194 Part 2: Strategic Actions: Strategy Formulation
The desire for increased compensation and reduced managerial risk are two motives
for top-level executives to diversify their firm beyond value-creating and value-neu-
tral levels.^114 In slightly different words, top-level executives may diversify a firm in
order to spread their own employment risk, as long as profitability does not suffer
excessively.^115
Diversification provides additional benefits to top-level managers that shareholders
do not enjoy. Research evidence shows that diversification and firm size are highly
correlated, and as firm size increases, so does executive compensation.^116 Because large
firms are complex, difficult-to-manage organizations, top-level managers commonly
receive substantial levels of compensation to lead them, but the amounts vary across
countries.^117 Greater levels of diversification can increase a firm’s complexity, resulting in
still more compensation for executives to lead an increasingly diversified organization.
Governance mechanisms, such as the board of directors, monitoring by owners, exec-
utive compensation practices, and the market for corporate control, may limit mana-
gerial tendencies to over diversify.^118 These mechanisms are discussed in more detail in
Chapter 10.
In some instances, though, a firm’s governance mechanisms may not be strong, allow-
ing executives to diversify the firm to the point that it fails to earn even average returns.^119
The loss of adequate internal governance may result in relatively poor performance,
thereby triggering a threat of takeover. Although takeovers may improve efficiency by
replacing ineffective managerial teams, managers may avoid takeovers through defensive
tactics, such as “poison pills,” or may reduce their own exposure with “golden parachute”
agreements.^120 Therefore, an external governance threat, although restraining managers,
does not flawlessly control managerial motives for diversification.^121
Most large publicly held firms are profitable because the managers leading them
are positive stewards of firm resources, and many of their strategic actions, including
those related to selecting a corporate-level diversification strategy, contribute to the
firm’s success.^122 As mentioned, governance mechanisms should be designed to deal
with exceptions to the managerial norms of making decisions and taking actions that
increase the firm’s ability to earn above-average returns. Thus, it is overly pessimistic
to assume that managers usually act in their own self-interest as opposed to their firm’s
interest.^123
Top-level executives’ diversification decisions may also be held in check by concerns
for their reputation. If a positive reputation facilitates development and use of man-
agerial power, a poor reputation can reduce it. Likewise, a strong external market for
managerial talent may deter managers from pursuing inappropriate diversification.^124 In
addition, a diversified firm may acquire other firms that are poorly managed in order
to restructure its own asset base. Knowing that their firms could be acquired if they are
not managed successfully encourages executives to use value-creating diversification
strategies.
As shown in Figure 6.4, the level of diversification with the greatest potential positive
effect on performance is based partly on the effects of the interaction of resources, man-
agerial motives, and incentives on the adoption of particular diversification strategies.
As indicated earlier, the greater the incentives and the more flexible the resources, the
higher the level of expected diversification. Financial resources (the most flexible) should
have a stronger relationship to the extent of diversification than either tangible or intan-
gible resources. Tangible resources (the most inflexible) are useful primarily for related
diversification.
As discussed in this chapter, firms can create more value by effectively using diversifi-
cation strategies. However, diversification must be kept in check by corporate governance