Why do conglomerates typically trade at a discount of 5% to 12%, compared with more-focused companies? According to a growing body of evidence, the failings of internal capital markets are at least partly to blame.
Ironically, greater access to internal financing was seen initially as an advantage for diversified firms. Headquarters staff had better information, economists believed, and could allocate funds more efficiently than outside investors or banks.
Lately, however, a more pessimistic view has emerged. Rather than distribute capital according to expected rates of return, explains Eric Powers, assistant professor of finance at the University of South Carolina's Darla Moore School of Business, “conglomerates seem to take a pool of resources and divide by ‘n’ [the number of divisions in the conglomerate].” Divisions in strong industries end up investing too little, divisions in weak industries invest too much, and both respond sluggishly as investment opportunities change.
In order to pin down that effect, Powers and two colleagues — Robert Gertner, professor of economics and strategy at the University of Chicago's Graduate School of Business, and David Scharfstein, professor of management at MIT's Sloan School of Management — analyzed 1981 to 1996 data from 160 spinoffs. Unlike previous researchers, who compared divisions with independent companies, they examined investment spending at business units before and after they were spun off. Their results appear in a working paper titled “Learning About Internal Capital Markets From Corporate Spinoffs.”
The study noted that capital expenditures showed greater sensitivity to changes in growth opportunities after a division became independent. Also, companies operating in high-growth industries tended to increase capital investment following the spinoff, whereas investment declined for post-spinoff companies operating in low-growth sectors.
The results were much stronger for those spinoffs in industries unrelated to their former parents' other lines of business. Within that group, changes in industry prospects had virtually no impact on pre-spinoff capital expenditures. But following a spinoff, the study predicted, a one-standard-deviation increase in Tobin's Q, or investment opportunity, would cause investment to rise 11.5%, or roughly $5.6 million at the average company. (Economists commonly use Tobin's Q — the ratio of a company's market value to the replacement value of its assets — to measure investment opportunity. The higher the Tobin's Q, the higher the market's growth expectations.)
Because concerns about investment allocation probably drive some spinoff decisions, the study sample may be biased in favor of the authors' findings.