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

2. 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. 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 generate profit streams that are either larger, less uncertain, or more stable that they would be otherwise.

4. 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. 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. 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. 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. 8 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 Incentives Resources ManagerialMotives Rationales (many questionable) No critical capability supported

9. 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 Managerial Motives Rationales (cont’d)

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

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

12. 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. 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. 14 So, back to the two basic approaches Related Diversification –share activities –transfer core competencies Unrelated Diversification –More efficiently allocate internal capital –restructure

15. 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. 16 Sharing Activities: Strong sense of corporate identityStrong sense of corporate identity Clear corporate mission that emphasizes the importance of integrating business unitsClear corporate mission that emphasizes the importance of integrating business units Incentive system that balances business unit & aggregate performanceIncentive system that balances business unit & aggregate performance

17. 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. 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. 19 Efficient Internal Capital Market Allocation: Firms pursuing this frequently diversify by acquisition: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. 20 Efficient Internal Capital Market Allocation: Assumes managers have more knowledge of the firm and its potential than outside investorsAssumes managers have more knowledge of the firm and its potential than outside investors Private information – no disclosure of sensitive competitive information to investorsPrivate 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)Firm may be able to reduce risk by allocating resources among diversified businesses (shareholders can diversify more economically on their own)

21. 21 Restructuring: Seek out undeveloped, poorly managed or threatened organizationsSeek out undeveloped, poorly managed or threatened organizations Parent company (acquirer) intervenes to: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 firmSell the firmExamples?

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