M&A and Diversification:

may they destroy shareholders value?

Elaborated by
Balushkina Tatiana
Campanella Cosimo
Francesca Giulio
Vellucci Antonio

















Summary
Introduction ...................................................................................................................... 3
1. Diversifications effects on firm value .............................................................. 4
1.1 Why diversify? .......................................................................................................... 4
1.2 Costs and Benefits ................................................................................................... 5
1.3 Diversification strategies over time ............................................................... 8
2. Diversification and firm value ........................................................................... 11
2.1 Corporate diversification does not destroy shareholder value ...... 11
2.2 Merging causes destroying value .................................................................. 13
2.3 Diversification creates Shareholders value .............................................. 16
Conclusion ....................................................................................................................... 17
Bibliography ................................................................................................................... 18



Introduction
Nowadays, the prevailing wisdom among financial experts is that
shares of diversified firms are sold at a discount. However, recent
studies has shown that the diversification discount could be not due to
corporate diversification and, as emerged in some analysis, it may be
the result of improper measurement techniques.
At the end of the twentieth century, levels of mergers and acquisitions
reached the record level of 2.3 trillion dollar. This impressive
expansion of such activities was mostly due to the necessity of firms to
expand their business in other markets. An example of this situation
could be J.P. Morgan Chase & Co: JP Morgan was known for its quality
and reliability in investment banking, asset management, and
operating services while Chase Manhattan was the third largest bank
in the United States and known for its retail banking capabilities in the
corporate and consumer market. In 2000, the two firms merged in a
deal that allows both of them to enter in the markets of each other, not
only regarding a number of new activities that were not treated
before, but also in a spatial sense: for instance, Chase Manhattan was
not well developed in Asian markets whereas Morgan was strong in
Japanese government bond.
If M&A are useful and often necessary to firms in order to increase or
simply continue their activities, it is not so clear how such operations
impact shareholders value. Given the large number of these
operations, this paper will try to explain how M&A modifies
shareholders value and answer to the question if corporate
diversification destroy their wealth by decreasing the value of shares.
The first part of this work will analyze how the diversification affects
firm value, underlining benefits and cost of M&A and the trend of such
operations over the time. The second part is dedicated to the impact of
corporate diversification on shareholders value showing and
analyzing the different opinions of financial literature about this
theme. Finally, we discuss the limits of the models used through this
paper and the problems that arises when collecting data about
corporate diversification.




1. Diversifications effects on firm value

1.1 Why diversify?
Different agents have different interests regarding the run of the
business of the firm. This will be reflected in the opinions of these
agents about corporate diversification. From the point of view of
managers, a bigger firm should be a better one though it is not always
like this. As the company proceeds with M&A operations managers
increase their compensation, prestige and power. This theory is called
Agency theory because explains the diversification discount as the
result of conflicts between stockholders and managers. But how do
managers gains from corporate diversification? Following this theory,
and in particular Jensen (1986) thought, managers put themselves in
advantage by creating new structures for the firm and manage them,
which make themselves more important to the living of the firm. For
instance, take a CEO who has to decide whether invest in upgrading
the factories of the firm he manages or raising dividends. In the first
case he will be able, through new investment in factories, to entrench
its position in the firm because he puts his hands on much more
resources with respect to the case rising dividends. Sheilfer and
Vishny (1989) observe that the degree of managerial entrenchment is
directly connected to the existing connection between the asset that is
being acquired or upgraded and the particular skill or knowledge of
the manager that has undertaken the operation. What has to be notice
is that not always these kind of operation are value-maximizing for the
firm and often they represent only the attempt of managers to
preserve their position or increase their wages. Anyway, we think that
M&A operations, although they are not much different from
purchasing new assets (or upgrading them), can be viewed in a
different perspective since they depends on much more variables: just
thinking about all the political and social consequences of the
acquisition of a firm by a foreign entity gives a degree of the
complexity of such activities.
From another point of view, called resource-based, we notice that a
firm could use its existing structure to operate also in markets that
were not treated before. A firm that has an excess capacity in
resources could try to allocate this surplus across different businesses
both in the same industry or outside of it. This idea, developed by
Penrose (1959) provide the theoretical bases for synergies and
economy of scope.
The third theory about corporate diversification developed by
Villalonga (2000) see this activities as the opportunity to rise
anticompetitive advantages for the firm. The argument of Villalonga is
that firms undertake diversification operations in order to acquire
more market power. The most classical case is when a large firm
proceeds with M&A operation with other large firms to drive small
competitors out of the business.

1.2 Costs and Benefits
To analyze costs and benefits of corporate diversification we must
remember that what represents a sacrifice for an agent could instead
be an advantage for someone else. Interests may differ, this is why we
must specify every time who is the beneficiary or the receiver of the
damage produced by corporate diversification. From the point of view
of the firm itself, corporate diversification, as the portfolio
diversification operated by an investor, modifies specific risks related
to the activities of the firm. This would affect also a number of agents
like workers, suppliers and creditors.
One of the most important contribution to financial theory of
corporate diversification was given by Lewellen, who introduced the
concept of coinsurance. Lewellen argues that corporate diversification
can reduce the volatility of the earnings if the combining businesses
are characterized by cash flows which are not perfectly positive
correlated. Through the reduction of the earnings volatility, firms can
sustain higher levels of debt and, since taxes on interest bearing debt
are deductible, the firm who decide to operate in different businesses
will have more borrowing capacity and for this reason would be more
valuable than firms that do not diversify. But how can the benefit be
valuated? Since the cash flows of the conglomerated firms are less
volatile than individual firms, Lewellen states that the benefit
produced by corporate diversification should be measured in terms of
reduction of default risk. Consider the following example by
Damodaran:



Lube & Auto and Dalton Motor Merger
These two firms are in two different business line, which as stated
above, reduce the volatility in earnings of the conglomerated firm. If
we assume that this reduction increases debt capacity, the value of the
combined firm after the takeover will be larger than the sum of the
values of the independent firms.


Note that the added debt increase the firm value from 729.69$ to
752.53 million.

Moreover, consider the following situation: a firm has tax deductions
but it cannot use them because it reported a negative net income in
the latest year while another firm has a positive income and pay taxes
on it. It follows that the combination of them would generate a tax
benefit.


Obviously, M&A activities has also a number of disadvantage.
Corporate diversification can modify substantially the products, the
target customers, the relationship with the workers and many other
practical aspects. Diversification expose to more competition either
because the firm is entering in a different market area or because it
has undertaken the production of new goods.
Consider the following situation: three firms decided to merge
themselves. One of this firms produce a good which is necessary to the
other two and it cant be sold on the market. So while there are two
firms producing and sell their goods, there is one firm of the
conglomerate which could be probably not efficient. In this case the
merger has a cost: you are spending money on a strategy that is not
paying off. Even if profit coming from the other two firms could repay
the losses of the inefficient firm, it might have been better to use a not-
diversified strategy.

In addition, corporate diversification could represents, in our opinion,
a supplementary opportunity for investors. In fact, if they want to
reduce the risk related to their portfolios, they can choose between
the composition of a diversified portfolio of shares or the purchase of
a share of a conglomerate (which can be seen as a share of a
diversified portfolio). Yet, these two option are, in most cases, not
equal; an investor who decide to compose his portfolio adding in
different shares with different risk profile is far more unconstrained
relative to another one who decide to buy shares of diversified firm. If
this is easy to understand, on the other hand it is not so clear which
strategy could be the best one: retail investors sometimes are
bounded in the acquisition that they can make, for example when a
firm is not publicly traded and so it is not possible to buy its shares on
the markets. Think about a firm who decides to diversify its portfolio
and buy a not-publicly traded firm. In this case an investor could be
more inclined to buy a share of that conglomerate instead of try to
diversify its portfolio through the addition of other shares. This choice
would be taken by the agent when there are no traded companies with
the same risk profile of the one which has been brought in the
conglomerate.



1.3 Diversification strategies over time
The age between 1950 and 1980 is considered the era of major
expansion of firms into different markets. The peak of diversification
activities was in the 1970s with the emergence of conglomerates.
Examples were the merger of ITT, Textron and Allied-Signal in the U.S.
or between Hanson, Slater-Walker and BTR in U.K.. Diversification
strategies during the late twentieth century is presented in the chart
below:



Source: "Contemporary Strategy Analysis: Text and Cases", R. M. Grant

As we can see, the trend of diversification strategies is focused on the
acquisition of related business. This means that during the considered
period, companies decided to move toward the specialization of their
production instead of proceed with acquisitions in unrelated business.
This is probably the consequence of the low profitability of
conglomerated companies relative to the high interest rates during
the same period.
At this point we must observe that M&A activities could not rely on a
special story for every decade. In fact, a theory which is not linked to
every particular period has been developed; in this sense we could call
this theory a unified one, which tries to found a defined behavior of
corporate diversification over time.
The oldest idea relating to this theory comes to Nelsons study of
merger waves in USA (1959): It appears that merger expansion was
not only a phenomenon of prosperity, but that it was also closely
related to the state of the capital market. Therefore, the main idea is
that stock market may misvalue potential acquires or potential targets
or, even more, a combination of the two. When a misevaluation occurs,
managers can take advantage of these inefficiencies and proceed with
M&A operations. Summing up, there are two main different theories
explaining corporate diversification over time: the first one, which can
be referred to as segmented, analyses the behavior of M&A in a
particular historical period and tries to found reasonable explanation
for the movements in such activities for each period; the second one,
unified, that tries to study changes in M&A operations trend through
a specific theory that is able to explain these movements in every
period.
Shleifer and Vishny presented in 2001 a model of merger and
acquisitions based on stock market misvaluation of the combining
firms. The authors assume in this model that, whereas stock market
is inefficient, the managers are perfectly rational and informed. They
perfectly know how the value of both their firms and the target firms
would change with respect to the efficiency level and what could be
the possible long run valuations. They try therefore to maximize their
objective functions given these data.
The interesting part of the work presented by Shleifer and Vishny is
related to their analysis of the consequences that using either cash or
stock in such operations can produce. In particular, they main result is
related to the long run; through the usage of their model they
demonstrate that the effect of a cash acquisition is zero in the long
term:

( ) value obtained by the target
( ) value obtained by the acquirer
where:
q value of assets per unit of capital
K capital stocks
P price paid by the acquirer for the operation

( ) ( ) What the target gain, the bidder losses.

Although a series of not very soft assumptions, the authors conclude
therefore that cash acquisitions have sense only if the target is
undervalued.
The situation is slightly different if the acquisition is made through
stock. Target shareholder would gain in this situation as long as the
price paid to the target firm exceeds the valuation of the combine
entity while the opposite holds for the bidder.


Returning to Nelsons study, this author noticed three important
features of M&A operations:

1) They occur during periods of high stock market valuation
2) Highly concentrated in time
3) They are generally paid with stock

Furthermore, recent study, particularly Andrades one (2001),
confirms Nelsons observation: in the 1980s, 45.6% of acquisitions
were made using any stock whereas in the 1990s this amount rose to
70.9%. in addition, acquisition composed all by stock were 32.9% in
the 1980s and57.8% in the 1990s.


Source: Thomson Financial, Institute of Mergers, Acquisitions and Alliances
2. Diversification and firm value
2.1 Corporate diversification does not destroy shareholder value
The issue about if corporate diversification destroy value has been the
focus of several recent papers that attemped to answer this question
comparing the market value of firms that operate multipe lines of
business to the value of a portfolio of stand-alone firms operating in
the same industries as the conglomerates divisions.
This paragraph deals with that kind of researches which do not want
to contest the notion that diversified firms sell at a discount but rather
that this discount depends on other factors than diversification itself.
Indeed, this paragraph wants to show that acquiring and acquired
firms sell at a discount prior to merging.
Diversified firms tend to trade at a dicount prior to diversification: it is
what Graham et al. affirm in their research on several hundred firms
that expand via acquisition or increase their number of segment
business segments. They have found that market reaction to mergers
is pretty positive since this kind of announcements create an excess of
value for conglomerate, but the excess value decline after the
diversifying event.
This reduction occurs because the firm acquires already discounted
business units and not because diversification destroy value.
They also stated that acquired firms sell at an average discount of
approximately 15% in their last year of operation as a stand-alone
firm. Concluding, they suggest that stand-alone firms could not be
used as benchmark for conglomerates divisions due to systematic
differences.
Comparing the market value of firms that operate multiple lines of
business to the value of a portfolio of stand-alone firms operating in
the same industies as the conglomerates divisions, Lang and Stulz
found that multisegment firms have low values of Tobins Q compared
to stand-alone firms. Moreover they investigate on the negative
relation between Tobins Q and firm diversification remarking that:
Our evidence is consistent with the view that firm seek growth
through diversification when they have exhausted internal growth
opportunities. Therefore, diversifying firms are poor performers
prior to conglomeration.

The same view of the problem is suggested by Hyland, that is
diversified firms trade at a discount prior merging. Thus, this firms
already have a discount relative to the median specialized firm to
which they are benchmarked. While diversification does not seem to
create value and hence does not improve performance, it does not
appear to destroy value relative to the current activities of the firm.
Therefore, there is no evidence that the market consistently views
diversification as a value-reducing decision. Moreover, a growing
number of firms try to diversify their activities portfolio. The
conclusion is the one mentioned above: conglomerates perform poorly
prior the diversification and have low growth opportunities in their
current activities, for this reason they adopt diversification strategy in
an effort to acquire growth opportunities.
Lastly, Campa and Kedia find that conglomerate firms differ from
single segment firms in terms of their size and, thus, if the differences
in size are controlled, the diversification discount either drops or
disappears entirely. In their research, three different econometrics
methodologies are employed to control for these differences. This
study shows that the failure to control for firm characteristics which
lead firm to diversify, may wrongly attribute the discount to
diversification instead of to the underlying characteristics.



2.2 Merging causes destroying value
In some case, as we can see, merging and acquisition could destroy the
shareholders value particularly for large M&A.
We showed why its important merging: it can improve existing
products or services, change of personality or direction and acquiring
talented people or intellectual property. But so, why in some cases
there is destroying of value? Well, the reasons for failed mergers
include tangible accounting and operation failures, but the most
complex reasons deal with people, culture and human emotion.
Fraudulent accounting practices are the most sinister cause of
overvaluing an acquisition. For example Caterpillar revealed, in 2013,
a 580 million of $ charge in relation with the acquisition of Siwei, a
Chinese firm, whose fraudulent team led Caterpillar to wildly overpay!
But not only this type of overvaluation due to deviance. In fact bankers
and executives can make wrong previsions about future market trend
of a specified firm.
M&As are first and foremost a strategic and financial transaction, but
assuming the relevant financial and legal steps are done correctly, true
success hinges on how effectively the most important intangible assets
of a brand its people assimilate. A major downside of negotiations
is that the legal and financial arrangements can give management
tunnel vision, such that the only human capital decisions made with
conviction are who will be the next CEO and who will comprise the
new Board of Directors. Meanwhile, in the trenches, anxious
employees are left to figure things out. People never fit as easily as
flow charts. If cultures are not compatible or managed carefully, the
partnership may be doomed from the start. In many cases, mergers or
acquisitions bring together groups of people who have spent their
working lives competing against one another. This is usually referred
to as a merger of equals because, on the surface, it brings together
two similar types of companies with strong market positions, such as
the unification of Daimler-Chrysler in 1998. In other cases, mergers or
acquisitions bring together two completely different types of
companies and cultures.
So cultural conflicts have usually two outcomes: the first possible
outcome is when management mutually admits defeat and dissolves
the merger as Daimler Chrysler did in 2007, selling what was once
the third largest auto-maker in the United States. Chrysler would file
for bankruptcy in 2009.
The second outcome is when the companies do manage to remain
whole, one brand assumes a secondary role within the company.
AN EXAMPLE:
Analysts agree that the cultural gap in corporate cultures was one of
the main reasons for the Daimler-Chrysler failure (Daimler was a
company conservative, efficient and safe).
So to summarise the cultural factors in play here:
differences in corporate cultures and values
lack of coordination
severe lack of trust among the employees
All three resulted in communication failures which in turn caused a
sharp reduction in productivity.
For a financing analyses if we see how much was paid by Daimler for
Chrysler in 1998 (38$ billion) and by Cerberus Capital, always for
Chrysler, in 2007 (7,4$ billion), we can have a more practical view
about how such a promising merger could fail so dramatically.
Usually, it is extremely difficult to show exactly what role culture
played in a success or in a failure. However, in the case of Daimler-
Chrysler, it would be a safe assumption to say that cultural factor was
among the crucial ones which determined the downfall of a new
company.

Is it only a cultural question the erosion of value in failed mergers?
Well, obviously this is not the only reason, but in a real view of facts
this is the most logical and dangerous reason.
For the example case above, the Daimler - Chrysler merger proved to
be a costly mistake for both the companies. Daimler was driven to a
loss, by its merger with Chrysler. Last year, the merged group
reported a loss of 12 million euros.
Contrasting cultures and management styles didnt permit the
realization of the synergies. Daimler-Benz attempted to run Chrysler
USA operations in the same way as it would run its German
operations. Daimler-Benz was characterized by methodical decision-
making. On the other hand, the US based Chrysler encouraged
creativity.


2.3 Diversification creates Shareholders value
Before starting to investigate the reason of why M&A activities could
increase shareholders value, we must observe that all the studies on
this particular argument begin with the assesment that there is no
diversification discount and that this result is due to lack in the data
used for the estimation or measurement errors.
Stated this the greatest contribute in explaining premiums generated
by corporate diversification was given by Villalonga (2000) who has
also the merit to explain why previous attempt to assess the
diversification discount were not correct.
What was notice by this author was the lack of business units
consistently defined across different firms in the US. This creates three
different problems to the estimation of M&A effects:

1) The firm could be diversified in a different way and different
amount with respect to its financial segmented reports.
2) Too flexible definition of business segments. This means that the
firm is able to combine in one single segment very different
businesses and this would lead to miscomputation and errors by
who is calculating the level of diversification of that particular
firm.
3) Some industries are composed of segments of diversified firms.

The effects of these problems are clear if we analyze them through the
usage of Tobins Q: this represents in fact the ratio between the total
market value of a firm and the total asset of the same. We are able to
compute the Q-ratio also for every single business in which the firm is
divided:





But, given the three problems above we are not sure about the
definition of both the nominator and the denominator of the ratio. So,
theoretically speaking, if Q > 1 we could issue shares relating to the
business and invest the proceeds in capital; However, since we are not
sure about the segment borders, we are not sure about the real value
of the Q-ratio and, for this way, we are not sure about the effect of
issuing new shares.
So, if we want to compute the effect of diversification looking at how
the Q-ratio has changed after the merger or acquisition, we should be
aware of the issues presented above and try to define, before all the
computations, precise business segments.
Villalonga correct her estimations for this bias and notice how
diversified firms trade at a premium compared to non-diversified
firms in the same industry.


Conclusion
Our paper has started with the analysis of corporate diversification,
underlying what this kind of operations represents, when they are
used and which are the possible outcomes. Regarding this last point,
the other sections of this paper have analysed it and demonstate that
there is not a unified view of such argument. This is mainly due to the
fact that the data used by the different models are usually not the
same. In this sense, the most important problem when dealing with
the estimation of corporate diversification level is indeed how data on
merged firms are collected. The last section of the present paper has
effectively deal with this problem: it was possible to assess that M&A
creates shareholders value noticing firstly that models which dont
accept this conclusion or confirm the opposite presented in fact errors
on the side of data collection.
Anyway, in our opinion, there cant be a unique view. If it is true that
some models have some drawbacks with respect to the inputs, it is
also true that other models which claim to be correct from that point
of view (like the one presented by Villalonga) can be weak on the side
of the hypothesis involved. For this reason we think that every M&A
operation has its peculiarities and, therefore, every case should be
analyse singularly. We are not saying that there is no space for a
general model when dealing with M&A. However, the variables
involved are many and often difficult to compute: how could we
possible compute the relation between shareholders value and social
or political aspects?
Bibliography
Campa, J.-M., Kedia, S., 1999. Explaining the diversification discount.
Unpublished manuscript, Harvard Business School (April).

Damodaran, A., 2009. Damodaran on Valuation, Wiley.

Dutta S., Kumar V., Mergers and Acquisitions (M&AS) by R&D
Intensive Firms, Journal of Risk and Financial Management 2(2009)

Graham, J.R., Lemmon, M.L., Wolf, J., 1999. Does Corporate
Diversification Destroy Value? Unpublished manuscript, Duke
University (December).

Hyland, D., 1999. Why Firms Diversify: An Empirical Examination.
Unpublished manuscript, University of Texas at Arlington.

Jarrad Harford, What drives merger waves? Journal of Financial
Economics, September 2005.

Jensen, M.C., 1986. Agency costs of free cash flow, corporate finance
and takeovers. American Economic Review, 76.

Lamont, O., Polk, C., 2000. Does Diversification Destroy Value?
Evidence from Industry Shocks. Unpublished paper, The Center for
Research in Securities Prices, No. 521 (July).

Lang, L.H.P., Stulz, R.M., 1994. Tobins q, corporate diversification, and
firm performance. Journal of Political Economy, 102.

Lewellen, W., 1971. A pure financial rationale for the conglomerate
merger. Journal of Finance, 26.

Martin D., Sayrak A., 2003, Corporate diversification and shareholder
value: a survey of recent literature, Journal of Corporate Finance 9
(2003).

Penrose, E.T., 1959. The Theory of the Growth of the Firm. Wiley, New
York.

Shleifer, A., Vishny, R., 1990a. Managerial entrenchment, the case of
manager specific investments. Journal of Financial Economics, 25.

Shleifer, A., Vishny, R., 1990b. The takeover wave of the 1980s.
Science, 249.

Villalonga, B., 1999. Does Diversification Cause the Diversification
Discount? Unpublished manuscript, Anderson Graduate School of
Management, University of California, Los Angeles.