The Effect of Institutional Factors on the Value of Corporate Diversification

by Venkat Kuppuswamy, George Serafeim & Belén Villalonga

Overview — How does the value of corporate diversification vary with institutional development? Using data on diversified firms from 38 countries over a 15-year period, the authors explore the effect of capital market efficiency, labor market efficiency, and product market efficiency on the excess value of diversified firms relative to their single segment peers. Specifically, the paper analyzes whether these institutional variables explain the variance in the value of diversified firms across different countries. Findings show that the value of diversified firms relative to their single-segment peers is higher in countries with less efficient capital markets. In addition, there is evidence that the efficiency of the country's labor market also has a significant effect on the excess value of diversified firms. Key concepts include:

Capital and labor market efficiency are important drivers of the value of diversification across the world.
As capital markets become more efficient, the value of corporate diversification decreases.
In countries where frictions in the labor markets are present, the value of diversified firms relative to their single-segment peers is greater. This finding supports HBS professors Khanna and Palepu's (2010) argument that other institutional voids besides those that may exist in capital markets can also influence the value of corporate diversification.
The efficiency of a country's product market does not influence the relative value of diversified firms, after the state of the external capital markets and labor markets are accounted for.

Author Abstract

Using a large sample of diversified firms from 38 countries we investigate the influence of several national-level institutional factors or 'institutional voids' on the value of corporate diversification. Specifically, we explore whether the presence of frictions in a country's capital markets, labor markets, and product markets, affect the excess value of diversified firms. We find that the value of diversified firms relative to their single-segment peers is higher in countries with less efficient capital and labor markets, but find no evidence that product market efficiency affects the relative value of diversification. These results provide support for the theory of internal capital markets that argues that internal capital allocation would be relatively more beneficial in the presence of frictions in the external capital markets. In addition, the results show that diversification can be beneficial in the presence of frictions in the labor market.