Economics of Strategy Fifth Edition. Besanko, Dranove, Shanley, and Schaefer. Chapter 7. Diversification. Copyright 2010 John Wiley Sons, Inc.

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1 Economics of Strategy Fifth Edition Besanko, Dranove, Shanley, and Schaefer Chapter 7 Diversification Slides by: Richard Ponarul, California State University, Chico Copyright 2010 John Wiley Sons, Inc. Why Diversify? Diversification across products and across markets can exploit economies of scale and scope Diversification that occurs for other reasons tends to be less successful Managers may prefer diversification even when it does not benefit the shareholders 1

2 Diversification and Relatedness To measure the degree of diversification in multi business firms the relatedness concept can be used (Richard Rumelt) Two businesses are related if they share technological characteristics, production characteristics and/or distribution channels Classification by Relatedness A single business firm derives more than 95 percent of its revenues from a single activity or line of business A dominant business firm derives 70 to 95 percent of its revenues from its principal activity 2

3 Classification by Relatedness A related business firm derives less than 70% of its revenue from its primary activity, but its other lines of business are related to the primary one An unrelated business firm or a conglomerate derives less than 70% of its revenue from its primary area and has few activities related to the primary area Classification by Relatedness Type Proportion of Revenue from Primary Activity Examples Single > 95 percent New York Times, DeBeers Dominant 70 to 95 percent Black & Decker, Harley-Davidson Related < 70 percent Abbott Laboratories, RR Donnelly & Sons Conglomerate <70 percent 3M, General Electric 3

4 Conglomerate Growth After WW II From 1949 to 1969, the proportion of single and dominant firms dropped from 70 percent to 36 percent Over the same period, the proportion of conglomerates increased from 3.4 percent to 19.4 percent More recently the post-war trend towards diversification has reversed Entropy Measure of Diversification Entropy measures diversification (analogous to information content) If a firm is exclusively in one line of business (pure play), its entropy is zero For a firm spread out into 20 different lines equally (5% in each line), the entropy is about 3 4

5 Entropy Decline in the 1980s During the 80s, the average entropy of Fortune 500 firms dropped form 1.0 to 0.67 Fraction of U.S. businesses in single business segments increased from 36.2% in 1978 to 63.9% in 1989 Firms have become more focused in their core businesses Merger Waves in U.S. History First wave created monopolies like Standard Oil and U.S. Steel (1880s to early 1900s) The merger wave of the 1920s created oligopolies and vertically integrated firms The merger wave of the 1960s created diversified conglomerates 5

6 Merger Waves in U.S. History In the merger wave of the 1980s cash rich firms grew through acquisitions. Leveraged buyouts were also used by private investors. In the fifth wave (mid 1990s through 2007) firms were merging with related businesses and private equity transactions were on the rise. Why do Firms Diversify? Diversification can improve corporate efficiency and benefit the shareholders Diversification may reflect the preference of the managers when the owners have no say in the decision 6

7 Efficiency Based Reasons Economies of scale and scope Economizing on transactions costs Internal capital markets Shareholder s diversification Identifying undervalued firms Evidence of Scale Economies If a merger is motivated by scale economies, the market share of the merged firm should increase immediately following the merger Thomas Brush study of mergers in manufacturing industries show that market shares increased as expected 7

8 Evidence Regarding Scope If firms pursue economies of scope through diversification, large firms should be expected to sell related set of products in different markets. Evidence (Nathanson and Cassano study) indicates that this happens only occasionally. Scope Economies Outside of Technology & Markets Firms that produce unrelated products and serve unrelated markets could be pursuing scope economies in other dimensions Two such explanations are: Resource based view of the firm (Penrose) Dominant general management logic (Prahalad and Bettis) 8

9 Resource Based View Specific resources of the firm are not fully utilized in its current product markets Applying them in other product markets creates economies of scope Dominant General Management Logic Managers develop specific skills (Examples: Information systems, finance) Seemingly unrelated business may need these skills The logic can be misapplied when the skills are not useful in the business I into which the firm diversifies 9

10 Economizing on Transactions Costs If transactions costs complicate coordination, merger may be the answer Transactions costs can be a problem due to specialized assets such as human capital Market coordination may be superior in the absence of specialized assets The University as a Conglomerate An undergraduate university is a conglomerate of different departments Economies of scale (common library, dormitories, athletic facilities) dictate common ownership and location Value of one department s investments depends on the actions of the other departments 10

11 Internal Capital Markets In a diversified firm, some units generate surplus funds that can be channeled to units that need the funds (internal capital market) The key question: Is it reasonable to expect that profitable projects will not be financed by external sources? Internal Capital Markets When outsiders are at an informational disadvantage they will be reluctant to buy equity or lend New lenders will be reluctant if the investment benefits existing debt Monitoring is costly in the case of external financing 11

12 Diversification and Risk Diversification reduces the firm s risk and smoothes the earnings stream But the shareholders do not benefit from this since they can diversify their portfolio at near zero cost. When shareholders are unable to diversify (Example: owners of a large fraction of the firm) they benefit from such risk reduction Identifying Undervalued Firms When the target firm is in an unrelated business, the acquiring firm is less likely to value the target correctly The key question is: Why did other potential acquirers not bid as high as the successful acquirer? Winner s curse could wipe out any gains from financial synergies 12

13 Cost of Diversification Diversified firms may incur substantial influence costs Diversified firms may need elaborate control systems to reward and punish managers Internal capital markets may not function well in practice Internal Capital Markets in Oil Companies If internal capital markets worked well, nonoil investments should not be affected by the price of oil Non oil investments tend to fall after a drop in the oil price (Lamont) Managerial preference for growth may explain this link between oil prices and non oil investments 13

14 Managerial Reasons for Diversification Managers may prefer growth even when it is unprofitable since it adds to their social prominence, prestige and political power. Managers may be able to enhance their compensation by increasing the size of their firm Managerial Reasons for Diversification Managers may feel secure if the performance of the firm mirrors the performance of the economy (which will happen with diversification) Manager controlled firms tend to engage in more conglomerate diversification than owner controlled firms. 14

15 Corporate Governance Shareholders are not knowledgeable regarding the value of an acquisition to the firm Shareholders have weak incentive to monitor the management Acquiring firms tend to experience loss of value indicating that acquisitions are driven by managerial motives. Market for Corporate Control Publicly traded firms are vulnerable to hostile takeovers Market for corporate control is an important constraint on the managers If managers undertake unwise acquisitions, the stock price drops, reflecting Overpayment for the acquisition Potential future overpayment by the incumbent management 15

16 Market for Corporate Control Acquirers profit by buying shares at the depressed levels and raising their value by imposing the necessary changes The incumbent managers concerned about potential loss of jobs desist from unwise acquisitions Market for Corporate Control Free cash flow (FCF) = cash flow in excess of profitable investment opportunities Managers tend to use FCF to expand their empires Shareholders will be better off if FCFs were used to pay dividends 16

17 Market for Corporate Control In an LBO, debt is used to buy out most of the equity Future free cash flows are committed to debt service Debt burden limits manager s ability to expand the business Market for Corporate Control LBOs may hurt other stakeholders Employees Bondholders Suppliers Wealth created by LBO may be quasi-rents extracted from stakeholders Redistribution of wealth may adversely affect economic efficiency 17

18 Redistribution and Long-Run Efficiency Takeovers that simply redistribute wealth are rational from the point of view of the acquirers but sacrifice long run efficiency Employees and other stakeholders will be reluctant to invest in relationship specific assets Purely redistributive takeovers will create an atmosphere of distrust and harm the economy as a whole Market for Corporate Control Gains in efficiencies in LBOs were substantial Even when firms defaulted on their debt the net effect was beneficial Corporate raiders profited handsomely for taking over and busting up firms that pursued unprofitable diversification 18

19 Market for Corporate Control Possible reasons for the end of the LBO merger wave Use of performance measures such as EVA Increased ownership stakes by the CEO Monitoring by large shareholders Market for corporate control may be a costly way to motivate managers Diversification & Operating Performance No clear relationship exists between performance and diversification Moderately diversified firms have higher capital productivity Unrelated diversification harms productivity 19

20 Diversification & Operating Performance Diversification into narrow markets does better than diversification into broad markets. Related diversification outperformed both narrower and broader strategies. Improvements in newly acquired plants may come at the expense of performance at the existing plants. Valuation and Event Studies Diversification discount exists in valuation. Discounts may have existed prior to acquisition for firms that elect to combine. Market for corporate control counteracts the diversification discount. Diversified firms with the largest discounts get taken over 20

21 Diversifying Acquisitions Shareholders of the acquiring firms do not benefit from the acquisitions Negative effects on the acquiring firms are more severe when: the managers of the acquiring firms were performing poorly before the acquisition the CEOs of the acquiring firms hold smaller share of the firms equity Diversifying Acquisitions The market value of the target firm tends to increase on announcement of the acquisition Gain for the target outweighs the losses for the acquirer. Though diversifying acquisitions create value, winners curse causes the acquirers to lose value. 21

22 Diversifying Acquisitions Acquirers had greater return when the targets were related firms. Gains to unrelated acquirers get bid away in the auction for the target. Firms with specialized resources engage in related diversification and achieve superior results. Firms with unspecialized resources such as cash do not. Diversification & Long-Term Performance Long term performance of diversified firms appears to be poor. A third to half of all acquisitions and over half of all new business acquisitions are eventually divested. Corporate refocusing of the 1980s could be viewed as a correction to the conglomerate merger wave of the 1960s. 22

23 Diversification & Long-Term Performance Diversification should be based on a core set of resources and a view towards integration of the old and the new businesses. To be worthwhile diversification should have a basis in economies of scope and efficiencies related to transactions costs. Copyright 2010 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in section 117 of the1976 United States Copyright Act without express permission from the copyright owner is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information herein. 23