Exploitation of the internal capital market and the avoidance of outside monitoring

- Conglomerates operating inefficient internal capital markets avoid external markets.
- Value-destroying conglomerates' bond yield spreads are 46 basis points higher.
- Value-destroying conglomerates' syndicated loan yields are 18 basis points higher.
- Value-destroying conglomerates' SEO announcement returns are 1% more negative.

Internal capital markets (ICMs) provide firms an alternative to costly external financing; however, they also provide an avenue to avoid the monitoring associated with issuing external capital. We argue that firms operating inefficient internal capital markets will avoid outside financing. Consistent with this view, conglomerates that cross-subsidize divisions or engage in value-destroying investment avoid external capital market oversight by refraining from issuing both debt and equity. We further show that firms issuing bonds while engaging in value-destroying investment experience yield spreads that are, on average, 46 basis points higher than those of other diversified firms. They similarly experience yield spreads that are 18 basis points higher when they issue syndicated loans. Value-destroying conglomerates also witness SEO announcement returns that are, on average, 1% more negative than firms operating more efficient internal capital markets.