Corporate diversification theory and evidence

James Campbell

2022-04-05 17:39:00 Tue ET

Corporate diversification theory and evidence

A recent strand of corporate diversification literature spans at least three generations. The first generation suggests that corporate diversification typically erodes firm value. The entire firm value is less than the sum of the imputed values of different segments. The diversification discount is 12%-15% of Tobin’s q (e.g. Lang and Stulz (1994) and Berger and Ofek (1995)). Also, the second generation suggests that the diversification discount is at least partly attributable to the use of anti-takeover provisions, which insulate incumbents from the direct influence of hostile takeovers and hence result in poor corporate governance (Hoechle, Schmid, Walter, and Yermack, 2012). Finally, the third generation sheds fresh light on the role of internal capital markets that help transfer valuable capital from one division to another division within the same enterprise (e.g. Duchin (2010) and Duchin and Sosyura (2013)). Both the bright and dark sides of internal capital markets warrant attention from corporate decision-makers.

 

Is there a corporate diversification discount?

Lang and Stulz (1994) empirically find that corporate diversification erodes firm value. The typical firm decides to diversify into some other industry segments when there are few internal investment growth opportunities. On average, the firm diversification discount is about 12%-15% of Tobin’s q. Furthermore, Berger and Ofek (1995) report that the diversification discount is much smaller when this diversification occurs in somewhat related industry segments at the 2-digit SIC codes. Also, overinvestment and cross-subsidization contribute to the loss of firm value that arises from corporate diversification.

More recent empirical studies suggest that firm diversification occurs endogenously in response to both corporate value and governance (Campa and Kedia, 2002; Graham, Lemmon, and Wolf, 2002; Villalonga, 2004). Valid instruments are the lags of firm performance, corporate governance, and several other firm attributes (Wintoki, Linck, and Netter, 2012). In the special case of both international and U.S. financial conglomerates, Laeven and Levine (2007) and Schmid and Walter (2009) empirically find an increase in the diversification discount when the econometrician uses the Heckman (1979) sample selection model to account for any self-selection bias that may arise from corporate diversification.

 

What can help explain the corporate diversification discount? 

Hoechle, Schmid, Walter, and Yermack (2012) investigate whether the diversification discount occurs as an artifact of poor corporate governance. A number of dynamic panel regressions adequately control for potential endogeneity of the typical firm’s diversification decision. The diversification discount shrinks by a full order of magnitude with the addition of governance variables such as anti-takeover provisions to the dynamic panel regressions. Differences in the quality of corporate governance across conglomerate firms can help explain at least part of the negative nexus between firm value and corporate diversification. Specifically, Hoechle, Schmid, Walter, and Yermack’s (2012) baseline panel regression model suggests that the diversification discount decreases from 15%-17% to about 13% when the econometrician adds a plethora of corporate governance variables such as institutional ownership, CEO stock ownership and its square, CEO power, and G-index of anti-takeover provisions to the panel regressions of excess value multiples to total sales or total assets with firm-specific fixed effects. If poorly governed firms often tend to diversify, perhaps through mergers, acquisitions, and overinvestments in somewhat unrelated industry segments, then the diversification discount could be the symptom of a larger problem in the fundamental context of corporate governance.

Hoechle, Schmid, Walter, and Yermack (2012) follow Campa and Kedia’s (2002) treatment of potential endogeneity by implementing the Heckman (1979) sample selection model to reassess the diversification discount. The Heckman method involves a two-step procedure that uses a probit model for the subsequent analysis of discount determinants. The econometrician first estimates the firm’s propensity to diversify with a probit model via quasi-maximum likelihood estimation. The inverse Mills ratio can be computed as the hazard rate of the probability density function (pdf) to the cumulative density function (cdf) from the first-step probit estimation. In turn, this ratio serves as an auxiliary explanatory variable in the second-step regression of excess firm value on a unique set of firm attributes. The resultant parameters would be consistent with the true counterparts (Heckman, 1979).

A firm’s current actions affect its future corporate governance and firm performance, the latter of which then affects the firm’s future actions (e.g. Hermalin and Weisbach (2004) and Wintoki, Linck, and Netter (2012)). In order to address the dynamic endogeneity issue, Hoechle, Schmid, Walter, and Yermack (2012) run the GMM panel regression model that corresponds to a dynamic system of simultaneous equations. The first step involves the inclusion of performance lags as explanatory variables in the dynamic model. The econometrician first-differences each factor to remove any unobservable heterogeneity and omitted-variables bias. Then the econometrician estimates the GMM panel regression model with the use of lags of the diversification, governance, and performance variables as well as some other firm characteristics as exogenous instruments.

While the Heckman (1979) sample selection model suggests that the diversification discount vanishes as a result of adding corporate governance variables to the set of explanatory variables, the dynamic GMM panel regressions produce a smaller but still significant diversification discount. Specifically, the GMM estimate of diversification discount decreases from 12% (t-ratio>2) to 7.6% (t-ratio<2) with the addition of corporate governance variables. Overall, poor corporate governance helps explain at least part of the corporate diversification discount.

Masulis, Wang, and Xie’s (2007) event study suggests that merger announcement returns are significantly lower for acquirers with poor corporate governance structures (e.g. more anti-takeover provisions in the market for corporate control). Specifically, acquirers with more anti-takeover provisions or joint CEO-chairman positions experience significantly lower merger-announcement cumulative abnormal returns. In order to evaluate whether the diversification discount decreases with better corporate governance in merger and acquisition announcements, Hoechle, Schmid, Walter, and Yermack (2012) add the same set of governance variables plus the diversification dummy variable to the panel regressions of post-merger announcement cumulative abnormal returns within short time windows. The main evidence suggests that the negative cumulative abnormal return for corporate diversification decreases from nearly 1.2%-1.6% (t-ratio>2) to 0.3%-0.6% (t-ratio<2). This event study echoes the overarching thesis of the dynamic panel regression results that poor corporate governance helps explain at least part of the diversification discount.

 

What are the bright and dark sides of internal capital markets? 

A major implication of corporate diversification pertains to the precautionary demand for cash retention. According to the precautionary cash demand story (Keynes, 1936), firms hold cash to protect themselves against adverse cash flow shocks that might force these firms to forego valuable investment opportunities due to costly external finance. Some recent empirical studies of structural shifts in corporate cash reserves lend credence to the central thesis that firms increasingly hold cash for a precautionary motive while the median firm’s net debt (i.e. total debt minus cash) is below zero (Opler, Pinkowitz, Stulz, and Williamson, 1999; Almeida, Campello, and Weisbach, 2004; Bates, Kahle, and Stulz, 2009).

Well-diversified firms exhibit lower cross-divisional correlations in investment opportunities and smaller financing deficits (Duchin, 2010). These well-diversified firms enjoy the benefit of coinsurance, which reduces their exposure to risk and allows them to hold lower amounts of precautionary cash in contrast to their standalone counterparts. Multi-divisional firms hold approximately half as much cash as highly specialized firms do. The difference is largely due to corporate diversification in investment opportunities and cash flows. Well-diversified firms hold low precautionary cash balances, which in turn reflect sound governance and efficient fund transfer within these firms.

Duchin and Sosyura (2013) draw a clear distinction between the bright and dark sides of internal capital markets. The bright-side view posits that internal capital markets benefit from stronger control rights and fewer information asymmetries across intra-firm divisions while this benefit in turn enables the CEO to make better fund allocation decisions (e.g. Naveen and Tice (2001) and Maksimovic and Phillips (2002)). In contrast, the dark-side view suggests that internal capital markets suffer from the agency motives of both divisional managers and the CEO who might prefer to pursue their private interests (Scharfstein and Stein, 2000; Rajan, Servaes, and Zingales, 2000; Ozbas and Scharfstein, 2009). The relative importance of divisional managers garners practical support from the survey evidence of Graham, Harvey, and Puri (2015) who report that the CEO’s opinion of a divisional manager is the second most important factor in internal capital allocation after the net present value rule.

Duchin and Sosyura (2013) offer evidence on the watershed between the bright and dark sides of internal capital markets by constructing a hand-collected dataset of divisional managers at S&P 500 firms with managerial attributes and connections to the CEO on capital allocation decisions. In particular, Duchin and Sosyura (2013) evaluate the involvement of divisional managers in the firm via various channels, ranging from formal board membership and seniority to informal social connections to the CEO via prior employment, educational institutions, and non-profit organizations. The evidence suggests that divisional managers with social connections to the CEO receive more capital after the econometrician controls for divisional size, performance, proxies for investment opportunities, and other characteristics. One social connection between a divisional manager and the CEO correlates with 7.2% greater capital allocation to his or her division or about $4.2 million in annual expenditure in a division with median characteristics.

At well-governed firms with high information asymmetries, where divisional managers are likely to have valuable information about investment opportunities, social connections between the CEO and divisional managers significantly correlate with better investment efficiency and firm valuation. In contrast, at firms with poor governance, which are more prone to agency-driven favoritism, managerial connections to the CEO are negatively related to investment efficiency and firm value. Duchin and Sosyura’s (2013) study draws a clear empirical distinction between the bright and dark sides of internal capital markets. In this light, corporate diversification results in some costs and benefits that must be weighed against managerial connections to the CEO in different contexts.

 

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