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.
