Advanced Corporate Strategy

ST104x

Diversification in Emerging Economies

Professor Sai: Since the evidence from the developed economies suggests that excessive
diversification seems to destroy value and the stock markets apply a conglomerate discount
to conglomerates, many conglomerates have been split up into separate companies. For
example, compared to the 60s and 70s, there are far fewer firms in the US that can be called
as conglomerates. However, the evidence from emerging economies has been quite different.
It is common to see firms that are present in multiple unrelated businesses such as Grasim in
India, IOI group in Malaysia, and Lippo Group in Indonesia.

Another unique feature of emerging economies is the presence of business groups. A business
group is a group of sometimes legally independent firms that are tied to each other in formal
or informal ways. The Tata group in India is a prominent example of a business group. Business
groups also tend to highly diversified.

For example, companies in the Tata group operated in a wide range of industries such as
 steel,
 automobiles,
 software,
 hotels,
 beverages and so on.

How can conglomerates and business groups in emerging economies continue to not only
survive but thrive as well? How come they do not face the high costs of diversification?

Professor Srinivasan: One well-accepted initial answer to this question is that such firms and
business groups in emerging economies thrive because they fill institutional voids.

What are institutional voids?

Khanna and Palepu identify five dimensions along which voids are likely to exist. It is useful to
compare US and India along these five institutional dimensions and see how the Tata Group
can fill the institutional voids that exist in India.

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 Advanced Corporate Strategy

ST104x

I. First, the capital markets are well developed in the US in that it is easy to raise money
from the stock market, the bond market or venture capitalists for ideas that are
considered viable. However, the same idea in India may not attract funding since
capital markets have been underdeveloped in India historically leading to a void in the
capital market. Given the lack of adequate safeguards, investors are willing to provide
capital to only those they trust. Since the Tata Group is large and the Group provides
an implicit guarantee to potential investors that their investments will be protected,
investors are more willing to provide capital to the Tata Group company.

II. Second, the United States has a large pool of skilled workers and talented managers.
In contrast, skilled workers and talented managers were in short supply despite the
large population due to the poor state of education. The Tata Group can fill this void
in the labour market by operating its own labour market. Given its large size and
reputation, group companies can attract employees easily. Further, the Group
provides training and a common managerial pool that can be used by the individual
companies. These group companies may not have the same access to talented
managers if they were standalone companies.

III. Third, the product markets are well developed in that consumers are well protected.
In the case of faulty or defective products, they can return to the product to the seller
easily. Further, there are many sources of information that make it easy for consumers
to figure out the quality of goods being sold. Powerful consumer activists have also
ensured that consumer rights are protected. In contrast, in emerging markets, it has
been typically a case of “buyer beware”. It is difficult to get redress in the case of a
faulty product or service. In this context, consumers tend to trust a brand such as Tata.
This has enabled Tatas to sell everything from salt to software to automobiles under
the Tata name.

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 Advanced Corporate Strategy

ST104x

IV. Fourth, in contrast to emerging markets, government regulation in developed markets

tends to be limited, the government tends to play a smaller role in the economic
matters and corruption tends to be low. In many emerging markets, there is high
government regulation and control, which means that the firms have to continuously
interact with the government. A company associated with a business group will be in
a much better to deal with the government compared to a standalone firm.

V. Fifth, the judicial systems in developed markets tend to work better than the judicial
systems in emerging markets. In India, while companies can go court for contract
enforcement, the outcomes tend to be unpredictable and can take a long time to
materialize. So, it is better to tie up with a company which is known to be a reliable
partner, such as a company belonging to a trusted business group. For example, Tatas
have built up a reputation as a trustworthy partner and over the years they have
formed alliances with a wide range of companies such as IBM, Honeywell and
Starbucks. This has also given them the opportunity to diversify into a wide range of
emerging industries.

Thus, you can see that many institutional voids exist in emerging economies and business
groups that fill these institutional voids can thrive.

Professor Sai: However, the puzzle still remains. In many emerging economies, institutions
have strengthened over time. For example, India now has a vibrant stock market and well-
developed venture capital funding. The labour market has also become much stronger. The
process of liberalization that was started in 1991 has reduced regulation and the role of
government in business activity. Thus, a good case can be made that institutional voids, while
they continue to exist, have become much smaller over time. If business groups exist because
they fill institutional voids, then as institutional voids become smaller, the role of business
groups in an economy should come down.

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 Advanced Corporate Strategy

ST104x

However, no such thing has happened. The percentage of India’s GDP that is accounted for
by companies belonging to business groups has stayed the same over the last 20 to 30 years.
Business group firms have made forays into emerging industries such as mobile telephone
services and retail.

Why do business groups continue to thrive despite the fact that institutions have become
stronger?

Professor Srinivasan: Our colleague Prof. Ramachandran and his co-authors Manikandan and
Anirvan Pant argue that conglomerates continue to thrive especially outside the US because
the benefits that they provide go beyond filling institutional voids. They suggest that business
groups are successful at diversification compared to a single company that is diversified into
multiple businesses because of how they are structured.

In business groups, the individual companies are legally independent entities with a high level
of involvement between ownership and management. These features provide business
groups three advantages over multidivisional structures.

I. First, in multidivisional companies, the divisions often do not the power to make
decisions by themselves. While the corporate office may provide parenting advantage
to the divisions, the involvement of the corporate managers, who may not be fully
familiar with each of the divisions can have negative consequences for decision
making. In contrast, the individual companies in a business group have more
autonomy in decision making because they have their own board of directors.

II. Second, the divisions in a multi-divisional company will have constraints on incentive
design since it is not easy to have too much variance in incentives under a single
corporate entity. In contrast, the individual companies in a business group are
independently listed companies and incentives in one company are in no way tied to
incentives in another group company.

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 Advanced Corporate Strategy

ST104x

III. Third, resource allocation in multidivisional companies is a challenging task due to

mismatches in supply and demand of cash, bureaucratic delays and politicking. These
are usually not problems in a business group since each company can keep its surplus
cash to itself and also raise funds from the external market. At the same time, each
group company has access to resources at its sister companies that it can use to utilize
growth opportunities.

Thus, business groups can garner some of the benefits of diversification while avoiding the
costs of diversification. This can help explain why business groups continue to thrive and why
they are likely to thrive in the coming years as well.

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