What Is an Internal Capital Market?

In the middle of the 20th century, a wave of mergers and mergers appeared in the United States, and a number of large enterprises and large groups also appeared. The emergence of these group-type enterprises has led to the emergence of internal capital markets. Because the capital of a group-type multi-sector enterprise needs to be circulated and allocated, each department can mobilize funds or finance funds from within each department. The competition between various departments to obtain funds is similar to the competition mechanism in the external market. However, the internal capital market can concentrate the cash flows of multiple channels and invest in high-yield areas, making the internal capital market superior to the external capital market in terms of supervision, incentives, internal competition, and low-cost allocation of capital. Therefore, the capital flow and capital allocation formed within this enterprise is what we call the internal capital market of the enterprise.

Internal capital market

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In the middle of the 20th century, a wave of mergers and mergers appeared in the United States, and a number of large enterprises and large groups also appeared. The emergence of these group-type enterprises has led to the emergence of internal capital markets. Because the capital of a group-type multi-sector enterprise needs to be circulated and allocated, each department can mobilize funds or finance funds from within each department. The competition between various departments to obtain funds is similar to the competition mechanism in the external market. However, the internal capital market can concentrate the cash flows of multiple channels and invest in high-yield areas, making the internal capital market superior to the external capital market in terms of supervision, incentives, internal competition, and low-cost allocation of capital. Therefore, the capital flow and capital allocation formed within this enterprise is what we call the internal capital market of the enterprise.

Chinese name

Internal capital market

Phenomenon

A wave of mergers and mergers

Ring

Two

Question

Incentives that plague external capital markets, etc.

Generally speaking, a complete capital allocation process can be abstractly described as the following two links: the first link, social capital allocates capital to enterprises of various organizational forms through the credit market and the securities market; the second link Enterprises with different organizational forms allocate capital to various branches or subsidiaries, and use them to allocate capital to different investment projects. The so-called "first link" is the external capital market; the "second link" is the internal capital market. In the internal capital market, the investor, the corporate headquarters, is the owner of the assets of the fund-using department and owns the ownership, while the investors of the external capital market are not the owners of the assets of the fund-using department. More precisely, the former has a residual claim, while the latter does not. Because of this essential difference, internal capital markets and external capital markets have different effects on corporate information transmission, supervision, and incentives, thereby avoiding the disclosure of investment projects in external capital markets and the problems that plague external capital markets. Motivation and other issues.

The initial cause of the internal capital market is due to the failure of the traditional capital market. The failure is due to the asymmetry of information in the external capital market and the problem of agents, resulting in inefficient resource allocation. Companies rely on internal financing instead. The internal capital market makes up for the limitations of the external capital market. Its essence is an alternative to market organization by enterprise groups.

1. Optimize headquarters supervision and reduce department manager incentives. The corporate headquarters is the owner of the assets. Owning ownership of the assets of each project can get greater benefits from supervision, and the higher the level of hard work the headquarters puts into supervision, the greater the benefits. In this way, even if the internal and external funders have the same supervision capabilities, the internal funders will choose stricter supervision. However, it should be noted that this kind of supervision is not endless. Because supervision has a cost, it is necessary to consider the issue of the optimal level of supervision. In contrast, external investors can only obtain investment income based on pre-contracted contracts, but not from providing supervision, so the supervision's enthusiasm is greatly reduced. In addition, ICM reduces the incentives of department managers because they have no residual control and their interests are easily affected by the speculative actions of the company's headquarters to obtain revenue.

2. Control information processing costs and improve efficiency. Headquarters has authority over subordinate departments and can directly audit them, including book records and document records. Compared with external investors, the truthfulness of their access to information is greatly improved. Although fraud cannot be absolutely avoided, the headquarters uses far more methods to identify the authenticity of information than external investors, and the costs are correspondingly reduced. Communication between ICM departments will also increase, and information disclosure is regarded as collective cooperation, while disclosure of internal information outside the collective is considered betrayal. These are all relative to external capital markets. Advantages in information processing costs.

3. Improve the efficiency of resource allocation within the enterprise. When the company headquarters has multiple related business units or multiple competing projects, ICM has certain advantages. The main responsibility of the headquarters is to allocate quantitative resources, that is, to select the optimal project among many competitive projects and to invest limited resources in these projects in order to maximize the overall profit of the enterprise. Therefore, when the headquarters decides to invest in a project, not only the absolute advantages of the project itself, but also the more important thing is to consider the comparative advantages of the project compared to other projects in the company's overall investment portfolio. On the contrary, the benefits of external funders are already stipulated in the contract, and they do not have the residual claim right after the fact. Therefore, under the condition of a fixed amount of resources, external funders can only reduce the investment for those projects with high risks but poor returns. Way to ensure that the benefits agreed beforehand will not decrease. In this way, the investment level of external investors depends on the absolute characteristics of the project, not the relative characteristics.

The internal capital market has the advantages of reducing transaction costs, conducting effective supervision, optimizing capital allocation, and relaxing external financing constraints, as explained below.

(1) Internal capital market information advantage: Investment and financing in the external capital market, due to the existence of information asymmetry, companies must bear higher transaction costs and face greater risks. The internal capital market shows its advantages in these two aspects. In the internal capital market, the headquarters and the departments belong to the same big family. The information obtained is more real and the cost is less. Company managers and department managers have access to sufficiently cheap information, and headquarters can coordinate the collective cooperation of various departments.

(2) Internal capital market supervision and incentives: The headquarters (group company) has residual claim and control rights. The headquarters has greater motivation and power to select outstanding projects than banks (banks are the main providers of funds on the external capital market). As a result of this advantage, the more efforts the headquarters has made in supervision, the greater its benefits, so it will choose stricter supervision. Of course, because supervision also has costs, this supervision is not endless supervision, but to find the optimal level of supervision at the point where the marginal benefit of supervision equals the marginal cost. In the external capital market, the investor obtains investment income according to the prior contract, and cannot obtain additional income from supervision, so even if he has the ability to monitor, he will not pay 100% of the effort.

(3) Advantages in resource allocation: First, the internal capital market's headquarters income comes from the surplus of the project. The headquarters will leave the cash inside the company for unified deployment, and invest limited resources on projects with high investment returns. To maximize the overall profit of the enterprise. Second, internal capital markets are conducive to better reallocation of corporate assets. When the company's headquarters has multiple related business units, if a department performs poorly, its assets will be effectively reconfigured due to poor performance and well-run projects financed by an owner (directly controlled by the company's headquarters). Consolidation of other assets). On the contrary, external funders can only sell assets to other users, and often cannot get full payment; because external investors must share the surplus with the manager of the poor project. Finally, in the internal capital market, the headquarters investment in the project is carried out in multiple phases. During the project development process, capital income does not automatically flow to its production department, but is redistributed by the headquarters through internal competition. The standard for allocation is funds Return on investment. This method greatly improves the efficiency of the use of funds.

Disadvantages of internal capital markets

(1) Cross-sectoral subsidies (internal "socialism") projects. After analyzing the data from 1986 to 1991, Berger and Ofek found that diversified companies often overinvest in sectors with poor returns, and that the "subsidy" of funds in such sectors is the main reason for the decline in company value. Extensive research by scholars also supports this cross-industry subsidy hypothesis. The internal capital flow of the company is more from investment opportunities, the department with a positive net present value flows to the department with less investment opportunities, and the department with a negative net present value is negative, thereby damaging the company's overall value.

(2) In terms of resource allocation, the internal capital market. There are two negative effects: on the one hand, because senior managers have the right to flexibly allocate resources, they may overinvest for personal personal gain; on the other hand, diversified companies consume large amounts of resources in order to strengthen their competitiveness.

(3) Internal agency tendency. Enterprise groups have multiple operating units (that is, multiple departments), and company managers and department managers can generate agency problems. This agency problem often causes inefficiency in the internal capital market. The performance is: the headquarters concentrates the resources of each branch and then invests in high-yield projects. This can increase the overall revenue of the group, but it affects the efficiency of the managers of each branch. power. In order to improve their reputation, department managers will spend more time and energy on external public relations activities. These rent-seeking behaviors will inevitably distort resource allocation, and the extension of the internal agency chain will lead to poor internal information and distorted information.

The essential difference between the internal capital market and the external capital market is that on the internal capital market, the corporate headquarters has different branches of operations and allocates capital for all projects within the enterprise, and has residual control and claim rights on the use of corporate resources; In the external capital market, external investors do not own the enterprises or projects that it provides financing, and the remaining control and claim rights of the project are owned by the managers. It is this difference that has led to the internal capital market relieving the friction between the external capital market and the enterprise by virtue of the organizational authority of the headquarters. In other words, the internal capital market of the enterprise has great advantages over the external capital market in terms of information processing, supervision and incentives, and resource allocation methods, thereby avoiding the disclosure of investment projects in the external capital market and distressing external capital The market's cheering and other issues.

Enlightenment of Internal Capital Market on China's Reform and Development

In the process of China's transition to a market economy, the external capital market is still underdeveloped, and enterprises are still subject to strong capital constraints in the process of obtaining external capital market financing. In this case, the significance of the internal capital market's ability to effectively reallocate limited resources between projects is even more significant. Because external capital markets are still immature in accounting and auditing, managers can easily obtain private benefits from projects. According to this situation, external investors will not provide sufficient financing for the project, making it difficult for companies in a single sector to attract optimal levels of financing, so that the internal capital market can potentially play a very important role. For example, in the internal market of a company, the headquarters also supervises and manages the funds of a long-established "big chimney" factory and several high-tech, innovative high-net present value development projects. From the standpoint of an independent project, the big chimney plant has ample cash flow and added value and is capable of substantial reinvestment. At the same time, the company's resources are generally scarce. It may be more effective to transfer these funds to more innovative development projects, but because these development projects cannot rely on their own strength to raise sufficient funds from external capital markets. In this case, the role of the headquarters in allocating resources is very important. In contrast, external investors cannot make Coase arrangements for the allocation of resources within the enterprise. Of course, with the development of external capital markets and the further improvement and maturity of accounting, auditing and information disclosure mechanisms, the comparative advantage of internal capital markets will gradually weaken.

In fact, China's reform itself provides a theoretical basis for the formation of the internal capital market of the enterprise. If we consider the complete planned economy system as a system without an external capital market. Then the functions of the external capital market are all internalized. The completely internalized arrangement is obviously uneconomical, which has been effectively confirmed in the process of China's economic development. With the deepening of the reform, after the external capital market is separated, the enterprise will have a vacuum period of the internal capital market. At this time, there is a serious problem of information and incentive friction between the enterprise and the external capital market. The internal capital market of a company to solve its problems with the external capital market. Therefore, from the perspective of the internal capital market theory of enterprises, China's current corporate mergers and reorganizations are the only way to reform.

However, in the process of establishing the internal capital market of an enterprise, that is, the process of mergers and reorganizations between enterprises, there is a serious phenomenon of "internal control". It is extremely easy for operators to damage the state and shareholders through mergers. In the current external environment of state-owned enterprises (the external capital market is incomplete and does not have the function to correctly evaluate the value of the enterprise), there is no personal cost for the operator. The cost of the "commercial trial" is mainly provided by the state, and the possibility of bad mergers between enterprises is relatively high. Therefore, the main problem existing in mergers and reorganizations between enterprises at present and in the future is the lack of effective restraint mechanisms, and how to establish effective restraint mechanisms becomes particularly important. The fundamental constraint mechanism comes from the improvement of the external capital market. In addition to the constraints of some non-economic factors such as internal incentives and information asymmetry, the internal capital market of an enterprise also develops because of external capital markets. It has a fundamental constraint. In theory, there is a reasonable boundary between the internal capital market and the external capital market. Due to the competitive nature of the market mechanism, when the marginal efficiency of the internal capital market drops to a certain degree, the external capital market will take its place. The internal capital market and the external capital market are interdependent, mutually restrictive, and mutually substitutable. During the period of economic transition, the two have sought a reasonable boundary after a long-term adjustment. Therefore, the development and improvement of external capital markets, including direct and indirect financing markets, is a key factor in the success of state-owned enterprise reform from the perspective of internal and external capital market theories.

After an enterprise establishes an internal capital market through mergers and reorganizations, the headquarters can effectively leverage its advantages in internal resource allocation and optimize resource allocation. According to the formation and characteristics of the internal capital market of an enterprise, the development and improvement of the external capital market should be based on increasing the probability of enterprises reviewing investment projects and reducing their review costs, developing and promoting the improvement of auditing and accounting technologies, and establishing effective information disclosure mechanisms. aims. Due to the imperfect external capital market of enterprises and the fact that there is a "internal person control" phenomenon in Chinese enterprises. Early research on the characteristics of the internal capital market of Chinese enterprises, the interaction between internal capital markets and external capital markets, and the relationship between internal capital markets and the types of enterprises, and establish effective constraints and supervision mechanisms. Avoid inappropriate intervention in the formation of internal capital markets. This is of great significance for the transformation of enterprise mechanisms.