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 Unrelated diversification
• The new business area has “meaningful” commonalities with the core business.
Unrelated diversification
• 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.

4. Performance???
, 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
Business Unit
Business Unit

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

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

10. Rationales (cont’d) Managerial Motives
TMT motives to diversify and shareholder goals are often misaligned
Incentives
Diversifying managerial compensation/employment risk
Increasing managerial compensation (grows along with firm size)
Resources
Managerial
Motives

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

12. Adding Value by Diversifying
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

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

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 identity
Clear corporate mission that emphasizes the importance of integrating business units
Incentive system that balances business unit & 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:
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

19. Efficient Internal Capital Market Allocation:
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

20. Efficient Internal Capital Market Allocation:
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)

21. Restructuring:
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?

22. Relationship Between Diversification and Performance
Dominant
Business
Related
Constrained
Unrelated
Business
Level of Diversification