What Drives Firms to Diversify?

Abstract

This paper examines whether corporate governance structures, serving as proxies for agency costs, can explain firms' decision to diversify. Specifically, it has been hypothesized that firms with worse corporate governance structures are more likely to diversify. The extant literature usually compares the governance characteristics of multi-segment firms to those of single-segment firms to address this issue. However, different governance characteristics may simply reflect differences in firm characteristics of diversified and focused firms. Furthermore, industry factors may affect both the propensity of firms to diversify and their governance characteristics. To separate out the agency costs explanation of firms' decision to diversify, I compare the corporate governance structures of single-segment firms that choose to diversify with those of a matched sample of single-segment firms in the same industry that choose to remain focused. Consistent with agency cost explanations for the decision to diversify, I find that firms that choose to diversify have significantly lower CEO ownership than firms that remain focused. However, CEO compensation, board size, board composition, CEO duality, institutional ownership, and blockholder ownership cannot explain why firms diversify. In addition, the CEO pay-to-performance sensitivity of diversifying firms is also not significantly different from that of firms that stay focused. Taken together, my evidence indicates that diversifying firms do not systematically have worse governance structures than firms that stay focused and, therefore, higher agency costs do not appear to drive the decision to diversify.