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28 Cards in this Set

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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
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
+Activities are classified in sector codes, e.g., NAICS (North American Industry Classification System)
31-33: Manufacturing
311: Food manufacturing
3111: Animal food manufacturing
311111:Dog and cat food manufacturing
Diversification: General Electric
Energy
Energy Services
Oil & Gas
Power & Water

Technology Infrastructure
Aviation
Healthcare
Transportation

GE Capital
Americas
Asia Pacific
Aviation Financial Services
Consumer Finance
Europe, Middle East & Africa
Energy Financial Services
Real Estate
Home & Business Solutions
Appliances & Lighting
Intelligent Platforms

NBC Universal
Cable
Film
International
Network
Sports & Olympics
Classification by Relatedness
single >95% NYT, de beers
dominant 70%-95%, harley davidson
related <70%, pfizer, philips
conglomerate, <70%, 3M, general electric
facts:
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: -Σpi*ln(pi) where pi is the proportion of firm’s sales in segment i.
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.
facts: 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.
facts: mergers 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 (unrelated) diversified conglomerates.
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?
+Efficiency-based reasons
Economies of scale and scope
Economizing on transaction costs
Internal capital markets
Diversifying shareholder’s portfolios
Identifying undervalued firms
+Managerial reasons for diversification
Benefits to managers from acquisitions
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
This shows that economies of scale are an important motive fro mergers in manufacturing.
Economies of 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.
+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
Dominant general management logic
RBV ?
Resource Based View (Penrose)
Organizational resources of the firm are not fully utilized in its current product markets
Applying them in other product markets creates economies of scope
Dominant Management Logic
Dominant general management logic (Prahalad and Bettis)
Managers develop specific skills (Example: Information systems)
Seemingly unrelated business may need these skills
Economizing on Transactions Costs:
If transactions costs complicate coordination between independent firms, an acquisition/merger may be the answer.
Transactions costs can occur due to specialized assets such as human capital.
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?
When external parties are at an informational disadvantage they will be reluctant to lend
Monitoring is costly in the case of external financing
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.
How to identifiy undervalued firms?
Shareholders benefit from a diversifying acquisition when the manager identifies and acquires an undervalued firm.
But, 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.
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 (‘cross subsidization’)
What are the 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.
Managers may feel secure if the performance of the firm mirrors the performance of the economy (which will happen with diversification).
Corporate governance
Managerial motives for diversification rely on an agency type of problem
Different objectives for manager and shareholder
Shareholders are not knowledgeable regarding the value of an acquisition to the firm (asymmetric information)
Shareholders have weak incentive to monitor the management
Acquiring firms tend to experience loss of value indicating that acquisitions are driven by managerial motives.
What is the 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
Acquirers profit by buying shares at the depressed levels and raising their value by imposing the necessary changes
The incumbent managers (concerned about potential job loss) refrain from unwise acquisitions
What is the market for corporate controlI?
Corporate raiders bought many (unrelated) diversified firms in the 1980s with cash and debt.
Corporate raiders profited handsomely for taking over and breaking up firms that pursued unprofitable diversification
Gains in efficiencies in leveraged buyouts (LBOs) were substantial
Even when firms defaulted on their debt, the net effect was beneficial
What is the market for corporate controlIII?
Possible reasons for the end of the LBO merger wave of the 1980s
Use of performance measures
Increased ownership stakes by the CEO
Monitoring by large shareholders
links between diversification & operation income
No clear relationship exists between performance and diversification
Moderately diversified firms have higher capital productivity
Unrelated diversification harms productivity
Diversification and market value?
Market value of equity (aggregate value of stocks) used as performance indicator.
“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.
Diversifying Acquisitions & Event Studies?
Event study examines the change in the market value in response to an event (announcement of acquisition).
Shareholders of the acquiring firm does not benefit from the acquisition.
Negative effects on the acquiring firm are more severe when:
the manager of the acquiring firms was 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, the winners curse causes the acquirers to lose value.
Acquiring firms with specialized resources engaged in related diversification achieve better results.
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.
To be worthwhile diversification should have a basis in economies of scope and efficiencies related to transactions costs.