Agency Problem And The Value Of Conglomerates

Abstract

Empirical studies show that a large portion of the diversification discount can be explained by controlling for firm-specific characteristics. Although these studies leave no doubt that there is a self-selection component in firm’s decision to diversify, the failure to explain the entire discount implies that some conglomerates destroy value and raises a question: why firms choose to diversify and what prevent them from value-increasing divestitures. This paper provides an answer to this question. It argues that the agency cost in a conglomerate is positively related to the number of divisions with good investment opportunities. Therefore, benefits of conglomeration offset agency costs for conglomerates with a number of bad divisions and make diversification profitable for bad firms. However, when investment opportunities of some divisions improve, the agency cost increases and offsets the benefits of diversification. Unfortunately, if investors cannot correctly price all of the conglomerate’s divisions, the conglomerate cannot receive the fair price for its good divisions and, therefore, cannot implement value-increasing divestitures. As a result, the paper predicts a negative relationship between the age of the conglomerate and the diversification discount, while a failure to control for the self-selection bias may lead to an incorrect conclusion that this relationship is positive. By looking at the exogenous shocks to the economy, the paper also predicts more refocusing activities and greater value-distortion of diversification during economic booms.