Financial Market Frictions and Diversification

Abstract

We document new facts, which relate the evolution of firm scope to the changing frictions in external capital markets over the last three decades. In the first part of the paper we study the scope of large, diversified publicly traded firms. We find that these firms increase their scope during times of high external capital market frictions, such as in the recent Great Recession. Moreover, during these times firms diversify their investment needs, and cash flows across industries. In the second part, we find similar phenomena outside diversified public firms. Examining the mergers and acquisitions activity of standalone and diversified private firms, we uncover similar patterns. In aggregate data, we find that the composition of mergers shifts from focused to diversifying and back with changes in external market conditions. Our evidence is broadly consistent with the notion that firms diversify their scope in response to tightening in external capital markets.