Resource Allocation within Firms and Financial Market Dislocation

The following post comes to us from Gregor Matvos and Amit Seru, both of the Booth School of Business at the University of Chicago.

Do firm boundaries mediate the effect of shocks to the financial intermediation sector? When the functioning of the intermediation sector is impaired – as was the case in the recent financial crisis – shocks can be transmitted to the broader economy since funds may not flow to highest value use without incurring significant cost. This issue has been extensively explored in the credit channel literature (e.g., Kashyap and Stein [2000]; Bernanke and Blinder [1988; 1992], and Bernanke and Gertler [1995]). However, unlike what is assumed in this literature, firms may be able to reallocate resources internally – for instance, between divisions in different industries – to ameliorate the effect of financial shocks. If so, external credit market conditions will impact the nature of resource allocation inside firms and between industries differently than they would in an economy with no internal capital markets. Diversified firms constitute a large part of economies around the world; therefore, resource allocation within firms can be of significant importance. In this paper we propose that firms shift resources between industries in response to shocks to the financial sector. We estimate a structural model to quantify the forces driving this reallocation decision, and show that these forces dampen shocks to the financial sector in economically significant ways.

In our paper, Resource Allocation within Firms and Financial Market Dislocation: Evidence from Diversified Conglomerates, which was recently made publicly available on SSRN, we study the resource allocation problem in a sample of diversified firms in the United States. Economists have used these firms as a laboratory for studying resource allocation decisions inside firms (Zingales [2000]). There are two prevailing views on how capital is allocated within these firms. Stein [1997], among others, has put forth the view that conglomerates may outperform external capital markets by virtue of exerting centralized control over the capital allocation process (“bright side” view). This view has been challenged by several studies, such as Rajan, Servaes, and Zingales [2000], and Scharfstein and Stein [2000], who argue that resource allocation inside firms is distorted toward weaker divisions by managerial socialistic concerns (“dark side” view). We propose and estimate a model that nests these views. Our model is based on a dynamic tradeoff between the bright and dark sides of internal capital markets. The cost of conglomerates arises from managerial preferences for corporate socialism. The benefit is that funds can be allocated between divisions without firms experiencing frictions of accessing external capital markets. The cost of accessing external capital markets varies over time introducing a time-varying wedge between the costs and benefits of internal capital markets.

We first present reduced form facts that motivate the economic forces in our structural model using data from diversified firms in the United States from 1980 to 2006. We show that conglomerates’ performance relative to stand-alone firms improves during times in which external capital markets are impaired. Moreover, during these periods, conglomerates with more productivity dispersion among their divisions perform relatively better. We plot the value of conglomerates with high productivity dispersion relative to the value of conglomerates with low productivity dispersion. The difference in these values narrows with an increase in the TED spread, our measure of external capital market distress. We also find that these valuation results are correlated with changes in capital allocation across divisions. These facts suggest that firms with high productivity dispersion among their divisions shift resources between industries in response to shocks to the financial sector.

This reduced form evidence allows us to track only the net benefit or cost of resource allocation inside the firm. However, our goal is to quantify how much of the dislocation in external capital markets is ameliorated by reallocation in internal capital markets. This requires us to identify and quantify the forces driving the reallocation and how they change as the external capital markets change. These forces are difficult to disentangle from the “net” estimates in reduced form. Moreover, crisis data are frequently subject to other shocks, such as declining productivity and government intervention, which makes it difficult to interpret the “net” estimates from reduced form analysis. The structural model allows us to separately identify and quantify the forces driving the reallocation decision. We can then conduct counterfactuals in which firms are exposed only to shocks in external capital markets, keeping demand-side factors such as changed productivity or investment opportunities fixed, to study our main object of interest: how much capital reallocates within firms in response to such shocks.

The structural model we use is a variant of an investment model with costly external financing such as Whited [2006], with three novel features. First, a firm comprises several divisions, which differ in productivity. The financing and investment decisions, however, are taken at the headquarters level, which is optimizing across all divisions. Second, the manager does not only maximize profit, but also has preferences for corporate socialism, where the headquarters gains some utility from minimizing the diversity in profits among divisions. Our motivation follows directly from the work of Rajan, Servaes, and Zingales [2000], and Scharfstein and Stein [2000], who present models that micro-found managerial socialism. Third, we allow the cost of accessing external capital markets to be time varying. These three features capture the dynamic tradeoff posited earlier. The structural model uses investment, financing, and cash stock decisions taken within the diversified firm to estimate the parameters of corporate socialism and time-varying cost of external financing.

We use the two-step estimator developed in Bajari, Benkard, and Levin [2007] to estimate the parameters of our problem. A major source of identification in our model is the division investment response to its own productivity and the productivity of other divisions. Our estimates could be biased if productivity is mismeasured in a systematic way due to various factors, including the endogenous composition of conglomerates (see Gomes [2001], Whited [2001], Chevalier [2004], Villalonga [2004], and Gomes and Livdan [2004]). We discuss the criteria that the measurement error must satisfy in order to generate our results, and argue that such measurement error is highly implausible. Nevertheless, we address concerns of measurement error by (a) showing that our results are similar when we use alternative measures of productivity, (b) showing that our results are robust when we use an oil-price-based shifter of dispersion in productivity across divisions of a conglomerate to account for potential bias from endogenous conglomerate composition, and (c) showing that when we simulate firm behavior in the crisis period (2007-2010) using estimates from our model during the pre-crisis period (up to 2006), we produce data that are comparable to actual data, even on dimensions that were not used to estimate our model, such as firm value.

A central result from our structural model is an estimate of preferences for corporate socialism, which allows us to quantify the frictions in internal capital markets. This uniquely differentiates our paper from the existing literature on conglomerates. Our estimate of the dark side of conglomerates is economically large and suggests significant corporate socialism inside diversified firms. Managers allocate too little capital to the strong division; an average two-division conglomerate behaves as though the stronger division’s productivity is 9 percentage points lower than it actually is. Conversely, managers allocate too much capital to the weaker division, treating it as though it is 12 percentage points more productive than it really is. This tilt is even larger in conglomerates with more dispersed productivity among their divisions. In absence of external capital market frictions, these estimates reveal the large advantage of stand-alone firms over conglomerates.

Our estimates of the bright side of internal capital markets are driven by the ability to reallocate resources between divisions without incurring the cost of raising funds in external capital markets. We estimate mean fixed cost of 8.6%, and marginal cost of 5%, evaluated at the median size of a two-division firm. This average cost conceals a substantial variation in the cost of external financing over time. We find a strong nonlinearity in the effect of time-varying external capital market conditions, suggesting a larger impact when there are episodes of extreme financial market dislocation. During these times of extreme financial market stress, the ability to reallocate resources between divisions is valuable and potentially allows diversified firms to mediate the effect of financial shocks. Notably, our estimates and inferences remain robust even when we consider alternative productivity measures, alternative measures of external financing conditions (EBP, excess bond spread), and different specifications of the model.

We next explore how shocks to the financial sector are mediated by resource allocation inside diversified firms using our estimated model. We use the recent financial crisis of 2007/2008 to simulate the disruption in the supply of financial capital and study how these shocks are propagated differentially through stand-alones and conglomerates. This allows us to examine the consequences of the credit shock on firm value and how this change in value is related to the allocation of resources within firms.

We start with our model, which is estimated on the period from 1980 to 2006, and expose the firms in the sample to capital market conditions from 2007 to 2010. We forward simulate, assuming that the only change from the pre-crisis period was an increase in the cost of accessing external capital markets reflected in an increase in the TED spread (i.e., the difference between the interest rates on interbank loans and short-term U.S. government T-bills). Using this simulated data, we find that the difference in value of conglomerates relative to a comparable portfolio of stand-alone firms decreases as TED spikes in 2008, but increases when TED drops in 2009 and 2010. In other words, as external market conditions tighten, conglomerates become more valuable relative to stand-alone firms, and as the financial markets normalize, the pattern reverses.

We also show that the source of this increase in relative value of conglomerates is the ability to reallocate resources between their divisions. In particular, we find that in noncrisis periods investment of conglomerate firms is less sensitive to productivity than that of stand-alone firms. However, as TED increases in 2008, this wedge decreases: conglomerates are able to shift more internal funds among divisions, but stand-alone firms are precluded from raising financing from the market.

Remarkably, even though these data are simulated out of sample and ignore any effect of the crisis on productivity or government intervention, we show that these patterns are consistent with those found in actual data of diversified firms between 2007 and 2009. We find that factors other than increased frictions in external capital markets explain up to 30% of the change in relative valuation of conglomerates during this period. Examining reduced form conglomerate valuations would therefore significantly overstate the extent to which capital reallocation within firms mediates the effect of financial shocks. The counterfactual exercise shows that an increase in financial market stress during the crisis was ameliorated in diversified firms through more efficient resource allocation by 16% to 30%.

The full paper is available for download here.

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