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.