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
No comments:
Post a Comment