Unrelated Diversification Unrelated Diversification Companies implementing unrelated diversification strategies hope to create value by realizing financial economies. Financial economies are cost savings realized through improved allocations of financial resources based on investments inside or outside the company. Financial economies are realized through internal capital allocations (that are more efficient than market-based allocations) and by purchasing other companies and then restructuring their assets. Although capital generally is efficiently distributed in a market economy through the capital markets, large diversified companies may be able to distribute capital more efficiently to divisions and thus create value for the overall organization. This generally is possible because corporate offices have access to more detailed and accurate information regarding actual division performance as well as future prospects. Investors have only limited access to internal information and generally are able only to estimate performance of particular divisions. One implication of increased access to information means that the internal capital market may be able to allocate resources between alternative investment opportunities more accurately (and at more adequate levels) than the external capital market. Information disclosed to capital markets through annual reports may not fully disclose negative information, reporting only positive prospects while meeting all regulatory disclosure requirements. Therefore, external capital sources have limited knowledge of the specifics of what is taking place within large, complex organizations. While owners have access to information, full and complete disclosure is not guaranteed. Therefore, an internal capital market may enable the company to safeguard information related to its sources of competitive advantage that otherwise might have to be disclosed. Through disclosure, the information could become available to competitors who might use the information to duplicate or imitate the company's sources of competitive advantage. Corrective actions may be more efficiently structured and underperforming management can be more effectively disciplined through the internal capital market than through external capital market mechanisms. This means that the internal capital market is more capable of taking specific, finely tuned corrective actions compared to the external market. If external intervention is required, only drastic alternatives generally are available, such as forcing the company into bankruptcy or forcing the removal of top-level managers. With an internal capital market, the corporate office can adjust managerial incentives or can suggest strategic changes to make the desired corrections. Companies also may be able to reduce their overall risks by allocating resources among a diversified mix of businesses. However, since investors and debtholders also can diversify their portfolios, unrelated diversification will not enhance the value of the overall company unless managers achieve diversification at a lower cost than investors or debtholders. |