Levels of Diversification

If acquisition is the strategy of choice, the next question is what type of companies one should acquire. There are firms that acquire related businesses, and firms that acquire completely unrelated businesses simply for diversification purposes. How diversified should your firm be?

There are 3 possible scenarios: First, remain in the dominant business and not diversify at all. Second, purchase a related business for medium level of diversification. Third, purchase unrelated businesses for high level of diversification. Research and our experience agree that scenario 2 is the best way to go. In other words, the firm’s performance is typically the highest when the firm purchases related businesses.

Why is this? The answer is that when a firm purchases a related business, synergy among the firms starts to occur. The firms can start to share resources, activities, knowledge, and core competencies. A firm may purchase its supplier (known as vertical integration), in which case both firms tend to do better as a result. Purchasing related businesses is a great way to achieve market power.

Purchasing unrelated businesses can work, although the resulting conglomerates (diversified firms with unrelated businesses) typically incur a diversification discount if the entire firm were sold at a later date, which means the sale price of the firm would be diminished somewhat. This is due to the fact that external financial markets are more efficient than the internal ones, and the diversification discount reflects the cost of coordinating unrelated businesses.

This is not to say that conglomerates are not a good idea. Purchasing unrelated businesses can be a great strategy if the firm is good at identifying and turning around inefficient or undervalued businesses, or is good at identifying and exploiting businesses in high growth markets that financial markets do not like to serve.