Corporate Strategy: Diversification

Diversification is entering a new business. When you think about entering a new business, there are 3 type of questions you should ask about diversification:

• Whether you should even enter a new business?
• Which business should you enter?
• How can you even enter a new business?

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Basic modes

If you are thinking about diversification, the main choices are described by the growth tree:

• entering into a new business
  • organic growth (without the help of anyone else)
  • inorganic growth
    • non-equity alliance
    • equity alliance
    • merger & acquisition (M&A)

The continuum of relationship between firms is used. On one hand is Arm’s length relationship (very little interactions between 2 firms), on the other hand is M&A (which entails a lot of interaction between 2 firms). From Arm’s length to M&A, the intensity of collaboration increases, level of equity (ownership) of one in another also increases.

Arm's length ---> non-equity alliance ---> equity alliance ---> M&A

Alliance are the relationships that can not be managed by contracts alone.

Ownership aligns incentives between partners; facilitates coordination; and enables information flows.

Diversification Test

We want to know if diversifying into a new business creates more value. We want to compare the old situation with the new situation, while taking into account the transition from old to new. The cost of entering a business and the value of old and new business combined, really depend on the growth mode you chose. We should do the comparison for every growth mode separately.

Value(old) < Valuemode(old + new) - Costmode(new)

The decision to enter a new business depends on just two things: first, synergies and second, bargains.

Synergies mean that the value of operating both business A and B is higher if they’re jointly operated than if they were operated separately. Thus the higher the synergies, the more value from linking business A and B; the lower the synergies, the less value in linking business A and B. So synergies relate to Value_mode(old + new).

A Bargain is if you pay less for a business than what it’s worth. If business B is a bargain, than you are more likely to enter. Bargains relate to Cost_mode(new).

If you have both synergies and bargains, you are very likely to diversify.

Synergies

Synergies are one of the most important construct within all of corporate strategy. We say that operational synergies exist if the value of 2 businesses operated together is worth more than the value of the 2 businesses operated separately. The synergies arise from the value chain. It is really about the resources that underlie the value chain.

Resources are the factor of production, classically they were land, labor and capital, but now more commonly known as technology, people and manufacturing facilities. Many classification schemes for synergies exist out there, and they tend to take a financial perspective, which is helpful for financial analysts but not for managers or strategists, who care more about where synergies come from.

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Four C’s Synergies Framework

High modification	Customization	Consolidation
Low modification	Connection	Combination
of resources	Low similarity	High similarity

An Approach to the Diversification Decision

Step 1: Finding Synergies

A value chain is a series of activities that are necessary to produce and deliver a product to your customers. The value chain is the business description of the “how”. The output of a value chain is really a product (the “what”) to customers (the “who”). If we are to link 2 businesses, where the value would come from? If you have difficulty identifying any value, you know that a potential diversification move will have to be justified on the grounds of it being a bargain.

Step 2: Identifying Resource Gaps

We need to think about what resource from the old business can be used to the new business. We look into additional resources needed to enter a new business. All of the remaining gaps need to be either filled organically or inorganically.

Step 3: Identifying Candidates

Optimal inorganic growth choices might vary by partner. There are 3 types of potential candidates:

1. Insider generalists. These are companies that are already active in the new business and occupy all steps in the value chain.
2. Insider specialists. They are active in the new business but only do a subset of the value chain.
3. Outsiders. The companies may help you enter the new business but they are not active in the new business themselves.

If your resource gap is large, it might be useful to start with an insiders and perhaps a insider generalist.

If you identify no candidates, you have no choice but to do organic growth. However if you can identify some candidates, you could consider inorganic growth.

Step 4: Ally or Acquire

Start with the least invasive mode (non-equity alliance), and then think about can you do better by selecting the more invasive modes(equity alliance or M&A). You want to particularly focus on the synergies you identified earlier, because these are where the value come from. What we are really doing is deciding on the level of equity. We need to think about what are the benefits of equity and what are the costs.

Benefits

Equity gives you the possibility to forge close working relationships, which can be important for your synergies. This close working relationship comes in 2 aspects:

1. Coordination (alignment of action)
2. Cooperation (alignment of incentive)

Equity also helps for exclusive working relationship.

Costs

1. Control premium: the most direct costs are those to acquire full or partial control.
2. Uncertainty: if the uncertainty is very high, you run the risk of paying the control premium for the business not that valuable.
3. Motivation: people could lose their motivation if you come in with a big equity stake.

Step 5: Organic or Inorganic growth

For the organic growth option, one approximation for synergies is whatever we come up with for the synergies in M&A option (both are of full ownership). Thus what really comes down is the costs of entry, which is about building up the resources. 3 factors influences the costs of building up the resources:

1. Whether it is easy to copy
2. Whether it is easy to catch up
3. Whether it is easy to substitute

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Related Quick Recap

Corporate Strategy: Sum-of-the-Parts Analysis

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