Does Diversification Create Value in the Presence of External Financing Constraints? Evidence from the 2008-2009 Financial Crisis
Executive Summary — The global financial crisis of 2008-2009 has led academics and practitioners to question many widely held beliefs about business and economics. One such belief relates to the value of corporate diversification. Popular views about diversification have swung like a pendulum over the past half-century, from a generally positive view in the 1960s and 1970s, when many large conglomerates were formed, to a generally negative view in the 1980s and early 1990s, when many such conglomerates were dismantled or at least fell out of the stock market's favor. In 2009, in the wake of the global financial crisis, a new view seems to be emerging that conglomerates are ready for a comeback. In this paper, HBS doctoral candidate Venkat Kuppuswamy and professor BelÚn Villalonga examine whether and why conglomerates have become more valuable during the 2008-2009 financial crisis. They find that they have, and that the increase does not simply reflect changes in investor perceptions but real differences in corporate finance and investment. Key concepts include:
- The change in the value of diversification triggered by the financial crisis reflects real differences in corporate finance and investment as opposed to a faddish change in investor sentiment or perceptions.
- There were two channels through which the financial crisis increased the intrinsic value of corporate diversification: greater access to credit markets as a result of the debt coinsurance provided by conglomerates, and access to (and/or more efficient use of) internal capital markets. While these financing alternatives are always available to diversified firms, evidence suggests that they became particularly valuable during the crisis.
- It remains to see whether the value advantage gained by conglomerates during the crisis will persist or disappear once the crisis is over.
- On the one hand, as credit becomes cheaper and more broadly available, both diversified and focused firms are likely to revert to their equilibrium leverage levels. The value of internal capital markets is also likely to decline as external capital markets return to their pre-crisis levels of efficiency and availability—partly because of the increased efficiency of external markets and partly because of the reduced pressure to allocate internal funds efficiently.
- On the other hand, the financing advantage that conglomerates have enjoyed during the crisis may have allowed them to tackle unique investment opportunities that can give them a sustainable competitive advantage over their focused rivals—or even put some of those rivals out of business.
- While it is too early for us to be able to analyze in this study some of these long-term effects, the shift in the relative pricing of diversified and single-segment firms suggests that the stock market anticipates that the advantage gained by conglomerates will last well beyond the crisis.
We show that the value of corporate diversification increased during the 2007-2009 financial crisis. Diversification gave firms both financing and investment advantages. First, conglomerates became significantly more leveraged relative to comparable focused firms. Second, conglomerates' access to internal capital markets became more valuable not just because external capital markets became more costly, but also because the efficiency of internal capital allocation increased significantly during the crisis. Our analysis provides new evidence on how the diversification discount and its drivers vary with financial constraints and economic conditions and suggests that corporate diversification can serve an important insurance function for investors.