2.1. The diversification value controversy
Many studies examine the effect of diversification on firm value, finding a diversification discount (e.g., Lang and Stulz, 1994; Berger and Ofek, 1995; and Burch and Nanda, 2003). Two strands of research try to explain this discount. One strand tries to identify the costs and benefits of internal versus external markets. Some authors note the managerial incentive problems in the efficient allocation of capital. For example, Holmstrom and Costa (1986) and Jensen (1993) explain that due to information costs and imperfect managerial incentive alignment, optimal internal control systems in firms are imperfect and can lead to varying degrees of internal capital misallocation. Ozbas (2005) notes that, in diversified firms, managers can have incentives to exaggerate the payoffs of their projects to obtain funding, reducing allocational efficiency. Other studies argue that agency and other costs of internal capital allocation lead to resource misallocation and subsidization of poor investments in internal markets, resulting in a diversification discount (e.g., Lang and Stulz, 1994; Rajan, Servaes and Zingales, 2000).
Other studies identify advantages related to information and control rights of internal markets over external markets. For example, segment managers are less likely to be able to hide embarrassing facts from their supervisors as easily as they can from outside shareholders, and internal capital markets can better keep sensitive data away from competitors. Matsusaka and Nanda (2002) develop a model that shows that using internal markets to allocate capital avoids the deadweight costs of using external capital markets, but also raises the costs of managerial overinvestment. This tradeoff determines whether there is a diversification discount or premium. These authors further show that differences in control rights between internal and external providers of capital can also lead to diversification discounts or premia. This is because managers of a diversified firm can terminate nonperforming projects more efficiently than managers of single segment firms. Gertner, Scharfstein and Stein (1994) make a similar argument in favor of internal markets. Diversified firms can also be more valuable because their segments can share valuable nontradable resources and because of economies of scope and market power (Teece, 1982; Tirole, 1995; Williamson, 1998).
Based on reported standard deviations of the diversification discount or premium, prior empirical work suggests that at least a third of diversified firms trade at a premium compared to their stand-alone counterparts (e.g., Lang and Stulz, 1994; Berger and Ofek, 1995; Rajan, Servaes and Zingales, 2000). Indeed, this literature concludes that diversification can create value and that internal capital markets can be efficient (e.g., Schipper and Thompson, 1983; Matsusaka, 1993; Servaes, 1996; Hubbard and Palia, 1999; Khanna and Tice, 2001; Maksimovic and Phillips, 2002; Villalonga, 2004).
The second strand of research asks whether it is diversification that causes the discount, or poor performance that causes firms to diversify. For example, Campa and Kedia (2002) and Villalonga (2004) suggest that the diversification discount disappears when corrections for selection bias are applied. On the other hand, Singh, Mathur and Gleason (2004) find that investors do not avoid diversified firms, suggesting that diversification does not hurt firm value.
This paper belongs to the first strand of research. We use transaction-cost theory to resolve the controversy regarding the positive or negative effect of diversification.
2.2. Transaction costs and firm boundaries
Transaction-cost economics focuses on the notion that when the transaction costs of market exchange are high, it can be less costly to coordinate production through a formal organization than through a market, i.e., it can be cheaper to use hierarchy to reduce contracting problems and costs (Williamson, 1998). The transaction costs of market exchange arise chiefly from efforts to reduce the uncertainties in contractual relationships (Hart, 1995). Such transaction costs depend on factors including uncertainty, frequency and asset specificity. These factors contribute to the costs of market exchange, such as search costs, costs of developing and delineating choices and options, costs of designing, negotiating and enforcing market-exchange contracts, and costs of activities that facilitate exchange.
According to transaction-cost economics (Coase, 1988; Williamson, 2000), firms should internalize operations when external markets are relatively inefficient, i.e., when a firm faces higher transaction costs in external compared to internal markets. In other words, a firm is likely to find it optimal to internalize operations in businesses that face external market transaction costs that are higher than agency and other internal transaction costs. Thus, according to transaction-cost economics, the balance between internal and external transaction costs determines the boundaries of a firm (Hart, 1995; Holmstrom and Roberts, 1998).
Transaction costs can be high for two reasons: difficulty in designing the optimal contract because of information asymmetry and difficulty in implementing the contracts because of a lack of control rights. Therefore, internalization of independent organizations is likely to be particularly beneficial in industries where there is a severe problem of information asymmetry and where the exercise of control rights in resource shifting is especially important. Emergent high-tech industries fit these descriptions.
Numerous studies report that firms with much research and development (R&D) tend to have high information asymmetry (e.g., Aboody and Lev, 2000). The information asymmetry stems from the high degree of uncertainty in payoffs from R&D (Mansfield, Romeo, Villani, Wagner and Husic, 1977; Harhoff, Narin, Scherer and Vopel, 1999) and because many R&D assets are firm-specific and hard-to-transfer tangible and intangible assets. Disclosure about such assets may be limited to keep competitors from inferring valuable technical knowledge. Further, many intangible assets are unrecorded in corporate accounts (Lev and Sougiannis, 1996; Boone and Raman, 2001). Therefore, firms in emergent high-tech industries are difficult for outsiders to evaluate and monitor.
On the other hand, many projects in high-tech industries are still at the early, exploratory stage. Some projects will be successful, but most will fail (e.g., Mansfield, Romeo, Villani, Wagner and Husic, 1977; Harhoff, Narin, Scherer and Vopel, 1999). Therefore, firms with high R&D are associated with higher managerial discretion (Himmelberg, Hubbard and Palia, 1999) and it is thus important that the owners have the control rights to quickly redeploy poorly performing assets. It is difficult for outside shareholders to exercise this control right effectively. Like other industries, outside ownership is generally widely distributed, which makes coordinated effort difficult to achieve. In addition, high-tech firms tend to be closely controlled by company insiders. Lorsch, Zelleke and Pick (2001) argue that this structure is deeply flawed because insiders have strong incentives to maximize short run returns and to engage in cash-out events, not to sacrifice their own jobs by terminating unpromising projects and returning cash to outside investors. In contrast, it is much easier for the central management in an internal market to terminate projects quickly, because the central management generally has the entire control rights over a subsidiary.
In summary, high-tech industries likely suffer from more severe problems of information asymmetry and external markets find these firms more difficult to monitor. Further, external markets lack the ability to shift resources quickly between operating units effectively, which the internal markets can do much better.
In contrast, an internal market is likely to be particularly costly in cases where (1) there is low information asymmetry and (2) there is little need to shift resources between divisions, so the value of the real option to avoid deadweight external financing costs is low, and the agency costs of an internal market become dominant (Matsusaka and Nanda, 2002). Firms in mature industries have high free cash flows and fewer investment opportunities, little or no R&D and little or no need for external financing. Diversification should be costly and value destroying in these industries.
In summary, we contend that internal capital markets can be more efficient in emergent high-tech industries; in such firms, we expect better operating performance across multiple segments and a diversification premium. We argue that the opposite is likely for firms in mature industries where we expect better operating performance for single segment firms and a diversification discount.