Except in a few circumstances corporate diversification, such as through mergers, acquisitions, takeovers or simply through investing in projects that are unrelated to their firm’s existing projects, provides no gains for shareholders.
Companies are constantly acquiring other assets and sometimes other companies in an effort to diversify. Starting with mergers, it is easy to see that this activity usually does nothing for shareholders that they could not do themselves. Consider Company A that acquires Company B. If the shareholders of Company A wanted to own Company B, they could simply buy the stock of Company B. The merger does nothing for the shareholders. In fact, it may hurt the shareholders, because companies expend large amounts of money for advice from investment bankers and lawyers. Also, managers, time is spread thin when managing a larger company. In contrast, the shareholders can acquire the stock of the other company at far less cost. Mergers can also be costly in other ways. Can the management of Company A successfully manage Company B? Can it integrate Company B into Company A?
Yet mergers occur frequently. Why? Mergers can potentially create value through synergy. If the combined company, A and B, can do things more efficiently that they two companies separately, there may be gains. Oftentimes these gains arise simply from cost reductions through firing employees. Sometimes gains can occur if the management of the acquired firm is doing a poor job but is so entrenched that the shareholders cannot get rid of it. Takeovers force a discipline on firms to do a good job or be taken over by an outside firm. Of course, the deposed management of the acquired firm does usually walk away with a nice severance package.
Other than with mergers, companies often diversify by entering into capital investment projects that are unrelated to their current lines of business. This type of activity is quite common. If companies carry it to the extreme, they become so broadly diversified they are called conglomerates. GE is an excellent example. Its products are primarily considered industrial and technological, but it is also a large financial institution and is in the healthcare industry and in entertainment. Are these activities beneficial to its shareholders? As with mergers, the answer is yes only if the diversifying activity can create value by combining with the company’s existing activities in such a way as to provide the combined products and services with greater efficiency.
Many diversifying activities take place because of empire-building. Managers seem to often want more power and one way to get it is to cause their companies to get larger. Also, diversification has a significant benefit to management. Since most management personnel are heavily compensated with shares and options, their personal portfolios are poorly diversified. Diversification at the corporate level reduces the risk of managers’ personal portfolios and the risks of the managers' reputation from being connected with the company.
Firms should generally not engage in these types of diversifying activities unless the activities clearly create value for the shareholders.
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Last updated: March 23, 2006