Agency Theory and the Influence of Equity Ownership Structure on Corporate

Diversification Strategies
Author(s): David J. Denis, Diane K. Denis and Atulya Sarin
Source: Strategic Management Journal, Vol. 20, No. 11 (Nov., 1999), pp. 1071-1076
Published by: Wiley
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 Strategic Management Journal
Strat. Mgmt. J., 20: 1071-1076 (1999)

RESEARCH NOTES AND COMMUNICATIONS

AGENCY THEORY AND THE INFLUENCE OF

EQUITY OWNERSHIP STRUCTURE ON CORPORATE
DIVERSIFICATION STRATEGIES
DAVID J. DENIS'*, DIANE K. DENIS1 and ATULYA SARIN2
'Krannert Graduate School of Management, Purdue University, West Lafayette,
Indiana, U.S.A.
2Leavey School of Business and Administration, Santa Clara University, Santa
Clara, California, U.S.A.

We articulate the agency theory view of managerial decision making and its implications for
corporate diversification strategies. From agency theory, we generate testable predictions for
the relation between equity ownership structure and diversification strategies and review the
existing evidence on this relation. On balance, the evidence strongly supports the view that
ownership structure influences corporate strategy. Copyright ? 1999 John Wiley & Sons, Ltd.

INTRODUCTION The overall debate centers on two primary

issues. First, the authors disagree on the theo-
In a recent series of papers, Amihud and
retical Lev
importance of agency theory in explaining
(1981, 1999) and Lane, Cannella, and Lubatkin managerial attitudes towards corporate diversifi-
(1998, 1999) hotly debate whether corporate cation. While Amihud and Lev argue that con-
ownership structure affects diversification strate- glomerate mergers can plausibly be viewed as a
gies. Though both sets of authors conduct similar form of managerial perquisite, Lane, Cannella,
empirical tests on virtually identical data, they and Lubatkin suggest that agency theory may
arrive at completely different conclusions. Lane have limited applicability to diversification strate-
et al. (1999: 1077) conclude that '...there is little gies, because such decisions represent situations
theoretical or empirical basis for believing that in which managerial interests do not directly con-
monitoring by a firm's principals influences its flict with those of shareholders. Second, the
diversification strategy and acquisition decisions.' authors disagree on the interpretation of existing
In contrast, Amihud and Lev (1999: 1064) con- evidence on the relation between ownership con-
clude that 'The evidence shows that there exists a centration and diversifying mergers.
relationship between the corporate diversification In this article, we contribute to the debate by
strategies and corporate ownership structure.' first attempting to clarify what agency theory
predicts about managerial behavior in general,
and corporate diversification strategies in parti-
Key words: agency theory; equity ownership struc- cular. We argue that because diversified firms,
ture; corporate diversification strategies on average, trade at a discount relative to their
*Correspondence to: David. J. Denis, Krannert Graduate
School of Management, Purdue University, West Lafayette,single-segment peers, diversification strategies do,
IN 47907, U.S.A. in fact, represent strategic decisions in which

CCC 0143-2095/99/000000-00 $17.50 Received 27 January 1999

Copyright ? 1999 John Wiley & Sons, Ltd.

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1072 D. J. Denis, D. K. Denis and A. Sarin

managerial interests can conflict with those flicts

of of interest between managers and share-
holders.' In some situations, managers may prefer
shareholders. If managers derive private benefits
from diversification that exceed their privateto undertake actions that run counter to the prefer-
ences of shareholders. Examples of such actions
costs, agency theory predicts that managers will
maintain a diversification strategy even if doing
include the payment of excessive salaries to man-
so reduces shareholder wealth. Amihud and Lev's agers, resistance to value-increasing takeover bids,
(1981) 'risk-reduction hypothesis' is a special
and outright shirking.
case of this broader 'agency cost hypothesis' inThese conflicts of interest between managers
and shareholders can be mitigated in two primary
which the manager's private benefit is a reduction
in personal portfolio risk. ways. First, managers may be given the incentive
We develop this agency cost hypothesis to
andtake actions that are in the interests of share-
holders. For example, if managers are large share-
its empirical implications for the relation between
ownership structure and corporate diversification.
holders themselves, their interests are aligned with
One important departure from the above studiesthose of shareholders. Similarly, structuring
executive compensation contracts such that the
is that we link equity ownership with both man-
manager's compensation is tied to shareholder
agers' desire to pursue diversification strategies
and with their ability to do so. The desirewealth
to can align managerial and shareholder
diversify stems from a trade-off between the interests even if managers do not hold large
potential managerial risk-reduction benefits equity
of stakes. Second, managerial actions can be
diversification and the potential loss in the value
monitored by the firm's board of directors or by
of the shares owned by the manager. The abilityshareholders themselves. These monitoring
mechanisms are imperfect, however. Managerial
to diversify depends on the monitoring intensity
of outside owners. actions are frequently unobservable. Moreover,
We then review the empirical evidence on thesmall outside shareholders have little incentive
relation between equity ownership structure andto monitor because they incur the full cost of
corporate diversification. We argue that, because
monitoring, but must share any monitoring bene-
fits with all other shareholders.
of data limitations, the tests conducted by Amihud
and Lev (1981) and Lane et al. (1998) are not The above discussion suggests that agency
powerful tests of the hypothesis that ownership problems are likely to be related to equity owner-
structure influences managerial decisions. Our ship structure. As managers own a larger fraction
own study (Denis, Denis, and Sarin, 1997) of the firm's equity, their interests become more
presents strong evidence that the likelihood of aaligned with those of the outside shareholders.
Hence, they are less likely to pursue actions
firm being diversified is negatively related to the
ownership of corporate insiders and negativelythat are counter to the interests of the outside
related to the ownership of outside blockholders.shareholders. In addition, as outside ownership
These findings support Amihud and Lev's (1981)becomes more concentrated, outside owners have
original assertion that ownership structure influ-a greater incentive to monitor managerial actions.
ences corporate diversification strategies. Hence, managers are less likely to pursue actions
counter to shareholder interests.
Lane et al. (1998, 1999) argue that the predic-
AGENCY THEORY, MANAGERIAL tions of agency theory are unlikely to apply to
BEHAVIOR AND CORPORATE corporate diversification because diversification
DIVERSIFICATION represents a strategic decision in which mana-
gerial interests do not clearly conflict with those
Agency theory is predicated on theofbelief shareholders.
that However, recent studies docu-
individual economic agents choose ment actions
three that
primary empirical facts that suggest
maximize their personal utility. Within that, the
on average,
mod-the costs of diversification out-
em corporation, there often exists weigh a separation
the benefits. First, diversified firms trade at
between the individuals making corporate a discount relative to their single-segment peers.
decisions (managers) and the individuals bearing
the wealth consequences of those decisions 'See Jensen and Meckling (1976) for a formal treatment of
(shareholders). This raises the possibility of con- the agency problem within the modem corporation.
Copyright ? 1999 John Wiley & Sons, Ltd. Strat. Mgmt. J., 20: 1071-1076 (1999)

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 Research Notes and Communications 1073

diversification arise from a reduction in the risk

Second, there has been a trend towards increased
corporate focus among U. S. corporations. Third,
of their personal portfolio, these private benefits
will increase with the manager's equity stake
increases in corporate focus are associated with
significant increases in shareholder wealth.2 since the manager's equity stake is likely to be
negatively correlated with the level of diversifi-
Why would managers maintain a diversification
cation in his/her personal portfolio.3 This effect
strategy if doing so reduced shareholder wealth?
potentially confounds the prediction that mana-
Agency theory predicts that managers will pursue
gerial ownership will be negatively related to
such a value-destroying strategy if their private
diversification.
benefits from diversification exceed their private
costs. Amihud and Lev (1981) argue that diversi- Agency theory also predicts that other aspects
fication can benefit managers because it reduces
of ownership structure will influence the level of
diversification. In particular, to the extent that
the risk of the managers' undiversified personal
outside blockholders (i.e., shareholders that own
portfolios. However, this is just one potential
private benefit from diversification. Managersa block of shares equal to at least 5 percent of
might also derive private benefits because ofthetheoutstanding shares of the firm) have a greater
power and prestige associated with managing incentive
a to monitor managerial actions, the
larger firm (Jensen, 1986; Stulz 1990), because agency cost hypothesis predicts a negative
managerial compensation is related to firm relationsize between diversification and the presence
(Jensen and Murphy, 1990), or because diversifi- of these blockholders.
cation helps make the manager indispensible to Agency theory thus offers testable predictions
the firm (Shleifer and Vishny, 1989). The bottom regarding the relationship between ownership
line is that there are several reasons to believe structure and corporate diversification strategies.
The alternative hypothesis is that ownership struc-
that managers derive private benefits from diversi-
ture and diversification are unrelated. In addition
fication strategies. Because such strategies reduce
to arguing that diversification decisions do not
shareholder wealth, on average, there is a clear
represent situations in which there is a clear-
conflict of interest between managers and share-
cut conflict of interest between shareholders and
holders regarding diversification as a strategic
decision. managers, Lane et al. (1998) argue that the pre-
If corporate diversification represents a dictions of agency theory may not apply to corpo-
manager-shareholder conflict, agency theory pre-rate strategic decisions for at least two other
dicts a relation between equity ownership struc-reasons. First, managerial behavior may be more
ture and corporate diversification strategies. Asaccurately described by stewardship theory than
the ownership stake of managers increases, theyby agency theory. Under stewardship theory,
bear a greater fraction of the costs associatedmanagers are inclined to serve the good of the
with value-reducing decisions, and are thereforeorganization even if there are minor conflicts
less likely to adopt policies that reduce share-of interest between shareholders and managers.
holder wealth. Thus, agency theory predicts Second,
a because outside blockholders have insuf-
negative relation between managerial ownershipficient information with which to evaluate stra-
and diversification. It is important to point out,tegic decisions, diversification strategies are
however, that this prediction rests on the assump- unlikely to be influenced by outside blockholders.
tion that the manager's private benefits from In sum, the agency theory and strategic man-
diversification are invariant with respect to theagement perspectives yield opposing predictions
manager's equity stake. Such an assumption regarding the relation between equity ownership
seems justified for benefits related to firm size or structure and diversification strategies. Ultimately
to the manager's increased value to the firm.the relation is an empirical issue, so it is
However, if the manager's private benefits fromimportant to carefully assess the evidence.

2See Berger and Ofek (1995a), Lang and Stulz (1994), and
Servaes (1996) for evidence on the valuation of diversified
firms, Comment and Jarrell (1995) for evidence on increased
corporate focus, and Berger and Ofek (1995b), Comment and3In our previous article (Denis et al., 1997), we incorrectly
Jarrell (1995), and John and Ofek (1995) for evidence on attributed this argument to Amihud and Lev (1981). We
shareholder wealth gains from corporate refocusing. apologize for this error.

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 1074 D. J. Denis, D. K. Denis and A. Sarin

EVIDENCE ON EQUITY OWNERSHIP attempt to circumvent these problems by studying

AND DIVERSIFICATION the relation between ownership structure and th
level of diversification in a cross-section of 933
Amihud and Lev (1981) and Lane et al. (1998) Value Line firms in 1984. We employ five differ-
test the relation between ownership structure and ent measures of diversification: the fraction of
diversification by examining the incidence of con- firms with multiple segements, the number of
glomerate mergers among Fortune 500 firmssegments reported by management, the number
between 1961 and 1970. Both sets of authors of 4-digit SIC codes assigned to the firm by
compare the incidence of conglomerate mergers Compustat, a revenue-based Herfindahl index, and
across three ownership categories as defined an asset-based
in Herfindahl index. As noted in
Palmer (1973). A strong owner-controlled Lane firmet is al. (1999), these diversification measures
one in which a single party owns at least 30 the broader view of corporate diversifi-
reflect
percent of the firm's shares. A firm in cation which favored
a by strategic management scholars.4
single party owns between 10 percent and Our30 results indicate a strong negative relation
percent of the firm's shares is classified betweenas weak managerial ownership and diversification.
owner-controlled, while a firm in which no For example, 79 percent of the firms in which
single
party owns 10 percent or more of the shares is
corporate officers and directors own fewer than
classified as management-controlled. 1 percent of the firms' shares operate in multiple
There are several reasons why this empirical lines of business. In contrast, only 39 percent of
approach does not provide a very powerful the firms
test in which officers and directors own
of the relation between ownership structure moreand than 25 percent of the firm's shares operate
in multiple segments. These findings are robust
diversification. First, the definition of conglomer-
ate mergers is somewhat subjective. This to alternative
issue is measures of diversification and to
debated in both Lane et al. (1999) and Amihud the inclusion of other well-known determinants
and Lev (1999). Second, once the sample mergers of the level of diversification. We also document
are broken down into finer measures of diversifi- a significant negative relation between the level
cation, such as those proposed by Rumelt (1974), of diversification and the equity ownership of
the resulting subsamples are arguably too small outside
to blockholders. Our results thus offer sup-
draw meaningful inferences. Third, the ownershipport for the view that increased equity ownership
structure classifications do not distinguish by managers reduces their desire to pursue value-
between inside and outside owners. Hence, a firm reducing diversification, while increased owner-
in which the CEO owned 35 percent of the shares ship by outside blockholders reduces managers'
would be classified as strong owner-controlled, ability to pursue such strategies.
as would a firm in which the CEO owned 1 These results are consistent with those of Ami-
hud and Lev (1981) in that we document a
percent of the shares and an outside blockholder
owned 30 percent of the shares. Thus, the evi- relation between large shareholdings and
negative
diversification levels. However, unlike Amihud
dence does not allow us to distinguish between
the incentive and the monitoring effectsand
of Lev (1981), we are uncomfortable with con-
large
shareholdings. cluding that it is the desire for personal risk
Both sets of authors recognize the limitations
reduction that drives managers to diversify. As
of their ownership measures but are constrained
we argued earlier, the private benefits from risk
by data availability over the 1961-70 reduction
period. are likely to increase with the man-
Lane et al. (1998) attempt to address thisager's
problem
equity stake. This effect potentially offsets
by studying a sample of large mergers the over the effects of equity ownership. Thus,
incentive
1980-87 period. However, even in this study,
under the risk reduction hypothesis, the predicted
they examine only the relation betweenrelation
merger between managerial ownership and diver-
type and the fractional ownership of large sification
outside is ambiguous.
blockholders. While this approach tests for the
monitoring effects of large blockholders, it
4We
ignores the potentially important incentive note that these diversification measures have also gained
effects
acceptance among finance scholars as evidenced by their use
of inside shareholdings. in Berger and Ofek (1995a), Comment and Jarrell (1995),
In our previous article (Denis et al., 1997), we
Lang and Stulz (1994) and Servaes (1996).

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 Research Notes and Communications 1075

Overall, therefore, we document strong evi- recently, is generating new insights into why such
dence of a link between equity ownership struc- valuation effects are negative, on average.5 Future
ture and corporate diversification. These findings
research that uses the insights of both disciplines
provide support for the hypothesis that agency can potentially contribute to our understanding of
why diversification is beneficial for some firms
problems affect corporate diversification strategies
and sharply contrast with the predictions of (e.g.,
Lane General Electric), but value-destroying for
et al (1998). most, and of the precise nature of the agency
conflict inherent in diversification.

CONCLUDING REMARKS
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(1997), and Shin and Stulz (1998).
net valuation effects of these strategies and, more

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