Poor Corporate Governance and the Diversification Discount

The following post comes to us from Daniel Hoechle of the Department of Finance at the University of Basel; Markus Schmid, Professor of Finance at the University of Mannheim; Ingo Walter, Professor of Finance at New York University; and David Yermack, Professor of Finance at New York University.

Two important sources of company value are governance and diversification. In our paper, How Much of the Diversification Discount Can Be Explained by Poor Corporate Governance? forthcoming in the Journal of Financial Economics, we investigate links between these two attributes. We seek to determine whether the negative association between firm value and diversification, established in many other studies, can be partly attributed to the quality of corporate governance in conglomerate firms.

We estimate a wide range of panel data regression models similar to those used in prior studies of the diversification discount. We estimate our regressions with and without a large set of corporate governance control variables. Our analysis indicates that between 16% and 21% of the diversification discount arises because of conglomerate firms’ choices about which corporate governance parameters to adopt. Our conclusions are based on the degree to which the estimated diversification discount narrows and moves closer to zero when governance variables are added to our regressions.

We also consider models that treat firms’ diversification decisions as endogenous. We estimate both Heckman sample selection models and dynamic panel GMM models. The former models treat the diversification decision as an endogenous function of past performance and other financial variables, while the latter models are more general, treating both the diversification decision and firms’ governance choices as endogenous.

We find that both models estimate a significant diversification discount, a result that contradicts prior research on the subject. In addition, in both settings we find that corporate governance variables explain a large amount of the diversification discount. In the Heckman sample selection framework, introducing governance variables as regression controls in the second stage causes the diversification discount to move all the way to zero. We place greater weight on the dynamic panel GMM models, which treat not only diversification but also governance variables as endogenous. In this framework, introducing governance variables as controls causes our estimate of the diversification discount to become less negative and move closer to zero, as it narrows by about 37% but remains negative and significant.

An event study of all mergers undertaken by our sample firms reinforces the findings from our panel regression analysis. For diversifying as well as undiversifying mergers, we find that better corporate governance is associated with less value destruction (or more value creation) as measured by shareholder reactions to the merger announcements.

The full paper is available for download here.

Both comments and trackbacks are currently closed.
  • Subscribe or Follow

  • Supported By:

  • Program on Corporate Governance Advisory Board

  • Programs Faculty & Senior Fellows