Why do firms undertake diversifying mergers? An analysis of the investment policies of merging firms

Recent empirical literature documents value-destroying \crosssubsidization" among the divisions of diversi ̄ed ̄rms. However, this literature relies upon two maintained hypotheses: that divisions of diversi ̄ed ̄rms are randomly allocated to their corporate parents and that the investment opportunities facing conglomerate divisions are identical to those of stand-alone ̄rms in their industries. This paper provides a benchmark of the importance of these selection biases. Using a sample of ̄rms that undertake diversifying mergers between 1980 and 1995, I examine the investment behavior of these ̄rms prior to their mergers. I show that investment patterns that the literature has attributed to cross-subsidization between divisions are apparent in the pairs of merging ̄rms prior to their mergers. Thus, the main results of the paper suggest that some of the cross-subsidization results in the literature may be attributable to selection bias. I also examine stock market responses to the announcement of diversifying acquisitions. The market believes that these acquisitions will create value, although there is some evidence that the most diversifying mergers in the sample are viewed unfavorably. I gratefully acknowledge research support from the Alfred P. Sloan Foundation and the University of Chicago Graduate School of Business. Seminar participants at the University of Chicago and the NBER Summer Institute provided helpful comments. I am extremely grateful to Mark Mitchell and the Center for Research in Securities prices for making the merger database available to me.