Why Firms Diversify: Internalization vs. Agency Behavior

Abstract

We present empirical evidence that cross-industry diversification, geographic diversification, and firm size add value in the presence of intangibles related to R&D or advertizing, but destroy value in their absence, presumably due to agency problems. This is consistent with synergy stemming from the internalization of markets for information-based assets. This supports Livermore (1935), who found a similar relationship between intangible assets, like R&D or advertising, and superior post-takeover firm performance in the U.S. turn of the century merger wave. We also find that the market for corporate control tends to make corrections in the appropriate direction. Firms that are large or diversified, but have few information-based assets, are unusually likely to become hostile takeover targets. In contrast, small undiversified firms with such assets are unusually likely to become targets in friendly mergers.