Managerial Incentives and Corporate Diversification Strategies

11 Pages Posted: 8 Feb 2019

See all articles by David J. Denis

David J. Denis

University of Pittsburgh

Diane K. Denis

University of Pittsburgh - Katz School of Business

Atulya Sarin

Santa Clara University - Department of Finance

Date Written: Summer 1997

Abstract

Because the break‐up of conglomerates typically produces substantial increases in shareholder wealth, many commentators have argued that the conglomerate form of organization is inefficient. This article reports the findings of a number of recent academic studies, including the authors' own, that examine the causes and consequences of corporate diversification. Although theoretical arguments suggest that corporate diversification can have benefits as well as costs, several studies have documented that diversified firms trade at a significant discount from their single‐segment peers. Estimates of this discount range from 10–15% of firm value, and are larger for “unrelated” diversification than for “related” diversification. If corporate diversification has generally been a value‐reducing managerial strategy, why do firms remain diversified? One possibility, which the authors label the “agency cost” hypothesis, is that top executives without substantial equity stakes may have incentives to maintain a diversification strategy even if doing so reduces shareholder wealth. But, as top managers' ownership stakes increase, they bear a greater fraction of the costs associated with value‐reducing policies and are therefore less likely to take actions that reduce shareholder wealth. Also, to the extent that outside blockholders monitor managerial behavior, the agency cost hypothesis predicts that diversification will be less prevalent in firms with large outside blockholders. Consistent with this argument, the authors find that companies in which managers own a significant fraction of the firm's shares, and in which blockholders own a large fraction of shares, are significantly less likely to be diversified. If agency problems lead managers to maintain value‐reducing diversification strategies, what is it that leads some of these same firms to refocus? The agency cost hypothesis predicts that managers will reduce diversification only if pressured to do so by internal or external mechanisms that reduce agency problems. Consistent with this argument, the authors find that decreases in diversification appear to be precipitated by market disciplinary forces such as block purchases, acquisition attempts, and management turnover.

Suggested Citation

Denis, David J. and Denis, Diane K. and Sarin, Atulya, Managerial Incentives and Corporate Diversification Strategies (Summer 1997). Journal of Applied Corporate Finance, Vol. 10, Issue 2, pp. 72-80, 1997, Available at SSRN: https://ssrn.com/abstract=3329485 or http://dx.doi.org/10.1111/j.1745-6622.1997.tb00137.x

David J. Denis (Contact Author)

University of Pittsburgh ( email )

Katz Graduate School of Business
Pittsburgh, PA 15260
United States
412-648-1708 (Phone)

Diane K. Denis

University of Pittsburgh - Katz School of Business ( email )

368B Mervis Hall
Pittsburgh, PA 15260
United States
412-624-0296 (Phone)

Atulya Sarin

Santa Clara University - Department of Finance ( email )

Leavey School of Business and Administration
Santa Clara, CA 95053
United States
408-554-4953 (Phone)
408-904-4498 (Fax)

HOME PAGE: http://business.scu.edu/asarin

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