In this paper we study the determinants of business groups' ownership structure using unique panel data on Korean chaebols. In particular, we attempt to understand how pyramids form over time. We find that chaebols grow vertically (that is, pyramidally) as the family uses well-established group firms ("central firms") to set up and acquire younger firms that have low profitability and high capital requirements. Chaebols grow horizontally (that is, using direct family ownership) when the family acquires firms that are highly profitable and require less capital. Our evidence suggests that the (previously documented) lower profitability of pyramidal firms is partly due to a selection effect (e.g., the family optimally places low profitability firms in pyramids). To show this, we examine instances of large changes in the ownership structure of group firms. Specifically, we find that poor past performance predicts an increase in the degree of pyramiding in a firm's ownership structure. Most compellingly, we find that the profitability of new group firms in the year before they are added to the group predicts whether they are added to pyramids or controlled directly by the family. We also examine the relative valuation of chaebol firms. We find that the group's central firms trade at a discount relative to other public group firms possibly due to the selection of low-profitability, high capital intensity firms into pyramids. Our results shed light on the process by which pyramids form, and provide new evidence on the performance and valuation of business group firms.
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