Conglomerate discount

Corporate Restructuring

Tim Thompson

Arguments based on fundamentals

• Conglomerates are good– Williamson (1975), with superior inside

information, diversified firms can allocate capital better than the market

– Stein (1997), can fund winners and abandon losers more efficiently than market, agency costs mgr/shareholder

Conglomerates are bad

• Morck, Schleifer and Vishny (1990)– Look at bidder returns to announcements of

acquisitions• Bad past performing managers incur larger negative

abnormal returns at the announcement of acquisitions, relative to good performers

• Avg bidder return in related acquisition is positive, avg bidder return in unrelated acquisition is negative, stat. insig, but seems signif in 1980’s

Conglomerates are bad, cont’d.

• Jensen (1988), agency costs of free cash flow argument for forming conglomerates

• Comment and Jarrell (1995)– Herfindahl index of focus– Increasing focus correlated with abnormal

positive stock returns– diversified firms don’t have more debt, don’t

rely less on cap mkt and are targets more often

Berger and Ofek

• Estimated conglomerate discount– Took sample of conglomerate firms (segments

in different 4-digit SIC codes)– Calc’ed Value to Sales, Assets, EBIT ratios for

companies, same industries as conglom segs – Used median comp ratio to value segments of

conglomerate– Summed to calc imputed value of conglom

Berger and Ofek, cont’d.

• Calculated ratio of market value of conglom to imputed value– Average 13-15% value discount for congloms

relative to single-segment competitors– Value loss greater when segments not in same

2-digit SIC code– Value loss related to overinvestment relative to

peers and cross subsidization

Divisional managers’ incentives

• Incentives of management may be enhanced with stock, options, SAR’s, etc.

• In diversified firm, often don’t have divisional stock (carve outs and target shares are rare)

• Conglomerate stock may not set up appropriate payoff for risk taking

Stock market explanations

• Market cannot understand multi-division firm and attach a correct multiple to its earnings or cash flow

• RJR/Nabisco, Phillip Morris/Kraft argument

• Companies don’t allocate analysts from each market segment to study conglomerate firm

Papers on Conglomerate Discount

• Berger, Philip and Eli Ofek (1995). “Diversification’s Effect on Firm Value,” Journal of Financial Economics.

• Berger, Philip and Eli Ofek (1996). “Bustup Takeovers of Value-Destroying Diversified Firms,” Journal of Finance.

• Comment, Robert and Gregg Jarrell (1995). “Corporate Focus and Stock Returns,” Journal of Financial Economics.

• Jensen, Michael (1986) “The Agency Costs of Free Cash Flow, Corporate Finance and Takeovers,” American Economic Review.

• Stein, Jeremy. (1997) “Internal Capital Markets and the Competition for Corporate Resources,” Journal of Finance.

• Williamson, Oliver (1975). Markets and Hierarchies, Free Press.