Corporate Governance and Firm Diversification

Financial Management (Financial Management Association), Spring, 2000 by Ronald C. Anderson, Thomas W. Bates, John M. Bizjak, Michael L. Lemmon

Michael L. Lemmon [*]

We empirically investigate whether corporate governance structure is different between focused and diversified firms, and whether any differences in corporate governance are associated with the value loss from diversification. We find that, relative to focused firms, CEOs in diversified firms have lower stock ownership and lower pay-for-performance sensitivities. Diversified companies, however, have more outside directors, no difference in independent block-holdings, and sensitivity of CEO turnover to performance similar to that in single-segment firms. Moreover, we find no compelling evidence that internal governance failures are associated with the decision to diversify, or that governance characteristics explain the value loss from diversification. Our findings suggest that diversified firms use alternative governance mechanisms as substitutes for low pay-for-performance sensitivities and CEO ownership. We conclude that agency costs do not provide a complete explanation for the magnitude and persistence of the diversification discount.

Recent studies by Lang and Stulz (1994), Berger and Ofek (1995), and Servaes (1996) suggest that diversified firms are valued at a substantial discount relative to the imputed values of their individual lines of business. The persistence of such a discount is consistent with two hypotheses. First, diversification may be associated with suboptimal corporate governance structures, which allow managers to entrench themselves and reap private benefits at the expense of shareholders. Alternatively, diversified firms may utilize optimal governance structures, but may forego divestiture if the transaction costs associated with the break-up offset the expected benefit of operating a more focused firm.

The purpose of this paper is to empirically examine the structure of corporate governance in diversified firms. Specifically, we investigate whether governance structures are significantly different between focused and diversified companies, and whether these differences, if any, are consistent with an agency cost explanation for diversification. Beginning in 1985 with a sample of 199 firms, and following the surviving firms through 1994, we examine the association between firm diversification and 1) both the level and sensitivity of CEO compensation, 2) firm ownership structure, including holdings of the CEO, officers and directors, and outside blockholdings, 3) the sensitivity of CEO turnover to firm performance, and 4) the size and composition of the board of directors.

We find that the structure of corporate governance is sensitive to the level of diversification. Consistent with an agency explanation for diversification, CEOs in multi-segment firms receive compensation that is less sensitive to firm performance and have lower stock ownership than CEOs in focused firms. Our results suggest, however, that multi-segment firms employ alternative governance mechanisms that can reduce agency problems. Specifically, we find that diversified firms have, on average, a higher fraction of outsiders on their board of directors, similar ownership by outside blockholders, and similar sensitivity of managerial turnover to performance relative to their single-segment counterparts.

To provide further understanding about the relation between diversification and corporate governance, this paper also identifies whether changes in diversification during the sample period can be explained by the ownership and governance characteristics of the firm. If diversification is the result of opportunistic behavior by managers, we expect to see a relationship between characteristics associated with weak corporate governance and the decision to diversify. In contrast to the idea that agency problems drive the diversification decision, we find that firms that increase their level of diversification over the sample period have governance and performance characteristics that are remarkably similar to firms that retain their focus. Firms that decrease their level of diversification, however, have lower insider ownership but more equity-based compensation relative to focused firms. While in general these findings imply that there is no systematic relation between the decision to diversify and the choice o f governance structure, they also suggest that equity-based compensation may play a role in motivating low ownership CEOs to reverse value decreasing diversification strategies. Finally, this research directly examines the extent to which corporate governance is associated with performance in a diversified firm. On average, we fail to find any reliable association between the governance characteristics of the firm, and the Berger and Ofek (1995) measure of the value loss from diversification in multi-segment firms.

We add to the existing literature on diversification and firm performance by providing a comprehensive analysis of differences in the overall structure of corporate governance between diversified and focused firms, and addressing how these differences are related to firm performance. Most prior studies have focused on a single governance characteristic. Given our results, we argue that the structure of corporate governance varies systematically with the degree of diversification, but that failures in internal governance mechanisms do not provide a complete explanation for the magnitude and persistence of the value loss associated with diversification.