1

Questions

• Why do firms diversify?– What drives the need to grow?– How is value created?

2

Transaction Cost Economics

• Make vs. Buy Decision– Question of relative efficiency (firm vs.

market) based on specifics of the firm– The firm is a bundle of transactions– The goal is to choose the right

governance form for the transaction(s) given asset specificity and partners’ incentives

3

Related/Unrelated

Related diversification• The new business area has “meaningful”

commonalities with the core business.

Unrelated diversification• Unrelated diversification lacks commonalities.• The objectives are mainly financial, to generateprofit streams that are either larger, less uncertain, or

more stable that they would be otherwise.

4

Performance???• 1950-1980, 2021 acquisitions made in new

industries by 33 large, diversified U.S. companies, More than half were divested by 1986 (Porter, HBR, 1987)

• 931 unrelated diversifications, 74% were divested (Porter, HBR, 1987).

• Sample of Fortune 500 firms – related highest in performance, followed by less related and finally unrelated (Rumelt, Strategic Management Journal, 1982)

• 450 related diversifications had a significantly higher ROA than 20 unrelated diversification firms (Simmonds, Strategic Management Journal 1990)

5

Diversification implies two levels of strategy

1. Business-Level Capabilities/resources to create competitive advantage within each business - low cost - differentiation- focused low cost - focused differentiation - integrated low cost/differentiation

2. Corporate-Level Capabilities/resources needed to create value across businesses

6

Corporate Strategy Decisions

1. What businesses to be in?

2. How to manage interrelationships?

3. Who decides what?

Corporate Strategy is focused on generating returns in excess of those that shareholders can obtain for themselves by diversifying investments

7

Value Creation & Diversification

•Economies of scope adapting/transferring resources and activities across businesses

•Market power - e.g., Vertical & horizontal integration, scale economies (Porter)

•Financial economics (e.g., advantages w.r.t. time, uncertainty, options, information)

8

IncentivesIncentives do not do not generate value generate value through resources / through resources / capabilities and so capabilities and so have neutral effects have neutral effects • Anti-trust regulation

• Tax laws• Low performance• Uncertain future cash

flows• Firm risk reduction

IncentivesIncentives

ResourcesResources

ManagerialManagerialMotivesMotives

Rationales (many questionable)

No critical capability supported

9

Resources / capabilities affect value creation (but have varying effects)

• Tangible resources financial resources physical assets

• Intangible resources tacit knowledge customer relations image and reputation

Incentives

Resources

ManagerialMotives

Rationales (cont’d)

10

TMT motives to diversify and shareholder goals are often misaligned

• Diversifying managerial compensation/employment risk

• Increasing managerial compensation (grows along with firm size)

Incentives

Resources

ManagerialMotives

Rationales (cont’d)

11

How to think about Value-creation

Related ConstrainedRelated ConstrainedDiversificationDiversification

V/H integrationV/H integration(Market Power)(Market Power)

UnrelatedUnrelatedDiversificationDiversification

(Financial(Financial Economies)Economies)

Both Operational andBoth Operational andCorporate RelatednessCorporate Relatedness

(Rare Capability -(Rare Capability -Risk Risk

Diseconomies ofDiseconomies ofScope)Scope)

Related LinkedRelated LinkedDiversificationDiversification

(Economies of(Economies ofScope)Scope)

Ability to transfer skills/capabilities Ability to transfer skills/capabilities among businesses among businesses

LowLow HighHigh

Ab

ility

to S

hare

act

ivit

ies

Ab

ility

to S

hare

act

ivit

ies

LowLow

HighHigh

12

Adding Value by DiversifyingDiversification creates value through two mechanisms:– Economies of scope: cost savings

attributed to transferring the capabilities and competencies developed in one business to a new business

– Market power: when a firm is able to achieve an improved configuration of resources / activities resulting in:

• price premium advantages for its products / services

• reduced costs of its primary and support activities

13

Scale economies?

Cost advantages from• Pooling activities to reach minimum

efficient scale (e.g., centralized acctg, MIS,)

• Centralizing administration & control e.g. strategic planning, creating internal capital market, legal, etc.

Risks???

14

So, back to the two basic approaches

RelatedRelated Diversification Diversification

– share activitiesshare activities

– transfer core competenciestransfer core competencies

UnrelatedUnrelated Diversification Diversification

– More efficiently allocate internal capital More efficiently allocate internal capital

– restructurerestructure

15

Sharing Activities:• Sharing activities often lowers costs or raises

differentiation (↑ mkt power)• Costs lowered if:

– achieves economies of scale– boosts capacity utilization– Speeds movement down the Learning Curve

• Sharing activities can enhance potential for or reduce the cost of differentiation– Must involve value chain activities impt to

competitive advantage

16

Sharing Activities:• Strong sense of corporate identityStrong sense of corporate identity• Clear corporate mission that emphasizes the Clear corporate mission that emphasizes the

importance of integrating business unitsimportance of integrating business units• Incentive system that balances business unit Incentive system that balances business unit

& aggregate performance& aggregate performance

17

Transferring Skills/Capabilities

• Exploits interrelationships among divisions

• Start with value chain analysis– identify ability to transfer skills or expertise

among similar value chains

How can an ability to transfer activities be developed?

18

Transferring Core Competencies:

• Transferring core competencies leads to competitive advantage only if the similarities among business units meet the following conditions:– activities involved in the businesses are

similar enough that sharing expertise is meaningful

– transfer of skills involves activities which are important to competitive advantage

– the skills transferred represent significant sources of competitive advantage for the receiving unit

Assumptions

19

Efficient Internal Capital Market Allocation:

• Firms pursuing this frequently diversify by Firms pursuing this frequently diversify by acquisition:acquisition:

– acquire sound, attractive companiesacquire sound, attractive companies

– acquired units are autonomousacquired units are autonomous

– acquiring corporation supplies needed capitalacquiring corporation supplies needed capital

– portfolio managers transfer resources from portfolio managers transfer resources from units that generate cash to those with high units that generate cash to those with high growth potential and substantial cash needsgrowth potential and substantial cash needs

– add professional management & control sub-add professional management & control sub-unit managers compensation based on unit unit managers compensation based on unit resultsresults

20

Efficient Internal Capital Efficient Internal Capital Market Allocation:Market Allocation:

• Assumes managers have more Assumes managers have more knowledgeknowledge of the of the firm and its potential than outside investorsfirm and its potential than outside investors

• Private informationPrivate information – no disclosure of – no disclosure of sensitive competitive information to investorssensitive competitive information to investors

• Firm may be able to reduce risk by allocating Firm may be able to reduce risk by allocating resources among diversified businesses resources among diversified businesses (shareholders can diversify more economically on (shareholders can diversify more economically on their own)their own)

21

Restructuring:Restructuring:• Seek out undeveloped, poorly managed or Seek out undeveloped, poorly managed or

threatened organizationsthreatened organizations• Parent company (acquirer) intervenes to:Parent company (acquirer) intervenes to:

– change sub-unit management teamchange sub-unit management team– shift strategyshift strategy– embed new technologyembed new technology– tighten control systemstighten control systems– divest parts of firmdivest parts of firm– Acquire more businesses to achieve critical Acquire more businesses to achieve critical

configurationconfiguration

• Sell the firmSell the firmExamples?Examples?

22

Relationship Between Diversification and Performance

Per

form

ance

Per

form

ance

Level of DiversificationLevel of Diversification

DominantBusiness

UnrelatedBusiness

RelatedConstrained