Cross shareholdings

What Are Cross Shareholdings?

Cross shareholdings refer to a reciprocal ownership arrangement where two or more companies hold shares in each other's capital. This interconnected web of ownership falls under the broad category of Corporate Finance, as it significantly impacts a company's capital structure, control, and strategic alliances. Unlike a typical investment where one entity holds equity in another for purely financial returns, cross shareholdings often serve to solidify business relationships, prevent hostile mergers and acquisitions, or foster long-term cooperation. Each company involved becomes a partial shareholder in the other, influencing their respective corporate governance structures.

History and Origin

The practice of cross shareholdings has historical roots in various global economies, most notably in post-World War II Japan and Germany. In Japan, the system became a cornerstone of the keiretsu business groups, which emerged after the dissolution of the pre-war zaibatsu industrial conglomerates. These networks of companies, often centered around a main bank and trading company, established mutual share ownership to promote stability, long-term collaboration, and defensive measures against outside influence. This arrangement provided a stable base of equity for companies to rebuild and grow, shielding management from short-term market pressures and potential hostile takeovers. By the late 1980s, over half of the value in the Japanese stock market reportedly consisted of such cross-shareholdings.⁵ The Federal Reserve Bank of San Francisco noted that the formation of new industrial groups, known as keiretsu, around the six largest city banks in Japan led to these banks typically providing significant loans and holding shares in member companies.⁴

Key Takeaways

• Cross shareholdings involve two or more companies owning stakes in each other.
• This arrangement is often used to establish strategic alliances, foster cooperation, and deter hostile takeovers.
• The practice can lead to complex valuation challenges due to potential double-counting of equity.
• Critics argue cross shareholdings may hinder effective corporate governance and reduce managerial accountability.
• Regulatory reforms, particularly in Japan, have sought to encourage the unwinding of cross shareholdings due to concerns over capital efficiency and market transparency.

Formula and Calculation

Cross shareholdings do not typically involve a specific universal formula for direct calculation, as they represent an ownership structure rather than a singular financial metric. However, their impact is often quantified in terms of the percentage of outstanding shares held by partner companies.

For a bilateral cross-shareholding between Company A and Company B:

Percentage of Company A held by Company B = (\frac{\text{Number of shares of A held by B}}{\text{Total outstanding shares of A}} \times 100%)

Percentage of Company B held by Company A = (\frac{\text{Number of shares of B held by A}}{\text{Total outstanding shares of B}} \times 100%)

These percentages are crucial for understanding the extent of mutual control and influence through voting rights and for purposes like consolidation in financial reporting.

Interpreting Cross Shareholdings

Interpreting cross shareholdings requires understanding the strategic intent behind the arrangements. While they can foster long-term stability and collaboration, they can also obscure true ownership and control. For instance, a significant cross-holding percentage can effectively make a company "takeover-proof" by concentrating control among friendly parties. However, this can also reduce market discipline and potentially lead to less efficient capital allocation.

Analysts examining financial statements must account for cross shareholdings to avoid distortions, particularly in valuing a company's true market capitalization. The presence of extensive cross shareholdings can indicate a focus on relationship-based business models rather than pure shareholder value maximization, often seen in economies with strong group affiliations. Understanding these complex relationships is vital for assessing a company's actual financial health and its susceptibility to external pressures.

Hypothetical Example

Consider two hypothetical companies, TechInnovate Inc. and FutureWorks Ltd. TechInnovate holds 10% of FutureWorks' outstanding shares, and FutureWorks, in turn, holds 8% of TechInnovate's outstanding shares. This creates a reciprocal cross-shareholding arrangement.

1. TechInnovate's Holding: If FutureWorks has 100 million shares outstanding, TechInnovate owns 10 million shares (10% of 100 million).
2. FutureWorks' Holding: If TechInnovate has 80 million shares outstanding, FutureWorks owns 6.4 million shares (8% of 80 million).

This arrangement signifies that each company has a vested interest in the other's success. TechInnovate, as a part-owner of FutureWorks, might share resources or technology to enhance FutureWorks' product development. Similarly, FutureWorks might offer preferential supply chain terms to TechInnovate. This mutual stake also acts as a deterrent against either company being easily acquired by a third party, as the cross-held shares represent a significant block that would likely resist such a move. The arrangement aims to deepen their strategic partnership rather than simply seeking short-term capital gains on the asset.

Practical Applications

Cross shareholdings appear in various real-world contexts, primarily as tools for strategic alliance and corporate defense.

• Strategic Alliances: Companies use cross shareholdings to formalize and strengthen long-term business relationships. For example, a supplier might hold shares in a key customer, and vice versa, to ensure stable demand and supply, fostering mutual trust and cooperation.
• Corporate Control and Defense: In some markets, cross shareholdings serve as a powerful defense mechanism against hostile takeovers. By having friendly entities own significant portions of their shares, companies can deter unwanted acquisition attempts. This creates a stable ownership base, insulating management from short-term investor pressures. The Research Institute of Economy, Trade and Industry (RIETI) highlighted how cross-holding relationships initially developed as a countermeasure against accumulation of shares and hostile bids following the postwar dissolution of zaibatsu conglomerates in Japan.³
• Group Affiliations: Historically prominent in economies like Japan (with keiretsu) and Germany, these arrangements bind groups of companies together, often including banks, manufacturers, and trading firms. This interconnectedness allows for internal resource allocation, risk sharing, and coordinated business strategies across the group.
• Regulatory Scrutiny: Regulatory bodies, like Japan's Financial Services Agency (FSA), increasingly require companies to disclose and justify their cross-shareholding policies. This push for transparency aims to address concerns about capital efficiency and potential conflicts of interest. The FSA has emphasized that the board should annually assess whether or not to hold each individual cross-shareholding, specifically examining whether the purpose is appropriate and whether the benefits and risks cover the company's cost of capital.²

Limitations and Criticisms

Despite their intended benefits, cross shareholdings face significant limitations and criticisms:

• Lack of Accountability and Transparency: Critics argue that cross shareholdings can entrench existing management by insulating them from external market pressures and shareholder activism. When a company's shares are primarily held by friendly partners rather than independent investors, there may be reduced pressure to maximize shareholder value or improve performance. This can lead to a lack of accountability and transparency in decision-making.
• Inefficient Capital Allocation: Holding shares in partner companies ties up capital that could otherwise be invested in growth opportunities or returned to shareholders. This can lead to lower returns on equity and overall inefficiency. Research from the London School of Economics (LSE) points out that in the 1990s, cross-held shares became "non-performing assets" for financial institutions during recessions, highlighting their unprofitability and burden.¹
• Conflicts of Interest: When companies hold shares in each other, potential conflicts of interest can arise, particularly for board members. Decisions might prioritize the interests of the cross-holding partners over the broader interests of all shareholders, leading to suboptimal outcomes.
• Reduced Liquidity: Shares held through cross-shareholding arrangements are often illiquid, as they are not intended for active trading. This can restrict a company's financial flexibility and its ability to divest assets quickly if needed, impacting its overall liquidity and potentially leading to a significant liability during market downturns.
• Valuation Challenges: The reciprocal nature of cross shareholdings can complicate financial analysis and valuation. Double-counting of equity can occur, making it difficult to accurately assess the true value of the companies involved.

Cross Shareholdings vs. Joint Venture

While both cross shareholdings and joint ventures involve shared ownership and collaboration between companies, their primary nature and scope differ.

Cross Shareholdings typically involve companies holding minority stakes in each other, often across different industries or within a broader corporate group (like keiretsu). The main purpose is usually to solidify long-term strategic alliances, ensure stable business relationships, and act as a defensive measure against takeovers. The shared ownership is generally a passive investment or a means to an end (relationship stability) rather than a direct operational partnership for a specific project. The companies retain their independent legal identities and operational autonomy for their core businesses.

A Joint Venture, on the other hand, is a specific business arrangement where two or more parties agree to pool resources for a particular, often time-limited, project or business undertaking. They create a new, separate legal entity (or a contractual agreement) to carry out this specific objective. The ownership in a joint venture is usually more substantial and active, with partners directly contributing capital, expertise, and other resources to the new entity. The focus is on shared operations and risks for a defined common goal, with profits and losses shared according to the agreement.

The confusion arises because both involve shared equity. However, cross shareholdings are more about mutual corporate influence and relationship stability between existing entities, whereas joint ventures are about co-creating and co-managing a new, distinct business endeavor.

FAQs

What is the main purpose of cross shareholdings?

The main purposes of cross shareholdings are to strengthen business relationships, foster long-term cooperation between companies, and act as a defense against hostile takeovers by creating a network of friendly shareholders.

Are cross shareholdings common in the United States?

While not as prevalent or structured as in Japan's historical keiretsu system, some forms of mutual minority investments or strategic alliances with equity stakes can occur in the United States. However, U.S. corporate governance and market structures generally favor more dispersed ownership and direct shareholder accountability.

How do cross shareholdings affect corporate control?

Cross shareholdings can significantly affect corporate control by creating a stable block of friendly owners. This can insulate management from external pressures, reduce the risk of hostile takeovers, and allow for more long-term strategic planning, but it may also diminish the influence of other independent shareholders.

Do cross shareholdings impact a company's valuation?

Yes, cross shareholdings can complicate a company's valuation. Analysts must carefully adjust for these reciprocal holdings to avoid double-counting the value of equity and to accurately assess the true financial position and performance of the companies involved.

Why are some countries unwinding cross shareholdings?

Countries like Japan have seen a trend of unwinding cross shareholdings due to concerns about their impact on corporate governance, capital efficiency, and market transparency. Regulators and investors increasingly advocate for a more market-driven approach that prioritizes shareholder returns and discourages inefficient asset allocation.