Industry Structure and the Conglomerate 'Discount': Theory and Evidence

Abstract

Recent literature has been largely negative in its assessment of corporate diversification. Diversified firms have been regarded as destructive of firm value, prone to agency problems and divisional rent-seeking. The empirical finding that multi-division firms tend to trade at a 'discount,' or negative 'excess value' relative to their single-segment counterparts, is claimed in support of this view. Our paper offers a different, more positive, perspective. We develop a simple, industry-based model to argue that conglomeration (and discounts) may, in fact, reflect an endogenous, value-enhancing response of firms to industry conditions and agency problems prevalent in all firms, not just conglomerates. With managers reluctant to reduce assets under their control, conglomeration emerges as a way to optimally induce managers to shift resources away from an industry, in response to unfavorable conditions. The model also provides a framework, with testable implications, to analyze patterns of conglomeration and excess values across different environments. The degree of conglomeration in an industry is predicted to have an inverse relation to the excess values of conglomerates in the industry and to the investment opportunities anticipated for single-segment firms. Using a panel data set of fifty of the largest US industries, over 1978-1997, we find significant empirical support for the model's predictions.