Working Paper: CEPR ID: DP2532
Authors: Sandro Brusco; Fausto Panunzi
Abstract: One distinguishing feature of internal capital markets is their ability to reallocate funds in favour of the most profitable divisions (winner-picking). Yet, diversified firms often trade at a discount with respect to their focused counterparts. The literature has tried to explain the apparent misallocation of resources with lobbying activities or power struggles. We show that the diversification discount can be explained even in a model where resources are efficiently allocated ex post. When managers obtain utility from the funds under their purview, moving funds across divisions may diminish their incentives. The ex ante reduction in managerial incentives can more than offset the increase in firm value due to the ex post efficient reallocation of funds.If headquarters have some commitment power, it is in general optimal to commit not to reallocate at least a fraction of funds. As a result, the investment in a given division is (optimally) more sensitive to the division's cash flow than to other divisions' cash flow, as confirmed by the empirical studies on internal capital markets.Our theory complements the view that links the diversification discount to the inefficient functioning of internal capital markets.
Keywords: internal capital markets; managerial incentives; winner-picking
JEL Codes: G32; G34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Reallocation of funds (H77) | Negative impact on managerial incentives (M52) |
| Negative impact on managerial incentives (M52) | Reduced incentive to generate cash flow (D25) |
| Headquarters committing to allow divisions to retain cash flow (G35) | Enhanced managerial incentives (M52) |
| Enhanced managerial incentives (M52) | Improved firm performance (L25) |
| Reallocation of funds (H77) | Loss of managerial motivation (M54) |
| Loss of managerial motivation (M54) | Decreased overall firm value (G32) |
| Sensitivity of investment in a division to its cash flow (G31) | Efficient functioning of internal capital markets (G31) |