Why Do Managers Diversify Their Firms? Agency Reconsidered
47 Pages Posted: 1 Feb 2001
Date Written: January 2001
We develop a contracting model between shareholders and managers in which optimal incentive contracts mitigate managers' propensity to diversify their firms. In our model, managers may diversify for two reasons: to reduce idiosyncratic risk and to capture private benefits. We derive comparative static predictions for the equilibrium relationships between incentives, diversification, and firm performance. We then test our model. Consistent with prior studies, we find that firm performance is positively related to incentives and negatively related to diversification. We find that diversification is positively related to managerial incentives. We show that the negative relationship between diversification and managerial incentives that has been observed in prior work is the result of omitted variable bias. We also find that the link between firm performance and managerial incentives is weaker for firms that experience changes in diversification than it is for firms that do not experience changes in diversification. These findings suggest that observed changes in diversification, incentives, and firm performance are equilibrium responses to changes in the level of private benefits that managers derive from diversification. Our evidence does not support the idea that managers diversify their firms to reduce their exposure to risk.
JEL Classification: G3
Suggested Citation: Suggested Citation