Friday, May 6, 2016

From Specialization to Diversification: Five Essential Principles of Successful Evolution

In business, it is reassuring to be specialized while it is exciting to be diversified. Human heart is shaped to be committed; a business person’s heart, not surprisingly, would stay anchored with his or her first business even decades after its maturity. Human mind is wired to wander; a business person’s mind would, not surprisingly, seek to explore new business opportunities. The balance (or the bridge) between specialization and diversification (or between heart and head) is dictated by each business person’s risk taking ability (or guts). The swing between specialization and diversification is also dictated by global commodity and economic conditions. In periods of continued oil price stability, for example, it would be prudent, equally, to be specialized in either oil exploration or oil refining. In periods of declining oil prices, it would be depressing to be solely in exploration business while in periods of booming oil prices, oil explorers would like to do nothing but drilling.

Times change, and so do business and profit considerations. Nothing that is cast in stone can guarantee success. Even assuming one were to have endless resources, diversification into all sectors need not fetch better returns than staying in one specialized sector. Even if one were to be well balanced in both oil exploration and oil refining what if alternate energy unsettles the fossil fuel scene? The energy industry and the governments may be required to consider solar energy or battery energy sooner than later. These decisions are neither easy to make nor quick to execute. What once seemed an allied domain to the core business could become a millstone to the core business in later years. There have been steel mills which saw mining on one side and power generation on another side as a great infrastructure play. Today, reeling under the burden of unserviceable debt, such businesses yearn to be specialized. Yet, the move towards diversification is a natural and necessary enterprise view, provided five essential principles govern such moves, as discussed below.

Principle of sustainable core  

One of the popular concepts is that diversification should be resorted to when the core business stares at an uncertain or unviable future. The truth is the other way; the core business of any diversifying business must continue to be successful for such diversification to be successful. Even technological obsolescence of the core business products need not necessarily be the trigger for diversification. As long as the basic usage requirement of the core business products or services continues, even specialized firms can have continued prosperity by substituting obsoleting technology with emerging technologies. A relevant case is that of light product companies. By shifting from incandescent bulb technologies to fluorescent technologies and later to LED technologies, the light products companies continue to be specialized yet successful. As long as the society needs artificial lighting, light product companies would be sustainable.

That said, a light products company may consider diversification as a deliberate strategy to scale up and scope up. Such diversification could be in terms of other electrical products like switches, cables and other accessories or in other areas of usage of electricity such as fans, air conditioners and voltage stabilizers. Whenever such diversification takes place, a sustainable core business is as important as an attractive new business. The huge problems of market capitalization faced by conglomerates without any of their core businesses being viable is proof of this hypothesis. This principle teaches that diversifying companies should continue to nurture the core businesses, and the teams deployed therein, and also commit to continuing investments in technology updates in the core business. Core competence arising from the core businesses can be extended to new businesses only when core businesses themselves are competitive.

Principle of dedicated organizations

The fundamental mistake of diversification usually relates to organization design. It is tempting to divert the organizational resources of an existing business to develop new businesses. The assumption is that the existing core businesses are on ‘auto pilot’. This is hardly the truth in most cases. Every business continuously faces disruptive technological and market trends and would need full-fledged dedicated teams to cope with them. Any diversion of resources would starve and fail the core. Many acquisitions also tend to be suboptimal because of the delayering of teams in either the acquired or acquiring companies, or in both. A well designed business, whether it is an established core or emerging new, must have a right sized as well as right talented organization which must continue to nurture the corresponding business.

Successful diversifications in India have been a result of dedicated teams; while organizationally leveraged diversification initiatives have not been as successful.  A study of diversified companies and conglomerates in US, Europe, and Asia supports the dedicated organization concept. The companies/conglomerates are GE, United Technologies, Sarah Lee, Honeywell, Tyco, Philipps, ABB, ThyssenKrupp, Siemens, Hitachi, Samsung, Toshiba, Mitsubishi, Sumitomo, Tata, Reliance, Birla, Hinduja, and L&T. Each of these firms may have a common ownership or at best common board representatives but each of the firms or conglomerates have distinctive business units, organization structures and talent profiles. Failed diversified companies in India (failed diversification in brackets) such as Unitech (telecom), Videocon (telecom), AB Nuvo (Retail), SPIC (pharma) illustrate the perils of underestimating the need for dedicated organizations for the core as well as the new.

Principle of progressive gestation

A popular (mis)conception is that efficient capital allocation for a balanced business portfolio helps support a successful transformation. The capital efficiency theory distorts capital allocation for diversification projects based on certain preconceived rules. In most cases, short gestation projects are favoured even though longer gestation projects may build longer term value. Traditional discounted cash flow and internal rate of return techniques do take into the life span of each project but are heavily dependent on assumptions. In contrast, a portfolio management approach based on the gestation periods of different projects provides better insight. Gestation period is the time taken from the incorporation of a business to first commercialization. Prior to diversification, the leadership must focus on analysing the gestation periods of different projects and classify them into different gestation buckets.

For those companies which are marked by successful core businesses, a gestation period not exceeding 3 to 5 years is probably the period that can be supported. Established core cannot diversify into projects which have gestation periods of 10 years or more (like power and ports) or completely uncertain domains (like oil and gas exploration). A more relevant approach would be to first consider a 3 year gestation guidance for diversification; as the group becomes successful in its first diversification it could take on projects with progressively higher gestation periods such as 5, 7, 9 and higher years sequentially. A relentless focus on gestation management in each of the diversified entities provides managerial inputs that are appropriate besides making both capital allocation and capital accountability processes efficient.

Principle of cultural diversity

It is understood that each organization tends to have its unique culture (although desirable cultural factors would be common across organizations). However, not many appreciate that each business has also its unique way of functioning, creating a sort of cultural filter through which cultural factors of an organization must pass through. Information technology, for example, requires a highly flexible, globally communicative, round the clock global delivery structure. It also requires significant on-site working when required. Similarly, construction, oil & gas exploration, logistics, hospitality, healthcare and several other businesses have their unique ways of conducting and delivering business through employee practices. It is important that the intrinsic cultural aspects of each business are understood by group CEOs and founders.

The essential feature of successful diversification is not managing different businesses but managing diversity. Diversity is the understanding that each business is unique and each employee will be unique not only as an individual but also as a business employee. The management of diversity will be very effective when the Group looks at core cultural values like ethics, collaboration, transparency, and leaves the business specific cultural nurturing to the respective business heads. There is, otherwise, no way an automobile-specialized group can successfully operate with a diversification into software, and vice versa. There could be similar cultural hurdles in a design firm in one sector becoming a manufacturer in another sector. Specialized firms undertaking diversification would be better off by avoiding cultural straightjacketing.  

Principle of corporate governance

The fifth, and quite a critical, principle is the principle of corporate governance. The standards of corporate governance one adheres to in a firm builds long term equity for a firm in its stakeholders. As a firm moves from being a specialized mono-business firm to a diversified multi-business conglomerate, the challenges for corporate governance increase manifold. Some will be structural like establishing legal entity boards, finding the right number and mix of whole time and independent directors, setting up operating executive committees, and so on. These are items that can be handled; the systemic challenges are the ones that will be challenging with conglomeration. Diversification offers additional avenues to derail governance; more opportunities for fund raising, related party transactions, and so on.

More subtly, just as group corporate thinking influences diversification decisions it also influences thinking of individual companies within the conglomerate. A major Indian conglomerate had several years ago decided to become global with overseas acquisitions, and made three big ticket acquisitions, in the beverages, automobiles and steel spaces. The first yielded indifferent results, the second astoundingly positive results and the third painfully negative results. If each of the firms were independent, specialized firms their decision making would have been more circumspect. This is not to hypothesize that conglomerate groups make inherently adventurous decisions; but certainly they become more powerful and more risk-prone, from a governance point of view. Robust corporate governance, at firm level and group level, as well as from structural and systemic angles, will help well-governed specialized firms evolve seamlessly as well-governed diversified entities and conglomerates.

Posted by Dr CB Rao on May 06, 2016       

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