The Dark Side of Internal Capital Markets II: Evidence from Diversified Conglomerates

Abstract

This paper is an empirical examination of capital allocation in a sample of 165 diversified conglomerates in 1979. I find that divisions in high-Q manufacturing industries tend to invest less than their stand-alone industry peers, while divisions in low-Q manufacturing industries tend to invest more than their stand-alone industry peers. This sort of socialism in which investment tends to get equalized across divisions is particularly pronounced in a conglomerate's smaller divisions. It is also more pronounced in firms in which management has small equity stakes suggesting that agency problems between corporate headquarters and investors are at the root of the problem. By 1994, only 53 (32%) of these firms continue to be free-standing diversified conglomerates. Fifty-five (33%) choose to sell off unrelated divisions and focus on one core business. These firms tend to sell their smaller divisions do, their investment behavior changes relative to 1979: it more closely resembles that of their stand-alone industry peers. The remaining 57 (35%) firms were acquired or (in two cases) liquidated.

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