Too Much of a Good Thing: Multibusiness Firms and Underperforming Investments

The efficiency of internal capital markets-i.e. how resources are allocated within the firm and whether such a budgeting choice is optimal-has long been one of the most debated issues in management, among scholars and practitioners alike. Specifically, when dealing with cash-needy businesses, managers might overinvest in the least profitable business lines, regardless of their likelihood of success. David Bardolet (Department of Management and Technology) does in fact manage to shed some light on the issue in his paper, titled The Hand of Corporate Management in Capital Allocations: Patterns of Investment in Multi- and Single- Business Firms, written with Dan Lovallo (University of Sydney), and Richard P. Rumelt, (UCLA Anderson School of Business), recently published on Industrial and Corporate Change (2010, Vol. 19(2), pp. 591-612., doi: 10.1093/icc/dtq007). The authors present empirical evidence showing that over-investment in poorly performing businesses is more likely to occur in multi-business rather than single-business firms, regardless of whether the business is cash-needy of self-sufficient.

In the article, the authors use the COMPUSTAT database to extract a large sample of business units from 1989 to 2004, grouping them in four main "types": cash-needy and unprofitable (CNU), cash-needy but profitable (CNP), self-sufficient but unprofitable (SSU), self-sufficient and profitable (SSP). Several business unit financial variables are then used in a multi-linear regression model to evaluate how variables such as the "type" of the business and the number business units in a firm impact the level of business unit investment, while controlling for factors like the median rate of investment in the industry and the past growth and profitability of the business unit.

The authors also investigate whether investing in low-profitability businesses might be justified by reasonable expectations of future growth. The paper tracks a subset of CNU businesses over time in order to check whether the additional investment poured in by multi-business firms does in fact lead to a higher rate of success in moving those businesses toward the profitable categories. The results show the opposite trend. Cash-needy unprofitable businesses in multi-business firms perform no better over time than comparable stand-alone firms.

In summary, this research paper highlights the role that corporate management plays in directing the flow of resources across business units by identifying a number of empirical differences regarding investment between comparable units in multi- and single-business firms. The authors further hypothesize that such differences might be explained by either the traditional "corporate socialism" account explored by the corporate finance literature or a novel cognitive account that focuses on the potential for "naïve diversification" in a company where the manager allocating resources has to choose among a number of options.