownership
structure, or as an independent firm, forming a horizontal
ownership structure.
We show that with tunneling alone, the pyramidal own-
ership cannot be optimal for the family because rational
25
More specifically, the value of s that will make bH

no prop ¼ b

P
is
q
s ¼ ð1qÞ .
2185
minority investors of the new firm will take the tunneling
into account in their investment decision and adjust their
willingness to pay for the firm’s shares accordingly. The
pyramidal ownership structure may be optimal in this case
if and only if investors are myopic and underestimate the
extent of tunneling.
With rational minority investors, the pyramidal structure
can only emerge in equilibrium if it has some additional
benefit over the horizontal structure. Our paper identifies
such a benefit in the form of intercorporate insurance in
case of financial distress. Suppose that the new, lower-level
firm B is in financial distress with some probability but can
be saved from bankruptcy when additional funds are
invested. In the horizontal structure the family can only
use her own share of the cash-flow of the old, higher-level
firm A for propping up firm B, whereas in the pyramidal
structure at can use the entire cash flow of firm A – unless
it is limited in doing so by some legal conditions protecting
minority investors, or transaction costs. Thus, at least for
some parameter values, the pyramidal structure may give
an insurance to outside investors against bankruptcy and
this may raise outside investors’ willingness to pay for firm
B’s shares to the extent that the pyramidal structure
becomes optimal from the family’s point of view.
Finally, note that both outside investors’ ability to ratio-
nally anticipate the extent of tunneling, legal protection,
and transaction costs have the same effect in discouraging
the controlling family to establishing a pyramidal owner-
ship structure. Ceteris paribus, the presence of more
sophisticated investors reduces outside investors’ willing-
ness to invest in the new firm and makes it more difficult
to obtain funds to cover the setup cost. Instead, stronger
legal protection of minority shareholders as well as transac-
tion costs limit the ability of the controlling family to tun-
nel funds and thereby reduce the expected future
profitability of the pyramidal ownership structure for the
controlling family.
Acknowledgements
The authors thank two anonymous referees, Yossi Spie-
gel, and participants of the FEMES 2004 (Seoul), EEA
2004 (Madrid), EARIE 2004 (Berlin), and APEA 2005 (To-
kyo) conferences, the workshop ‘The Role of Corporate
Crossholdings in Germany: Theory and Evidence’ (2005,
Deidesheim), and seminars at the National University of
Singapore and the University of Groningen for helpful
comments.
Appendix
Proof of Proposition 1
With propping in both structures, the pyramidal structure
is strictly preferred over the horizontal structure if and only
 
if D ¼ PP  PH prop > 0. Using (2) and (7) this can be
expressed as
2186 Y.E. Riyanto, L.A. Toolsema / Journal of Banking & Finance 32 (2008) 2178–2187

D ¼ ð1  aÞI B þ ð1  aÞqF  ð1  aÞð2  qÞpB 1 a a

ð2  qÞpB  qpB þ ð1  qÞð1  lÞspB þ qF
 að1  qÞð1  lÞspB > 0 1a 1a 1a
< 2ð1  qÞpB ;
or
a which can be rewritten as
ð2  qÞpB þ ð1  qÞð1  lÞspB  qF < I B :
1a ð1  qÞð1  lÞspB  qpB þ qF < 0: ð10Þ
For the family’s expected payoffs with firm B to exceed It can easily be verified that the condition for the first fea-
those without it we require the feasibility conditions sibility constraint to be more strict than the second reduces
to precisely this expression. That is, whenever the first fea-
ð2  qÞpB  qF P I B ; sibility condition is more strict, this expression holds true,
ð2  qÞpB  ð1  qÞð1  lÞspB  qF P I B : and this suggests that the pyramidal structure may
dominate.
Since the latter condition (for the pyramidal structure) is Second, assume that the second feasibility condition (for
stricter than the former (for the horizontal structure), we the pyramidal structure) is more restrictive. Then the
can focus on the latter. Thus, the pyramidal structure is pyramidal structure is strictly preferred over the horizontal
strictly preferred over the horizontal structure when both structure when both this condition and the condition D > 0
this condition and the condition D > 0 hold. For these hold. This requires
two conditions to be satisfied simultaneously we require
a 1 a a
ð2  qÞpB þ ð1  qÞð1  lÞspB  qF ð2  qÞpB  qpB þ ð1  qÞð1  lÞspB þ qF
1a 1a 1a 1a
< ð2  qÞpB  ð1  qÞð1  lÞspB  qF ; < ð2  qÞpB  ð1  qÞð1  lÞspB  qF ;

that is, a
1a
< 1. Since 0 < a < 1 this can never be which can be simplified into (10). Thus, if the second feasi-
satisfied. bility condition is more restrictive the pyramidal structure
can never be preferred over the horizontal structure.
Proof of Proposition 2 Combining, this suggests that the pyramidal structure
With propping in the pyramidal structure only, the pyrami- may dominate in this situation if and only if the first
dal structure is strictly preferred over the horizontal struc- feasibility condition is more restrictive than the second,
 
ture if and only if D ¼ PP  PH no prop > 0. Using (4) and (7)
that is, if (10) holds. Of course, before concluding that the
this can be expressed as pyramidal structure may indeed be optimal for some
parameter values, one should also check the conditions for
D ¼ ð1  aÞI B  qaF  ð1  aÞð2  qÞpB propping to occur in the pyramidal structure but not in the

þ qpB  að1  qÞð1  lÞspB > 0 horizontal structure, that is, apA < F 6 minfspA ; bP pB g.
We illustrate this by presenting a numerical example. Let
or l ¼ s ¼ 1, q ¼ 0:5, a ¼ 0:8, pA ¼ 7, pB ¼ 10, I B ¼ 4, and
1 a F ¼ 6. It can easily be verified that (10) is satisfied for these
ð2  qÞpB  qpB þ ð1  qÞð1  lÞspB parameter values, and so are the feasibility conditions and
1a 1a  

a the condition apA < F 6 minfspA ; bP pB g, where bP ¼ 0:6

þ qF < I B :
1a
For the family’s expected payoffs with firm B to exceed
those without it we require the feasibility conditions
2ð1  qÞpB P I B ;
ð2  qÞpB  ð1  qÞð1  lÞspB  qF P I B :
It is not clear beforehand which condition is more restric-
tive. Therefore, we consider two cases.
now. Finally, we have D ¼ 25 > 0. Thus, indeed, in this
example setting up firm B is feasible in either structure,
propping will occur only in the pyramidal structure, and
the pyramidal structure is optimal.
Proof of Proposition 3
With tunneling only ðq ¼ 0Þ, the pyramidal structure is
strictly preferred over the horizontal structure if and only
 

First suppose that the first feasibility condition (for the if D ¼ PP  PH no prop > 0, substituting q ¼ 0. Using (4)

horizontal structure) is more restrictive. In that case, for and (7) this can be expressed as
some parameter values setting up firm B is feasible only in D ¼ ð1  aÞI B  2ð1  aÞpB  að1  lÞspB > 0
the pyramidal structure, so the pyramidal structure is
or
clearly preferred. Now consider parameter values for which
the first feasibility condition is satisfied as well. Then the a
2pB þ ð1  lÞspB < I B :
pyramidal structure is strictly preferred over the horizontal 1a
structure when both this condition and the condition D > 0 For the family’s expected payoffs with firm B to exceed
hold. This requires those without it we require the feasibility conditions
 Y.E. Riyanto, L.A. Toolsema / Journal of Banking & Finance 32 (2008) 2178–2187 2187

2pB P I B ; condition D > 0 hold. For these two conditions to be satis-

ð2  ð1  lÞsÞpB P I B : fied simultaneously, we require
 
asl
Since the latter condition (for the pyramidal structure) is 2 1 pB < 2pB ;
2ð1  aÞ þ as
stricter than the former (for the horizontal structure), we asl
can focus on the latter. Thus, the pyramidal structure is that is 2ð1aÞþas > 0. This condition is satisfied for all feasi-
strictly preferred over the horizontal structure when both ble values of a, s, and l. Thus, the pyramidal structure is
this condition and the condition D > 0 hold. For these optimal for some parameter values.
two conditions to be satisfied simultaneously we require
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