•
Why do firms diversify?
–
What drives the need to grow?
–
How is value created?
1

• 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
2

• The new business area has “meaningful” commonalities with the core business.
• Unrelated diversification lacks commonalities.
• The objectives are mainly financial, to generate profit streams that are either larger, less uncertain, or more stable that they would be otherwise.
3

• 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)
4

Diversification implies strategy two levels of
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
5

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
6

• 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)
7

Incentives
Resources
Managerial
Motives
Incentives do not generate value through resources / capabilities and so have neutral effects
• Anti-trust regulation
• Tax laws
• Low performance
• Uncertain future cash flows
• Firm risk reduction
No critical capability supported
8

Incentives
Resources / capabilities affect value creation (but have varying effects)
Resources
Managerial
Motives
• Tangible resources
 financial resources
 physical assets
• Intangible resources
 tacit knowledge
 customer relations
 image and reputation
9

Incentives
TMT motives to diversify and shareholder goals are often misaligned
Resources
• Diversifying managerial compensation/employment risk
• Increasing managerial compensation (grows along with firm size)
10

High
Related Constrained
Diversification
V/H integration
(Market Power)
Both Operational and
Corporate Relatedness
(Rare Capability -
Risk
Diseconomies of
Scope)
Low
Unrelated
Diversification
(Financial
Economies)
Related Linked
Diversification
(Economies of
Scope)
Low High
Ability to transfer skills/capabilities among businesses 11

Diversification 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
12

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???
13

Diversification
– share activities
– transfer core competencies
Unrelated Diversification
– More efficiently allocate internal capital
– restructure
14

• 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
15

• Strong sense of corporate identity
• Clear corporate mission that emphasizes the importance of integrating business units
• Incentive system that balances business unit
& aggregate performance
16

• 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?
17

Assumptions
• 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
18

• Firms pursuing this frequently diversify by acquisition:
– acquire sound, attractive companies
– acquired units are autonomous
– acquiring corporation supplies needed capital
– portfolio managers transfer resources from units that generate cash to those with high growth potential and substantial cash needs
– add professional management & control sub-unit managers compensation based on unit results
19

• Assumes managers have more knowledge of the firm and its potential than outside investors
•
Private information – no disclosure of sensitive competitive information to investors
•
Firm may be able to reduce risk by allocating resources among diversified businesses
(shareholders can diversify more economically on their own)
20

• Seek out undeveloped, poorly managed or threatened organizations
• Parent company (acquirer) intervenes to:
– change sub-unit management team
– shift strategy
– embed new technology
– tighten control systems
– divest parts of firm
– Acquire more businesses to achieve critical configuration
• Sell the firm
Examples?
21

Dominant
Business
Related
Constrained
Level of Diversification
Unrelated
Business
22