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MT6 tutorial essay question: Why is diversification often problematic? How might it be managed successfully?

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  • June 27, 2024
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Why is diversification often problematic? How might it be managed successfully?
Supporting the notion that diversification is problematic is evidence showing a negative relation
between diversification and firm performance (Montgomery, 1994) and firm value (Berger &
Ofek, 1995). This essay highlights two sources of problems in diversification: agency issues and
faulty justification of diversification benefits. Nevertheless, the essay argues that diversification
can be managed successfully if related diversification is pursued, mechanisms are put in place
against agency problems, managers ensure diversification benefits are material, and bidder
resource heterogeneity is considered for diversification via M&A.

Firstly, shareholder-manager agency problems could mean diversification is pursued for
managerial interests at the expense of shareholder value. Under the agency view of
diversification, managers diversify for the purpose of managerial entrenchment where the
diversified firm has a greater demand for their skills or for employment risk diversification, as a
diversified firm can withstand industry-specific shocks better (Montgomery, 1994). In the case
of diversification via acquisition, agency problems are seen with CEO hubris being associated
with large premiums in acquisitions that usually cause shareholder losses, with the relation
strengthened when there is little oversight by a board with more inside directors or a CEO
board chair (Hayward & Hambrick, 1997). Agency problems arise because dispersed small
shareholders free ride on each other to monitor management (Hart, 1995). For example, Meta's
recent massive metaverse-related diversification investments have been met with shareholder
backlash, accounting losses, and share price plunges. However, CEO Mark Zuckerberg's grip on
the corporate governance structure with ownership of class B shares (with 10:1 voting power)
and his seat on the board prevents strong oversight. While it is hard to attribute this case to
agency problems since Zuckerberg may be acting with full good intent of increasing long term
shareholder value, it is arguable that some elements of Zuckerberg fighting for his personal
agent interests in terms of protecting his reputation in his metaverse bet could be at play.

Secondly, diversification is problematic as it is easy to make faulty justifications of benefits,
leading to losses post-diversification. A common poor justification is risk reduction, since
shareholders can diversify more cheaply with different stocks, whereas diversification by the
firm is often costly and constraining (Porter, 1988). Another justification often used is the
benefits of access to internal capital markets which could be cheaper than external ones.
However, there are very limited circumstances where this is true, and often the centralisation
of capital allocation in diversified firms mean higher costs (Liebeskind, 2000). Moreover, access
to internal capital could lead to excessive cross-subsidisation of poorly performing segments or
overinvestment which could lead to losses (Berger & Ofek, 1995). Another justification often
used is parenting advantage, or the value the parent firm can add to a formed business unit.
While such added value may exist, firms should only maintain such diversified structures if they
can add value the best. Otherwise, it may be wiser to sell it to a firm that can do so better and
can therefore pay a higher price than whatever value that can be realised through normal

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