QuestionsTransaction Cost EconomicsRelated/UnrelatedPerformance???Slide 5Corporate Strategy DecisionsValue Creation & DiversificationRationales (many questionable)Rationales (cont’d)Slide 10How to think about Value-creationAdding Value by DiversifyingScale economies?So, back to the two basic approachesSharing Activities:Slide 16Transferring Skills/CapabilitiesTransferring Core Competencies:Efficient Internal Capital Market Allocation:Slide 20Restructuring:Relationship Between Diversification and Performance1Questions•Why do firms diversify?–What drives the need to grow?–How is value created?2Transaction Cost Economics•Make vs. Buy Decision–Question of relative efficiency (firm vs. market) based on specifics of the firm–The firm is a bundle of transactions–The goal is to choose the right governance form for the transaction(s) given asset specificity and partners’ incentives3Related/ UnrelatedRelated diversification• The new business area has “meaningful” commonalities with the core business.Unrelated diversification• Unrelated diversification lacks commonalities.• The objectives are mainly financial, to generateprofit streams that are either larger, less uncertain, or more stable that they would be otherwise.4Performance ?? ?•1950-1980, 2021 acquisitions made in new industries by 33 large, diversified U.S. companies, More than half were divested by 1986 (Porter, HBR, 1987)•931 unrelated diversifications, 74% were divested (Porter, HBR, 1987).•Sample of Fortune 500 firms – related highest in performance, followed by less related and finally unrelated (Rumelt, Strategic Management Journal, 1982)•450 related diversifications had a significantly higher ROA than 20 unrelated diversification firms (Simmonds, Strategic Management Journal 1990)5Diversification implies two levels of strategy1. Business-Level Capabilities/resources to create competitive advantage within each business - low cost - differentiation- focused low cost - focused differentiation - integrated low cost/differentiation2. Corporate-Level Capabilities/resources needed to create value across businesses6Corporate Strategy Decisions1. What businesses to be in?2. How to manage interrelationships?3. Who decides what?Corporate Strategy is focused on generating returns in excess of those that shareholders can obtain for themselves by diversifying investments7Value Creation & Diversification•Economies of scope adapting/transferring resources and activities across businesses•Market power - e.g., Vertical & horizontal integration, scale economies (Porter) •Financial economics (e.g., advantages w.r.t. time, uncertainty, options, information)8IncentivesIncentives do not do not generate value generate value through resources / through resources / capabilities and so capabilities and so have neutral effects have neutral effects •Anti-trust regulation•Tax laws•Low performance•Uncertain future cash flows•Firm risk reductionIncentivesIncentivesResourcesResourcesManagerialManagerialMotivesMotivesRationales (many questionable)No critical capability supported9Resources / capabilities affect value creation (but have varying effects)•Tangible resourcesfinancial resourcesphysical assets•Intangible resourcestacit knowledgecustomer relationsimage and reputationIncentivesResourcesManagerialMotivesRationales (cont’d)10TMT motives to diversify and shareholder goals are often misaligned•Diversifying managerial compensation/employment risk•Increasing managerial compensation (grows along with firm size)IncentivesResourcesManagerialMotivesRationales (cont’d)11How to think about Value-creation Related ConstrainedRelated ConstrainedDiversificationDiversificationV/H integrationV/H integration(Market Power)(Market Power)UnrelatedUnrelatedDiversificationDiversification(Financial(Financial Economies)Economies)Both Operational andBoth Operational andCorporate RelatednessCorporate Relatedness(Rare Capability -(Rare Capability -Risk Risk Diseconomies ofDiseconomies ofScope)Scope)Related LinkedRelated LinkedDiversificationDiversification(Economies of(Economies ofScope)Scope)Ability to transfer skills/capabilities Ability to transfer skills/capabilities among businesses among businesses LowLowHighHighAbility to Share activitiesAbility to Share activitiesLowLowHighHigh12Adding Value by DiversifyingDiversification creates value through two mechanisms:–Economies of scope: cost savings attributed to transferring the capabilities and competencies developed in one business to a new business–Market power: when a firm is able to achieve an improved configuration of resources / activities resulting in:•price premium advantages for its products / services •reduced costs of its primary and support activities13Scale economies?Cost advantages from•Pooling activities to reach minimum efficient scale (e.g., centralized acctg, MIS,)•Centralizing administration & control e.g. strategic planning, creating internal capital market, legal, etc.Risks???14So, back to the two basic approachesRelatedRelated Diversification Diversification–share activitiesshare activities–transfer core competenciestransfer core competenciesUnrelatedUnrelated Diversification Diversification–More efficiently allocate internal capital More efficiently allocate internal capital –restructurerestructure15Sharing Activities:•Sharing activities often lowers costs or raises differentiation (↑ mkt power)•Costs lowered if:–achieves economies of scale–boosts capacity utilization–Speeds movement down the Learning Curve•Sharing activities can enhance potential for or reduce the cost of differentiation–Must involve value chain activities impt to competitive advantage16Sharing Activities:•Strong sense of corporate identityStrong sense of corporate identity•Clear corporate mission that emphasizes the Clear corporate mission that emphasizes the importance of integrating business unitsimportance of integrating business units•Incentive system that balances business unit Incentive system that balances business unit & aggregate performance& aggregate performance17Transferring Skills/Capabilities •Exploits interrelationships among divisions•Start with value chain analysis–identify ability to transfer skills or expertise among similar value chainsHow can an ability to transfer activities be developed?18Transferring Core Competencies: •Transferring core competencies leads to