Pyramidal Discounts：Tunneling or Overinvestment？.pdf

International Review of Finance, 9:1–2, 2009: pp. 133–175 DOI: 10.1111/j.1468-2443.2009.01088.x Pyramidal Discounts: Tunneling or Overinvestment?n ´ w ¨ ¼ MARTIN HOLMEN AND PETER HoGFELDT wDepartment of Economics, Uppsala University, Uppsala, Sweden and ¼Department of Finance, Stockholm School of Economics, Stockholm, Sweden ABSTRACT Swedish families exploit the strong separation between ownership and control in pyramiding to establish control over several firms’ internal cash flows via a very small capital investment. We establish that the discounts on the portfolio firms at the bottom of the pyramid as well as pyramid holding company are directly linked to costs from overinvestment that increase with the separation between ownership and control. In a financially developed economy where pyramids are transparent and the tax system regulates the flow of dividends within the pyramid and to shareholders, the primary cause of the discounts is not tunneling but overinvestment costs. I. INTRODUCTION In this paper, we investigate the investment and financing behavior within Swedish pyramid structures. Swedish pyramids are transparent and usually consist of only three layers with a family at the top, a holding company in the middle, and portfolio firms at the bottom. Furthermore, the holding company typically has tax status as a closed-end investment funds (CEIFs), which means that (i) dividends received by the CEIF are tax exempt as long as they are redistributed to the shareholders of the CEIF and (ii) the CEIF’s realized capital gains are tax exempt if reinvested. The design of taxes implies that (i) families have limited