Diversification and acquisitions

Chapter 9

The next chapters will focus on corporate-level strategy which is how a firm creates value through the
configuration and coordination of its multimarket activities. Before we were dealing with business-level
strategy which is defined as ways to build competitive advantage in an identifiable market. For larger,
multimarket firms, corporate strategy is perhaps the most important.

First, we will focus on diversification which is adding new businesses to the firm that are distinct from its
existing operations. It can be accomplished along two dimensions.

1. Product diversification: entries into new product markets and/or business activities that are related
to a firm’s existing markets and/or activities.
2. Geographic diversification: entries into new geographic markets.

Product diversification
Most firms start as small businesses focusing on a single product or service with little diversification, known as
single business strategy. It is a typical strategy encompassed by new small businesses.

Product-Related Diversification
Product-related diversification refers to entries into new product markets and/or business activities that are
related to a firm’s existing markets and/or activities. The emphasis is on operational synergy or scale
economies.

Operational synergy is defined as increases in competitiveness beyond what can be achieved by engaging in
two product markets and/or activities separately. It is a synergy driven by having shared activities, personnel,
and technologies. Sources of operational strategy are technologies, marketing and manufacturing.

Scale economies or economies of scale is the reduction in per unit costs by increasing the scale of
production.

Product-Unrelated Diversification
Product-unrelated diversification refers to entries into industries that have no obvious product-related
connections to the firm’s current lines of business. The product-unrelated diversifiers are called conglomerate
and their strategy, conglomeration, focusses on financial synergy.

Financial synergy or economies of scale, is the increase in competitiveness for each individual unit that is
financially controlled by the corporate headquarters beyond what can be achieved by each unit competing
independently as standalone firms.

So a conglomerate serves as an internal capital market that channels financial resources to high-potential
high-growth areas. It is a term used to describe internal management mechanisms of a product-unrelated
diversified firm (conglomerate) that operate as a capital market inside the firm.

If conglomerate units beat individual rivals, then there is a diversification premium or conglomerate
advantage which is when product-unrelated diversification adds value. It is the increased level of performance
because of associations with a product-diversified firm. Otherwise there can be diversification discount or
conglomerate disadvantage when units are better off by competing as standalone entities.
It is the reduced levels of performance because of association with a product-diversified firm.
 Product Diversification and Firm Performance
Hundreds of studies suggest that, on average, performance may increase as firms shift from single business
strategies to product-related diversification, but performance may decrease as firms change from product-
related to product-unrelated diversification. The linkage can be described by the following graph.

However, important is to note that not all

product-related diversifiers outperform
unrelated diversifiers. In EMs in particular,
conglomeration strategies seem to be successful.

Geographic diversification
We focus on international diversification, the number and diversity of countries in which a firm competes.

Limited versus Extensive International Scope

Two broad categories of geographic diversification can be identified:
1. Limited international scope, which emphasizes on geographically and culturally adjacent countries in
order to reduce the liability of foreignness.
2. Extensive international scope, maintaining a substantial presence beyond geographically and
culturally neighboring countries.

Geographic Diversification and Firm Performance

In this age of globalization, we frequently hear the calls for greater geographic diversification. All firms need
to go “global,” non-international firms need to start venturing abroad and firms with a little international
presence should widen their geographic scope.

As captured by the S curve in figure above, two findings emerge:

1. At a low level of internationalization, there is a U-shaped relationship between geographic scope and
firm performance; initially negative effect of international expansion on performance before the
positive returns are realized. It stems from liability of foreignness.
2. At moderate to high level levels of internationalization, there is an inverted U-shape, implying a
positive relationship between geographic scope and firm performance, but only to a certain extent,
beyond which further expansion is again detrimental.
Combining product and geographic diversification
Although most studies focus on a single dimension of diversification (product or geographic) that is already
very complex, in practice, most firms have to entertain both dimensions of diversification simultaneously.

The figure below illustrates the four possible combinations.

o Anchored replicator: a firm that seeks to replicate a set of activities in related industries in a small
number of countries anchored by the home country.
o Multinational replicator: a firm that engages in product-related diversification on the one hand and
far-flung multinational expansion on the other hand. E.g. Volkswagen.
o Far-flung conglomerate: a conglomerate firm that pursues both extensive product-unrelated
diversification and extensive geographic diversification. One example might be Samsung. E.g.
Samsung
o Classic conglomerate: a firm that engages in product-unrelated diversification within a small set of
countries centered on the home country. E.g. Indian TATA group.

Overall, it is possible to migrate from one cell to another, although difficult. Example: from C4 to C1 it means
that the costs for doing business abroad have declined and the costs for managing conglomeration have risen.

Further, asserting that firms in a particular cell will outperform those in other cells is foolish. In every cell, we
can find both highly successful and highly unsuccessful firms.

A comprehensive model of diversification

Industry-based considerations
Porter’s five forces analysis.

A motivation for diversification is the growth opportunities in an industry. Next to this, the structural
attractiveness is also significant.

1. Firm rivalry, intense firm rivalry may motivate firms to diversify. E.g. PepsiCo diversified into sports
drinks.
2. Entry barriers, high entry barriers facilitate certain kinds of firms to diversify.
3. Power of suppliers and buyers, the bargaining power of suppliers and buyers may prompt firms to
broaden their scope by acquiring suppliers upstream and/or buyers downstream. E.g. Coca cola
recently acquired its leading bottlers.
4. Threat of substitutes, also has a bearing on diversification.

In summary, the industry-based view has largely focused on product-related diversification with an industry
focus (often in combination with geographic diversification).
 Resource-Based Considerations
1. Value: yes, but only under certain conditions. Diversified firms are able to spread risk and
diversification can create value by leveraging certain core competencies, resources, and capabilities.
2. Rarity: for diversification to add value, firms must have unique skills to execute such a strategy.
3. Imitability: while many firms undertake acquisitions, a much smaller of them have mastered the art of
post-acquisition integration. Consequently, firms that excel in integration possess hard-to-imitate
capabilities.
4. Organization (focused on product diversification): with proper organization, both product-related
diversification and product-unrelated diversification can add value.

The table below, shows that product-related diversifiers need to foster a centralized organizational structure
with a cooperative culture. The key is to explore operational linkages among various units and some units may
need to be pulled back to coordinate with other units. Consequently, corporate headquarters should not
evaluate division performance solely based on strict financial targets (such as sales). The principal control
mechanism is strategic control or behavior control, controlling subsidiary/unit operations based on whether
they engage in desirable strategic behavior.

However, the best way to organize conglomerates is exactly the opposite. The emphasis is on financial control
or output control, controlling subsidiary/unit operations strictly based on whether they meet financial/output
criteria.

Consequently, the appropriate organizational structure is decentralization with substantial divisional

autonomy.

Overall, the key to adding value through either product-related or product-unrelated diversification is the
appropriate match between diversification strategy and organizational structure and control. Conglomerates
often fail when corporate managers impose a more centralized structure undermining lower-level autonomy.

Institution-Based Considerations
FORMAL INSTITUTIONS
Formal institutions affect diversification strategies. E.g. The popularity of conglomeration in emerging
economies is often underpinned by their governments’ protectionist policies. Business groups, or
conglomerates, can leverage connections with governments by obtaining licenses, arranging financing, and
securing technology. However, if governments dismantle protectionist policies, competitive pressures for
foreign MNE’s may intensify, forcing an improved performance by reducing their scope.

INFORMAL INSTITUTIONS
Informal institutions can be found along normative and cognitive dimensions.
Normatively, managers often seek to behave in ways that will not cause them to be noticed as different.
Therefore, when the norm is to engage in conglomeration, more managers may simply follow such a norm.
Another informal driver for conglomeration is the cognitive dimension, or rather the internalized beliefs that
guide managerial behavior. Managers may have motives to advance their personal interests that are not
necessarily aligned with the interests of the firm and its shareholders. These are called managerial motives for
diversification, such as (1) reduction of managers’ employment risk and (2) pursuit of power, prestige, and
income.
The Evolution of the Scope of the Firm
At its core, diversification is essentially driven by economic benefits and bureaucratic costs.
- Economic benefits, benefits brought by the various forms of synergy in the context of diversification.
- Bureaucratic costs, the additional costs associated with a larger, more diversified organization.

The scope of the firm is determined by a comparison between MEB and MBC (figure below).
- Marginal economic benefits (MEB), the economic benefits of the last unit of growth (such as the last
acquisition).
- Marginal bureaucratic costs (MBC), the bureaucratic costs of the last unit of organizational expansion
(such as the last subsidiary established).
The optimal scope is at point A, where the appropriate
level of diversification should be (D1).

If the level of diversification is D2, some economic

benefits can be gained by moving up to D1 .

If the level is at D3 , reducing the scope to D1 becomes

necessary.
The figure below shows how conglomerates in emerging economies may add value at a higher level of
diversification, whereby firms in developed economies are not able to. We in fact make two crucial and
reasonable assumptions:
1. MEBEMergingEcon > MEBDevelopedEcon
This is primarily because underdeveloped external capital markets in emerging economies make
conglomerates as internal capital markets more attractive.

2. MBCEMergingEcon < MBCDevelopedEcon

Relative to firms in developed economies, firms in emerging economies typically feature a lower level
of bureaucratization, formalization, and professionalization, which may result in lower bureaucratic
costs.

Consequently, for any scope between D1 and D2, firms in developed economies at point C need to be
downgraded towards A. Whereas there is still room to gain for firms in Ems at point E, which can move up to
B. However, the wider the scope, the harder it is for corporate headquarters to coordinate, control and invest
properly in different units.

Overall, industry dynamics, resource repertoires, and institutional conditions are not static, nor are
diversification strategies.

Acquisitions

Setting the Terms Straight

Although the term “mergers and acquisitions” is often used, in reality, acquisitions dominated the scene.
Merger and acquisition (M&A) is merging with or acquiring other firms.

Acquisition is the transfer of control of assets, operations, and management from one firm (target) to another
(acquirer); the former becomes a unit of the latter.

A Merger is the combination of assets, operations, and management of two firms to establish a new
legal entity.

There are three primary categories of M&As:

1. Horizontal M&A refers to deals involving competing firms in the same industry.
2. Vertical M&A are deals involving suppliers (upstream) and/or buyers (downstream).
3. Conglomerate M&A are deals involving firms in product-unrelated industries.

The terms of M&A can be friendly or hostile.

- Friendly M&A is a deal in which the board and management of the target firm agree to the
transaction (although they may initially resist).
- Hostile M&A = hostile takeover is a deal undertaken against the wishes of target firm’s board and
management, who reject the M&A offer.
 The variety of cross-border M&A

Motives for Mergers and Acquisitions

The table below shows three drivers of M&As illustrated by three leading perspectives.

While all the synergistic motives, in theory, add value, hubris and managerial motives reduce value. Hubris
refers to managers’ overconfidence in their capabilities. Managers acquiring firms make very two strong
statements:
1. We can manage your assets better than you.
2. By paying an acquisition premium, difference between acquisition price and the market value of
target firms, we are smarter than the market.

They may simultaneously coexist.

Performance of Mergers and Acquisitions

One average, acquiring firms’ performance does not improve after acquisitions and is often negatively
affected. Target firms, after being acquired, often performed worse than when they were independent
standalone firms. Why then do many acquisitions fail? Problems can be identified in both pre- and post-
acquisition phases.
Strategic fit is the complementarity of the partner firms’ “hard” skills and resources, such as technology,
capital, and distribution channels.

Organizational fit is the complementarity of partner firms’ “soft” organizational traits, such as goals,
experiences, and behaviors, that facilitate cooperation. Firms may also fail to address the concerns of multiple
stakeholders (see below), including job losses and diminished power.

Bottom-line is that, although M&As are often the largest capital expenditures most firms make, they
frequently are the worst planned and executed activities of all.

Restructuring. Chapter 9.6.

Setting the Terms Straight
Although restructuring normally refers to adjustments to firm size and scope through either diversification
(expansion or entry), divesture (contraction or exit) or both, its common definition is reduction of firm and
scope.

Using this definition, there are two primary ways of restructuring:

1. Downsizing which is reducing the number of employees through lay-offs, early retirements, and
outsourcing.

2. Downscoping which is reducing the scope of the firm through divestitures and spin-offs.
The flip side of downscoping is refocusing which is narrowing the scope of the firm to focus on a few
areas.

Motives for restructuring

- From an industry-based view, restructuring is often triggered by a rising level of competition within an
industry.
- The resource-based view suggests that while restructuring may bring some benefits, significant costs
also arise (organizational chaos, anxiety, and low moral).
- From an institution-based perspective, firms in developed economies increasingly felt pressure in the
80s and 90s from capital markets to restructure. Corporate restructuring is not widely embraced
around the world.
Debates and extensions
Product Relatedness versus Other Forms of Relatedness
How to actually measure product relatedness remains debatable.
Beyond measurement issues, an important school of thought, known as the dominant logic school, argues that
it is not the visible product linkages that can only count as product relatedness. Rather, it is a set of common
underlying dominant logic that connects various businesses in a diversified firm.

Dominant logic is a common underlying theme that connects various businesses in a diversified firm.

Finally, from an institutional-based view, some “product-unrelated” conglomerates may be linked by

institutional relatedness which is a firm’s informal linkages with dominant institutions in the environment that
confer resources and legitimacy.

The savvy strategist

Guided by the three leading perspectives that underpin the strategy tripod, the savvy strategist draws three
important implications for action:
1. Understand the nature of your industry that may call for diversification, acquisitions and restructuring
2. Develop capabilities that facilitate successful acquisitions and restructuring
3. Master the rules of the game governing acquisitions and restructuring around the world

As always, then there are some do’s and don’ts to follow.

- Pre-acquisition
o Do not overpay for targets and avoid a bidding war when premiums are too high
o Engage in thorough due diligence concerning both strategic fit and organizational fit
- Post-acquisition
o Address the concerns of multiple stakeholders and try to keep the best talents
o Be prepared to deal with roadblocks thrown out by people whose jobs and power may be
jeopardized