Should the Conglomerate Discount Persist? When Business Groups Add Value

Conglomerates were in fashion until the 1970s, when Michael Jensen, finance professor and Nobel Prize winner, observed that they suffer from “billions in unproductive capital expenditures and organizational inefficiencies.” This led to the belief that companies or groups with unrelated multi-business portfolios do a lot of things badly rather than a few things well.

As a result, the ‘conglomerate discount’ — the value of the diversified group in developed markets is 10-15 percent less than the sum of its parts — refers to the penalty that markets impose on diversified multi-division enterprises. Yet, Berkshire Hathaway and General Electric (GE) have been able to avoid the conglomerate discount in developed markets, and business groups are rather common in emerging markets.

I would like to distinguish between four different types of multi-business portfolios and argue that one must not necessarily be pessimistic about all of them.

  1. Type A are holding groups like Berkshire Hathaway that ‘hold’ a portfolio of usually listed companies for the long term. The group center leaves the individual companies to manage on their own without any active search for synergies between its different businesses. They see themselves as an investment company and, consequently, the headquarters has few employees (Berkshire Hathaway has fewer than 30 people at its group center). While they can easily exit any business by simply selling their holding in it, they exit rather infrequently.
  1. Type B are classic conglomerates like GE, where the holding company is listed while individual businesses are unlisted. As strategy evolves, businesses are acquired or divested according to need, but in general they are in businesses they wish to “run” over the long term. The headquarters is substantial in size and actively pursues synergies between its businesses as well as deploys common practices and policies across all units. Since the subsidiaries are wholly owned, synergies that are win-win (both cooperating units see gains) as well as win-lose (one unit gains while the other loses, albeit less than the gains of the former) are sought.
  1. Type C are private equity firms that usually acquire companies and take them out of the market’s view to ‘repair’ them. Both the holding company and the individual business units are unlisted. The reason to acquire is to exit at a much higher valuation within a tightly defined time horizon. The relatively lean headquarters is populated with a few experienced executives having turnaround capabilities. These specialists are deployed to individual units and usually revert back to the private equity firm after the exit. No synergies between individual businesses are sought since they have to be ultimately shed as standalone enterprises.
  1. Type D are business groups like Aditya Birla Group or Tata, which comprise an unlisted holding company and individual businesses that are usually listed. Business groups are essentially in ‘build’ mode since most of their businesses are incubated in-house. As is to be expected, in the process of sequentially launching new businesses, there will be a substantial failure rate here, especially compared with the ‘repair’ business of private equity firms. But, overall, successes will compensate for failures in well-managed business groups. In relative terms, the headquarters will be smaller than at conglomerates, but larger than at holding companies and private equity firms. Only win-win synergies will be pursued by the group center as the rights of minority shareholders in the individually listed companies (as well as joint ventures that may be unlisted) have to be protected.

The above exposition is a result of my many discussions with INSEAD professor Phanish Puranam, who is both a coauthor and dear friend. I’m not sure I’m saying anything original here, beyond quoting what he taught me. On my return to India, I devoted significant effort to understanding how diversified business groups can create value.

Professors Tarun Khanna and Krishna Palepu explained that the popularity and superior performance of business groups in emerging economies was a result of the poor quality of institutions (e.g., capital markets, talent markets) in these markets. This came to be known as the ‘institutional voids’ theory. The argument that followed was that as emerging markets matured, business groups would go out of fashion.

However, various studies since then demonstrated that business groups continue to thrive in some well-developed markets such as Singapore and Sweden, whilst there are some emerging markets such as Pakistan and Peru where business groups perform poorly. As a result, the validity of the institutional voids theory was questioned.

Phanish and his coauthors examined the performance (on ‘return on assets’) of 10,500 Indian companies between 1994 and 2009. Their data demonstrated:

  • Overall in India, companies affiliated with business groups did not outperform companies that were not so affiliated.
  • Listed companies affiliated with business groups outperformed both listed companies that were unaffiliated with business groups as well as unlisted companies affiliated with business groups.
  • Over time, despite the Indian markets maturing, the performance of listed firms affiliated with business groups improved, debunking the institutional voids theory.

Listed business group companies obtain the benefits of being affiliated with the business group, combined with the scrutiny that comes from markets and helps reduce the many disadvantages of belonging to a business group.

The benefits that flow from being affiliated with a business group include access to internal capital, talent, technology and product markets at lower transaction costs. In addition, the heft of the business group with various stakeholders also brings advantages.

Listing a business group-affiliated company protects their performance against the frequent criticisms levied against business group affiliated firms. Market scrutiny reduces the security given to managers who do not perform, the nepotism of placing relatives in important positions, and costly group functions that do not add value to individual group enterprises.

The most telling criticism of business groups used to be the cross-subsidies involving affiliated companies. Fortunately, increased regulation in India has led to greater minority shareholder protection and related-party transactions now have to be above board. This has dramatically lowered the practice of forcing companies to buy uncompetitive inputs from other group companies, of having poorly performing companies subsidized by better ones, and of tunneling, which refers to moving profits from companies where the business group had a lower holding to those where its shareholding was higher.

In conclusion, listed companies affiliated with business groups — as at least Indian data indicates — do rather well when compared with other types of companies. And their superior performance is increasing rather than decreasing as markets become more sophisticated.

Warmly

Nirmalya


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