Are Diversifying M&As Operational Hedges?

Abstract

Conventional wisdom suggests diversification reduces risk. However, the change in the riskiness of the firm after diversifying acquisitions has not been directly tested in the literature. Using a sample of 447 diversifying M&As that occurred between 1980 and 2003, we find that total firm risk does not decrease significantly after these transactions. We then conduct tests on various segment- and firm-level risk variables and show that while total firm risk does not change, core-business risk increases significantly after the diversifying M&A transactions. When we compare these 447 diversifying M&A transactions to 632 related M&A transactions that occurred in the same time period, we find that capital expenditures in the acquirers' core business segments increase significantly more after diversifying transactions relative to that of non-diversifying transactions. The evidence supports the hypotheses that diversifying firms i) take on more risk in their core segments post-transaction, and ii) invest more in their core segments post-transaction in order to exploit their core competency better. They are able to increase core-business risk post-transaction because the newly acquired unrelated unit serves an operational hedging purpose. We also find that diversifying firms with higher ability managers invest significantly more in their core segments post-acquisition compared to diversifying firms with lower ability managers. This is consistent with studies that argue that better managers hedge more. Overall, the evidence in this paper adds to the risk management literature that says hedging is a means of allocating risk rather than reducing risk and offers an alternative explanation for why firms diversify.