Some years ago, when a major oil company announced plans to use its own resources to create an internal bank that would service the group’s requirements and reduce the need to use outside financial institutions, the Financial Times illustrated the story with a cartoon of a petrol pump that also dispensed cash.
At the time, this development seemed novel and rather daring, but in fact diversified corporations have always moved funds round the business, from commercial areas with a surplus to those that need cash, whether for investment or to plug holes caused by a downturn in trade.
It is no secret that most of the allocation of resources in the economy takes place within firms and not within markets. That would suggest that the more diversified a company’s operations are, the more benefit can be gained from this internal banking activity, because the greater the chance is that one line of business will be profitable and will be in a position to provide resources to another line that may be unprofitable or which may need to fund capital expenditure.
Less cash more splash?
Our research, focusing on American companies, took this as the starting point and we posed an extension question. Given the more diversified a corporation is the more it is able to re-allocate capital from one subsidiary or business line to another, and given the undoubted fact that such internal allocation of resources will prove especially valuable when external financing sources, such as banks and capital markets, are, for economic or other reasons, tightening up their credit conditions, is there any evidence that such tighter conditions actually promote corporate diversification?
On the face of it, that may sound fanciful. Expansion of business activities is surely a by-product of good times, not challenging ones. But this is to misunderstand the question we sought to answer, which was not about expansion per se but about expansion with a view to the diversification of the scope of the business.
To begin with we looked at conglomerates, large publicly-quoted corporations operating in more than one business sector. During the last three or more decades, these conglomerates have changed significantly in terms of the span of business sectors in which they are involved.
In the early Eighties, for example, the average number of business segments – using the standard industrial classification (SIC) for such sectors – was 2.4. But by the early Nineties, this average had shrunk to 1.6. The crisis that struck in 2007 and led to the Great Recession saw this number increase further.
So what was happening in the outside world as these firms’ activity scope concertinaed? A widely used-measure of stress in the credit markets is the so-called TED spread, which measures the difference between interest rates payable on inter-bank loans and those payable on short-term US Treasury bills. This gauges the extent to which markets want more return for unsecured interbank lending than for paper backed by the US government.
During the recessionary early Eighties, the TED spread exceeded 1.5 per cent as the safe haven of Treasury bills seemed a lot more preferable than unsecured lending. But in the early Nineties, as the long boom hit its stride, the TED spread declined to 0.5 per cent. More recently, it has widened again.
Put together, the evidence suggests that conglomerates extend the scope of their operations when external credit conditions are tight and allow them to contract once more when external conditions ease. In this later state, easier credit conditions weaken the incentive to ensure a spectrum of different activities that can provide funds for internal re-allocation of capital.
The more diversified the conglomerate, the greater the likelihood that there will be occasions when a good investment opportunity occurs in a division of the group that lacks cash at the same time as a cash surplus arises in a division where good investment opportunities are scarce. As the TED spread increases, the attraction of such happy coincidences increases as well, hence the demonstrable fact that the average number of SIC segments in which conglomerates operate rises and falls in direct relationship to stress in the external credit market.
Beyond conglomerates, we extended our research to find out whether this relationship held good in other types of firms, both diversified and stand-alone and in both the publicly-quoted and the private sector. To do so, we looked at merger activity.
As with the general expansion of the scope of a business, there is a popular view that mergers are a response to lax credit conditions, as empire-building corporate chiefs marry their businesses in haste and often repent at leisure. But again, this is not about mergers as such but about the type of merger that is being undertaken.
Broadly, there are two types of mergers: diversifying mergers, in which the parties are in different business sectors, and focused mergers, in which they are in the same line of activity.
Our findings are that, pre-1990, most deals, weighted for their value, were diversifying mergers. But during the Nineties, that proportion dropped below 40 per cent. Come the Great Recession, however, and it was back above 50 per cent.
Again, there is a very direct relationship between credit-market conditions and the behaviour of firms in terms of the value they clearly put on having diversified sources of internal funding. This contrasts with the emphasis during easier credit-market periods on building a bigger position in their core market.
In conglomerates and in other types of firms, the pattern is the same. Changes in external capital markets generate a direct response in terms of the structure of corporations. But then that ought not to be too surprising.
After all, when we talk about firms being financed by external sources as opposed to accessing their own internal capital markets, we are essentially talking about the same thing. One business has surplus cash, the other needs access to it. With stand-alone firms, the channel from the former to the latter is a bank. But during times of credit-market stress, the value of having both the surplus and borrower business under one corporate roof should become clear. Our findings demonstrate that this, indeed, the case.