Corporate Diversification and Performance A Partial Review of the Literature Hadi Satyagraha, Ph.D.

Topics What Is Diversification? Extent of Diversification Why Diversify: Theories of Diversification Two Streams of Research Diversification Performance Some Future Directions

More than 50% of merger activity Diversification One of the most important structural phenomena in post-war economic activity More than 50% of merger activity (Gollop and Monahan 1991)

What Is Diversification? Firms operating in multiple business segments (Lang and Stulz 1994, Berger and Ofek 1995, Seravaes 1996) Means by which a firm expands from its core business into other product markets (Chandler 1962, Ansoff 1965, Berry 1975, Aaker 1980, Andrews 1980, Gluck 1985)

Extent of Diversification 86% of Fortune500 are diversified in 1974 (Rumelt 1986) Rise in diversified firms (Hoskisson and Kitt 1990, Datta, Rajagopalan and Rashid 1991) Europeans actively pursue diversification (Kerin, Mahajan and Varadarajan 1990)

Why Diversify: Exploiting Advantage Synergies and economies of scope (Penrose 1959, Ansoff 1965, Rumelt 1974, Palepu 1985, Prahalad and Bettis 1986, Amit and Livnat 1988, Wernerfelt and Montgomery 1988, Farjoun 1994, Markides and Williamson 1994, Chatterjee and Wernerfelt 1991, Ilinitch and Zeithaml 1995, Robin and Wiersema 1995, Capron and Hulland 1999) Economies of growth, size, and market power (Penrose 1959)

Why Diversify: Internal Capital Market Segment’s assets used as collateral for obtaining funding Cash flows of one segment used to subsidize investment (Gertner Scharfstein Stein 1994, Stein 1997, Campa and Kedia 2002, Maksimovic and Phillips 2007)

Why Diversify: Agency Theory Increase power, compensation, and perquisites (Jensen 1986, Jensen and Murphy 1990, Stulz 1990) Reduce their risk (Amihud and Lev 1981) Entrench themselves (Shleifer and Vishny 1989)

Why Diversify: Debt Co-Insurance A combination of different businesses with imperfectly correlated cash flows: Reduce overall risk Decrease probability of insufficient debt service Lead to higher potential debt capacity Increase tax shields (Penrose 1959, Berger and Ofek 1995, Lewellen 1971)

Why Diversify: Value Maximizing Diversification as a value-maximizing response to increasing firm age and growth: Investment in current business no longer profitable Economies of scope (Lividan 2004)

Two Streams of Research Strategic Management: Firms as portfolio of resources and capabilities linked by people Finance: Firms as portolio of investments whose performance depends on market forces

Diversification Performance The literature on corporate diversification is highly controversial and still has not reached a consensus. It is difficult to argue that diversification is generally value-reducing or enhancing.

Strategic Management: Curvi-linear Performance Level of Diversification

Finance Discount

Diversification premium Create Value Diversification premium (Palich et al 2000, Campa and Kedia 2002, Miller 2004, Villalonga 2004, Santalo and Becerra 2008, Kuppuswamy and Villalonga 2010)

Focused firms outperform diversified firms (Rogers 2001, Destroy Value Focused firms outperform diversified firms (Rogers 2001, Mackey and Barney 2006) Diversified firms created 24% less value than focused firms (Lang and Stulz 1994)

Some Future Directions Diversification-performance linkage across economic environments: Research on Indonesian firms Successful versus unsuccessful diversifiers: What distinguhishing characteristics? Other determinants of firm performance: Intervening variables: capability of top management, industry structure, etc.