Diversification

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Diversification Chapter 5
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Diversification occurs when a firm broadens the
scope of its activities in a horizontal direction
Related diversification
Unrelated diversification Conglomerate
Understanding Diversification
Limited theoretical framework for systematically
analyzing diversification
Understanding based more on observation than hard
analysis
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Six Major Merger Waves
Mid-1880s to about 1900
Rise of trust and holding companies, eventually
resulted in the Sherman Anti-trust Act.
Post World War I
Most merger activity was in the form of vertical
integration. Birth of the U.S. vertically
integrated corporation as the corporate model.
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Six Major Merger Waves
The 1960s
Increase in the number of diversified companies
(conglomerates). Growth through acquisition
easier than through internal financing.
Post 1980s
Increased rise of conglomerates. Bargain
hunting and hostile take-overs. Creation of
junk bonds created a great deal of liquidity.
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Six Major Merger Waves
The 1993-2000
Mega-mergers Exxon-Mobil, Chrysler-Daimler,
AOL-Time Warner. This wave was predicated on the
belief that size matters.
2000 until 2008?
Mergers encouraged by globalization, desire of
countries to create strong global champions,
availability of low-cost funds, hedge funds and
private equity.
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Reasons for Diversification
Economies of Scope
Financial Synergies
Economizing on Transaction Costs
Pursuit of Managerial Objectives
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Economies of Scale and Scope
Producing or selling similar products and services
Selling in similar markets
Dominant general management logic/ core
management competencies
Most research provides modest support for the
importance of economies of scope in
diversification
Probably more related to limitations of data and
difficulty in measuring scope than an indication
of non-importance economies of scope
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Financial Synergies
Main argument is that diversified growth is
necessary for stable growth and access to
consistent cash flow
Firm as a banker- internal capital markets?
Incomplete information in financial markets
Difficulties in acquiring debt
External finance and monitoring of managers
Winners Curse
Difficulties in identifying undervalued firms
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Economizing on Transaction Costs
Some argue that diversification is an efficient
organizational alternative to independent firms
in the presence of transaction costs and hold-up
Problems with this argument include
Influence costs (capital markets versus internal
allocation of resources)
Incentive effects (management control and
sub-goal pursuit)
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Managerial Reasons for Diversification
Pursuit of managerial goals rather than
shareholder objectives
Large but uncertain literature on the importance
of this influence on diversification
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Benefits to Managers from Acquisitions
Managers may enjoy running larger firms
Potential to increase compensation
Shield against risk
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The Market for Corporate Control
Corporate control is a valuable asset that exists
independently of economies of scale or scope
Provides a disciplining mechanism on corporate
management
Incentive for corporate-raiders and hostile
take-overs
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Performance of Diversified Firms
Ultimately, diversity can only be worthwhile if
corporate management adds value in some way and
the test of a corporate strategy must be that the
businesses in the portfolio are worth more than
they would be under any other ownership -Goold
and Luchs (1993)
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The Bottom Line
The financial benefits of diversification are
unclear
There is no clear association between between
simple measures of diversity within a business
portfolio and overall corporate performance
Firms that diversify according to a core set of
resources tend to outperform those that do not
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The Big Picture
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Examples of conditions, mechanisms and managerial
transaction costs