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Strategists and scholars point to five main reasons why firms pursue inorganic growth:

1 Maturing product line.

2 Regulatory or antitrust limits.

3 Value creation through horizontal and vertical integration.

4 Acquisition of resources and capabilities.

5 Value creation through diversification.

GROWTH IN THE CONTEXT OF A MATURING PRODUCT LINE Many businesses experience a life cycle of growth, as depicted in Part A of Exhibit 6.11. The explosive growth rates of the start-up phase of the business are eventually replaced by more sedentary growth. This is to be expected: High growth tends to attract imitators, who may sap the growth of the leader. Also, all the forces of turbulence (see Chapter 4) such as technological innovation, demographic change, deregulation, and globalization render products (and industries) obsolete. This degradation of the business in its maturity years can produce headaches for CEOs. A common response is to acquire new businesses, still early in their life cycles, to create a total growth trajectory. This strategy of buying growth to sustain a growth curve is illustrated in Part B of Exhibit 6.11. The executive must retain two criticisms about this motive:

EXHIBIT 6.10 Range of Transactions in a Decision Framework

EXHIBIT 6.11 Life Cycle of the Firm

1 May harm shareholder value. This product life cycle perspective can create a frenzy for added revenue or earnings that ignores costs, investments, risks, and the time value of money. It is possible to achieve higher revenue growth and at the same time destroy shareholder value. See Chapters 9 and 17 for more about this.

2 Is it sustainable? In the limit, a trajectory of a high real growth rate (i.e., relative to the real growth rate of the economy) is bounded by the size of the economy. Growing at an excessive rate for a sufficiently long period of time, the firm will eventually own the entire economy.

GROWTH TO CIRCUMVENT REGULATORY OR ANTITRUST LIMITS Simply reinvesting in the core business may not be feasible if the firm operates under regulatory constraints. For instance, at various times broadcasters and banks have been limited in the scope of their operations. Inorganic growth through diversifying acquisition permits the maintenance of a growth trend. But like the previous point, one must critically assess the sustainability of growth and the impact on shareholder value of this kind of circumvention. The thoughtful CEO must relentlessly ask, “Is the shareholder better off if we return the cash through a dividend, and stop this growth program?”

VALUE CREATION THROUGH HORIZONTAL OR VERTICAL INTEGRATION Improving economic efficiency may be served by integration of the firm with peers, or with suppliers and customers. Chapter 4 described the first two large waves of M&A activity in the United States as waves of integration.

1 Horizontal integration entails combination with peer firms in an industry. This may exploit economies of scale, which will reduce costs, and market power, which may result in increased prices. Antitrust regulation seeks to forestall monopoly power in horizontal combinations (see Chapter 28).

2 Vertical integration combines firms along the value chain. For instance, a steel manufacturer might acquire upstream operations (such as iron ore mines) and downstream operations (such as fabricators of steel products). Harrigan (1985) noted that vertical integration can create value if it improves economic efficiency by cutting out intermediaries and reducing overhead expense and redundant assets. Improved coordination through inventory and purchasing business processes may create further efficiencies. And strategically it may guarantee a source of supply in a tight market, preempting competitors and preventing being locked out. But vertical integration also has potential disadvantages: Locking in suppliers and customers makes your firm an equity participant in their fortunes; if they fail to remain competitive, their problems can harm your core business. Furthermore, the creation of internal markets can lead to the loss of economic discipline and a distancing from the information conveyed by external markets.

ACQUISITION OF UNIQUE RESOURCES AND CAPABILITIES In some situations, it may be impossible to create internally those resources that are vital to the continued success of the firm. In fields such as biotechnology, computer software, defense electronics, and filmed entertainment, large corporations regularly reach beyond their internal operations to acquire intellectual property, patents, creative talent, and managerial know-how.

VALUE CREATION THROUGH DIVERSIFICATION The classic motive for diversification is to create a portfolio of businesses whose cash flows are imperfectly correlated, and therefore might be able to sustain one another through episodes of adversity—this is a straightforward application of the theory of portfolio diversification that Levy and Sarnat (1970) explored at the corporate level. It is not clear what value this kind of portfolio management adds to shareholders’ wealth—couldn’t shareholders build these portfolios on their own? If so, why should they pay managers to do this for them? Salter and Weinhold (1979) argued that corporate diversification could do things that shareholder portfolio formation cannot. Thus, diversification might pay if it:

 Promotes knowledge transfer across divisions. This might lift the productivity of weak divisions. For instance, General Electric practices Total Quality Management and extends its productivity-enhancing techniques to new businesses that it acquires.

 Reduces costs. Where the diversification is into related fields, it may be possible for the diversified firm to reduce costs through improved bargaining power with suppliers. Also, the cost of financing may be lower thanks to the portfolio diversification effect. Lewellen (1971) suggested that combining two unrelated businesses whose cash flows are imperfectly correlated can reduce the risk of default of the entire enterprise, and therefore expand debt capacity and reduce interest rates.⁴

 Creates critical mass for facing the competition. Diversification may bring an aggregation of resources that can be shaped into core competencies that create competitive advantage.

 Exploits better transparency and monitoring through internal capital markets. Internal markets might function better than external markets. First, there may be lower transaction costs: shifting funds from cash cows to cash users may not entail the contracting costs associated with loan agreements or equity underwritings. Coase (1932) argued that the chief explanation of why some firms internalize activities that could, in theory, be conducted among independent firms was that high transaction costs made it cheaper for the firm to do so. Weston (1970), Alchian (1969), and Williamson (1975) offered supporting arguments that internal markets may be more efficient in some circumstances than external markets; Stein (1997) highlights one of these circumstances to be where the corporate headquarters is competent in “winner-picking,” the shifting of funds to the best projects. Second, disclosure is probably greater: within the confines of the diversified firm, senior executives can obtain sensitive information that might not be available to outside sources of funds. Chandler (1977) documented the rise of the modern corporation and showed that enhanced methods of monitoring and information transfer enabled senior executives to manage larger and more diverse operations effectively. But the evidence about the effectiveness of internal capital markets is mixed. For instance, Lamont (1997) studied the behavior of oil companies during the oil price collapse of the mid-1980s and found evidence consistent with the story that “large diversified companies overinvest in and subsidize underperforming segments.” (Page 106)