The Conglomerate Discount and the Danger of Over Diversifying a Business
Diversification is good. For personal savings, diversification prevents concentrating too much risk on a single stock or investment type. For companies it means avoiding reliance on a single product, customer, or supplier. Lenders and investors appreciate this type of risk mitigation.
In the world of corporate acquisitions, however, companies can “over diversify” to the point of destroying value by having too many dissimilar types of businesses. Such reduction of corporate value is called the “conglomerate discount”.
What is a conglomerate?
A conglomerate is a company with disparate entities under one corporate umbrella with common management. Conglomerates are not established from birth but are created when companies diversify their activities by acquiring dissimilar businesses to smooth out cyclicality or venture into more profitable, higher growth sectors. In addition to being dissimilar, there are usually few, if any synergies among the operating units. Although conglomerates are typically very large companies, several smaller companies also fit the definition.
Conglomerate discount refers to the tendency of markets to value a company with a diversified group of business at less than the sum of its parts. The discount can be calculated by comparing the value of the corporation to the sum each segment on its own. If the sum of the parts is greater than the whole, then there is a discount. Empirical research shows that conglomerate discounts tend to be around 5% to 15% in developed economies.
What causes the market to apply such a discount? Several explanations exist:
- Market Preference: financial investors prefer to create their own diversified portfolios of businesses using “pure play” companies when allocating their capital;
- Resource Allocation Disadvantage: Companies have a finite amount of capital and resources to allocate to projects. While some projects might have an attractive return and create value over time, they may have to be forgone to more pressing capital uses in other segments;
- Focus Disadvantage: There is only so much time in a day. Having multiple businesses prevents management from focusing one hundred percent of their time to improve and grow anyone business. The corporate suite cannot be 100% versed in every field either. Some sectors, especially technology and pharma, are too complex for generalist skills to suffice;
- Speed: As an organization grows, so do the number of management layers thereby slowing the decision-making process;
- Financial leverage: When you mix more cyclical segments to sectors generating very stable returns, such as real estate or infrastructure investments, financial markets will not give you the higher leverage that are tied to long-term contracts or annuities. Therefore, a conglomerate’s cost of capital will be on average higher than the pure play stable income assets should deserve. This will put the conglomerate at a competitive disadvantage in a bidding process; and
- Incentives disadvantage: In conglomerates, management will be rewarded to a greater extent on the overall performance of the corporation rather than the performance of the individual divisional results. This can be a demotivating factor when compensation is tied to other managers/sector’s performance.
How to a Avoid Conglomerate Discount
Not all conglomerates are faced with a market discount. Some trade at a premium where it can be demonstrated that they can generate consistent profit and growth. Exploiting cross-selling, bundling of services, economies of scale on overheads or shared services are all good examples of how to create added value within a diversified business.
If you have a diversified portfolio of businesses under a single corporate roof, Cafa can help you quantify and unlock the conglomerate discount by establishing the value of each component and structuring the necessary moves to unlock shareholder value. Come and talk to us.
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