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Financial Services Industry

Corporate Governance and Firm Diversification

Financial Management (Financial Management Association), Spring, 2000 by Ronald C. Anderson, Thomas W. Bates, John M. Bizjak, Michael L. Lemmon

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The remainder of the paper is organized as follows. Section I reviews previous literature on diversification, and discusses the manner in which diversification affects contract design and firm value. Section II provides a description of the sample. Sections III and IV document the differences in governance characteristics between focused and diversified firms. Section V presents time-series evidence on the association between the structure of corporate governance and the decision to alter the level of diversification. Section VI documents the relation between governance characteristics and the value loss from diversification, and Section VII concludes with a brief summary.

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I. Diversification and Corporate Governance

Several previous studies have examined the relationship between firm value and diversification. Lang and Stulz (1994) find a positive correlation between Tobin's q and firm focus. Berger and Ofek (1995) observe that the sum of the imputed values for the individual segments of a diversified firm is 13% to 15% higher than the value of the combined firm. Comment and Jarrell (1995) demonstrate that reductions in diversification are associated with increases in firm value, while John and Ofek (1995) note that asset sales lead to an improvement in operating performance when there is a corresponding improvement in focus. In general, the evidence suggests that diversification is associated with lower firm value, although Servaes (1996) finds that the diversification discount was near zero during the 1970s; a period characterized by large increases in diversification.

Agency conflicts between stockholders and managers are frequently cited as contributing to the value loss from diversification. For example, Jensen (1986) and Stulz (1990) argue that managers diversify to increase firm size and to benefit from the power and prestige of managing a larger firm. Shleifer and Vishny (1989) demonstrate that managers can use diversification to entrench themselves and extract rents from shareholders by making manager-specific investments. Amihud and Lev (1981) also suggest that managers may diversify to reduce the risk of their undiversifiable human capital.

If diversification strategies are the result of managerial entrenchment and heightened agency conflicts within the firm, we should observe significant differences between the governance structures of diversified firms, and firms that are relatively more focused. Specifically, multi-segment firms should exhibit systematically less dependence upon those governance mechanisms designed to align the interests of managers and shareholders. If diversification is associated with suboptimal corporate governance, then relative to focused firms we expect diversified firms to exhibit: 1) higher levels of CEO pay and lower pay-for-performance sensitivities, 2) lower CEO and insider equity ownership, 3) fewer outside directors and more inside directors, 4) lower equity ownership by unaffiliated blockholders, and 5) CEO turnover that is less sensitive to firm performance. Furthermore, if governance is consistently associated with value reducing diversification strategies, we should detect a systematic relation between the structure of corporate governance, the decision to diversify, and the value loss from diversification.

Financial Services Industry

Corporate Governance and Firm Diversification

Financial Management (Financial Management Association), Spring, 2000 by Ronald C. Anderson, Thomas W. Bates, John M. Bizjak, Michael L. Lemmon

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