An RBV Approach to Conglomerate Diversification

24 November 2006 at 12:33 am 10 comments

| Peter Klein |

The resource-based view of the firm has spawned a vast literature on corporate diversification. Inspired by Penrose (1959) and Rumelt (1974), this literature has emphasized the benefits of related diversification over expansion into industries that are not good fits for the firm’s current portfolio of resources. Unrelated or conglomerate diversification is typically viewed, within the RBV, as an anomaly, either a mistake (as in the conglomerate merger wave of the 1960s) or pure luck (those few conglomerates, such as GE, that are consistently high performers). Of course, relatedness is difficult to define and measure consistently, and the kinds of relatedness that presumably matter for firm performance are not captured well by conventional measures of inter-industry relatedness (see this paper for details). There is evidence that conglomerate diversification can add value by creating internal capital markets (see here and here), but this approach has little to do with resources and capabilities.

John Matsusaka’s “Corporate Diversification, Value Maximization, and Organizational Capabilities” (Journal of Business, 2001) develops a model in which firm capabilities are unknown ex ante, but must be discovered over time as entrepreneurs experiment with different combinations of business units. Hence in a cross-sectional analysis diversified firms may appear to underperform more focused firms, but the unrelated diversification is a necessary step toward the discovery of future capabilities, and is thus value creating.

Now comes a new paper by Oliver Gottschalg, “What Does It Take to Be a Good Parent? Opening the Black Box of Value Creation in the Unrelated Multibusiness Firm,” arguing that unrelated diversification may occur when firms possess excess capacity in “headquarter services.” The conglomerate’s central office, like a consulting firm, provides specialized support and advising services to its portfolio companies, creating value even when there are no operational synergies among the operating units. Gottschalg applies the theory to a sample of European LBO associations, viewing them as “private conglomerates” to which the same principles apply. An advantage of using LBO associations is that they are typically forbidden (by the terms of their debt covenants) from reallocating cash flows among portfolio companies, so the findings cannot be driven by internal capital markets. Gottschalg finds some support for the hypothesis that conglomeration adds value when the parent possesses specific headquarter resources that the target company lacks. These resources are measured using survey data on the parent and target firms’ expertise in operations, finance, management recruiting, and strategy. (The dependent variable, firm performance, was also measured subjectively.) Worth a read. (And thanks to John Chapman for the pointer.)

Entry filed under: - Klein -, Strategic Management, Theory of the Firm.

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10 Comments Add your own

  • 1. Joe Mahoney  |  24 November 2006 at 9:46 am

    First, Peter your exploration of conglomerates has been impressive. I would add the following thoughts to the conversaton:

    One of the more fundamental concepts in the field of Strategic Management that tends to be underemphasized in the field of Economics is that of “co-specialized” assets (Teece, 1986).

    Consider the example of an Acquisition. If there are economies of scope savings (Baumol, Panzar and Willig, 1982) AND they are co-specialized assets then the acquiring firm can achieve economic rents in this bilateral monopoly scenario.

    Thus, besides “asymmetric information and luck” (Barney 1986), an important third category is co-specialized assets, which enable us to overcome the efficient market result of zero economic rents for the Acquirer.

    My premise is that co-specialized assets are more common than the typical industrial organization economists or corporate finance Professor believes. And my conjecture is that co-specialized assets are more likely with diversification that is related — however measured — than unrelated.

    If this premise and conjecture are correct, it would be a sufficent resource-based theory explanation of the superior performance of related relative to unrelated diversificaton, which complements Montgomery and Wernerfelt (1988).

    (I also add parenthetically that Chandler (1977) THE VISIBLE HAND, and Chandler (1990) SCALE AND SCOPE can be read to support the importance of co-specialized assets.)

  • 2. Peter Klein  |  24 November 2006 at 1:11 pm

    Thanks Joe. I agree that co-specialized assets get little attention in the IO and corporate finance literatures. To what extent are transaction costs part of the story — i.e., why can’t asset owners exploit the gains from co-specialization through contract rather than integration? Also, do you regard the notion of asset specificity as in Williamson or Hart a special case of co-specialization, a case in which assets are relationship-specific because they are co-specialized with the human capital of one or both trading partners?

  • 3. Bruce’s Blog / links for 2006-11-25  |  24 November 2006 at 7:25 pm

    […] An RBV Approach to Conglomerate Diversification « Organizations and Markets Resource Based Approac to diversification (tags: resource_based diversity strategy economics resources) Share and Enjoy:These icons link to social bookmarking sites where readers can share and discover new web pages. […]

  • 4. Joe Mahoney  |  25 November 2006 at 12:26 pm

    To answer the second part of your question first, I regard Teece’s (1986) concept of co-specialized assets to be a special case of Williamson’s (1975, 1985) asset specificity.

    Teece (JEBO 1982) extensively deals with the first part of your question concerning why a diversifed multi-product firm may be superior to a contractual relationship. Thus, to directly answer your question, transactions costs are a substantial part of the story.

    Thus, economies of scope that are achieved by complementary assets can be achieved by a contract if there are “large numbers” of both assets.

    Economies of scope that are acheived by co-specialzed assets may require internalization due to the inherent bilateral monopoly problem.

    Note that my original comment was that co-specialized assets can be a sufficient condition for the firm achieving economic rents — since there are transaction costs (market) frictions.

    The Mahoney conjecture (as Makadok calls it in an SMJ article) is that the market frictions that are sufficient to explain the firm achieving economic rents (in RBV) will be sufficient conditions for the firm to exist (in transacton costs theory). (see my Journal of Management paper in 2001):

    If Descartes was a firm he would have said: “I generate rents, therefore I exist.”

  • 5. Nicolai Foss  |  25 November 2006 at 6:29 pm

    I am not sure I have understood the “Mahoney conjecture.”
    Suppose a firm earns classical factor rents/Ricardian rents (BTW, no “frictions” are necessary for this to take place). When you talk about “market frictions” being “sufficient” for “the firm achieving economic rents”, do you mean costs of imitation? Aren’s such information costs different from the transaction costs that may provide “sufficent conditions for the firm to exist”?
    (See also my SO! paper in 2003).

  • 6. Joseph Mahoney  |  27 November 2006 at 9:27 am


    My thinking starts with the two Fundamental Welfare Theorems of Economics, which leads to zero economic profit in equilibrium. Following Kenneth Arrow, I view a market friction as an impediment to the Pareto optimal competitive market equilibrium. Thus, I consider the claim that there must be some market friction to lead to sustainable competitive advantage to be a tautology. That is, some premise of the Fundamental Welfare theorems must be relaxed for positive economic profit.

    In fact, I strongly suspect that my conjecture is also a tautology. If someone provides a model where the firm has sustainable competitive advantage due to market frictions (in RBV), those will be a sufficient set of (transaction cost) market frictions for the firm to exist (in transaction costs theory).

    That is, if the firm’s long-run Tobin’s Q is greater than 1, then the firm will continue to exist (not as catchy as the Descartes one that “I generatate rents therefore I exist.”)

    What do you and Peter think about this line of reasoning? — it is one of the few original ideas that have left my brain on to the printed page, and it is still a conjecture — although Mike Peng in JIBS is more confident in calling it the “Mahoney theorem.”

  • 7. Nicolai Foss  |  28 November 2006 at 6:58 am

    Joe, We can agree that both firms and SCA wouldn’t exist in the world of Arrow and Debreu. However, in my understanding “frictions” are in the nature of transaction costs. I wouldn’t call, say, non-convex technology a “friction.” And while firms wouldn’t exist when TC are zero, SCA may (see Foss and Foss, SMJ 2005). Therefore, I have problems with the “Mahoney conjecture” (which, BTW, also seems to have been stated by Silverman, MS, 1999).

  • 8. Peter Klein  |  28 November 2006 at 10:03 am

    Let me offer a slightly different challenge to the Mahoney conjecture. As Nicolai says, for either firms or SCA (or, for that matter, short-term profit) to exist, there must be some deviation from Arrow-Debreu conditions (call it “friction” or “market imperfection” or, a la Williamson, “market failure”). But are the deviations that explain the firm the same as those that explain SCA? Knightian uncertainty, for instance, is sufficient to explain the existence of the firm, but not SCA. On the other hand, capital heterogeneity is sufficient to explain supra-normal factor returns, but not necessarily the firm. (Imagine a unique factor that generates rents but is not co-specialized, e.g., a particular piece of land; the factor owner may receive rents but does not need to form a firm.)

  • 9. Joseph Mahoney  |  29 November 2006 at 9:57 am


    I tend to use “market imperfection” and “market friction” interchangeably — your example suggests that for precision of language (Semantics IN Economics) I should not.

    Also, the Mahoney conjecture is that if the FIRM achieves economic rents then the market imperfections that lead to economic rents for the FIRM will be sufficient market frictions for the firm to exist. For the empirically minded, my conjecture is that a firm with a long-run Tobin’s Q greater than 1 (due to some market imperfections) will be sufficient market imperfections for the firm to exist. If you have an example to refute this conjecture, please provide it.

    As a coincidence, I reviewed a paper yesterday for SMJ that referenced the Silverman 1999 paper and I did note (much to my surprise !!) that a similar conjecture was made — albeit more in terms of asset specificity. Thus, even if the Mahoney conjecture does not hold (in terms of ALL market imperfections), the Silverman conjecture still might hold. And, of course, if you refute the Silverman conjecture then you have sleighed the little Mahoney beast conjecture :-)

  • 10. Joseph Mahoney  |  29 November 2006 at 10:12 am


    My argument is that the market imperfections that lead to the firm achieving sustainable competitive advantage (SCA) are sufficient market imperfections for the firm to exist. I DID NOT SAY that the market imperfections that are sufficient for the firm to exist are sufficient for SCA !! Thus, your example of Knightian uncertainty being sufficient to explain the existence of the firm but not SCA does not refute the Mahoney conjecture.

    In terms of your other example that capital heterogeneity is sufficient to explain supra-normal FACTOR returns, but not necessarily the firm. Of course that is correct!! However, the Mahoney conjecture is that the market imperfections that result in supra-normal returns FOR THE FIRM (measured by TOBIN’S Q greater than one) will be sufficient market frictions for the firm to exist.

    I still (tentatively) believe that the Mahoney conjecture is a tautotolgy.

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