The role of debt and institutional investors in business diversification : evidence from real estate firms in China

Abstract

Many previous studies suggest that business diversification destroys firm value, resulting in a diversification discount. One proposed explanation for the diversification discount is the agency problem, where the motive of diversification is for the firm managers to benefit themselves from the diversification process. Other studies suggest that the agency problem can be mitigated by third-party monitoring, such as debtors and institutional investors. If the diversification discount is a result of the agency problem, which can be mitigated by third-party monitoring, increased involvement of the debt and institutional investors can lower the diversification discount. This thesis aims to investigate the role played by the firm’s debt and institutional investors in mitigating the value destruction effect of business diversification. Using panel data of listed real estate firms in China from 2010 to 2019, this study first reveals that the firm’s business diversification strategy is an important determinant of diversification discount. The business diversification strategy in this study is divided into different categories, namely related business diversification as well as unrelated business diversification. Related businesses in this study refer to the businesses in the real estate industry according to the definitions adopted by the Industrial Classification for National Economic Activities in China, which include real estate development and management, real estate agency services, property management, and real estate leasing, while unrelated businesses refer to the businesses in other industries. Since there are fewer agency conflicts between managers and shareholders in related business diversification, the agency problem is less serious compared with that of unrelated business diversification. The empirical results show that diversification discount only exists in unrelated business diversification, which is consistent with the conjecture that the diversification discount arises due to the agency problem. In addition, the results show that the diversification discount is lower for firms with a higher leverage ratio and more institutional investor ownership, which confirms the role of the debt and institutional investors in alleviating the agency problem if firms diversify into unrelated businesses. This study also finds that the monitoring role of the debt and institutional investors is substitutive, and less significant for the firms that are audited by the Big Four auditor firms, which is an external governance device to alleviate the information asymmetry problem and thereby reduce agency problem of unrelated business diversification, and more prominent for low-growth firms and firms with excess free cash flow. Moreover, results are robust with Propensity Score Matching analysis, alternative measures of business diversification and the leverage ratio, as well as more control variables.