Why Are There So Many Conglomerates in the Developing World?

And why are they so uncommon here?

Why should firms have many divisions, making entirely different products? They are rare in the developed world, but dominate in the developing world. Why is this? There are three principal reasons which stand out to me. First, diversified holdings allow companies to insure against downturns, especially when they could not buy conventional insurance policies due to issues of moral hazard. Relatedly, companies may have access to internal credit markets, which are an advantage in the developing world. Second, better management is tacit knowledge and not easily communicable between people. In order to take advantage of better management, it is necessary for the managers to actually own the company. Third, technology may spill over from department to department in unexpected ways. I think the first two are what explains the persistence of conglomerates in the developing world, and I hope in this essay to present a theory of the firm for profoundly imperfect markets. 

i. Insurance

Businesses prefer a constant stream of income, and will be cautious in order to get it. The fact that firms start small and only slowly ramp up production, even when their costs are the same, is evidence that firms are especially averse to losing money, compared to simply foregoing profits. It is very hard though, if not impossible, to purchase insurance for speculative ventures. Something like fire insurance is easy. While you are incentivized to set your own property on fire, or at least underinvest in fire prevention measures, these are clear for an insurance company to regulate. “This contract is void if there are not enough fire extinguishers, or if the place is intentionally destroyed by the owner” are clear. “The owner shall try their best to create a useful invention during this time, and if they don’t, we must pay” is meaningless. What concrete actions are they directed to take? 

Without the ability to pool risk in the insurance market, companies must self-insure. Very obviously, the larger the company, the more willing they are to take on a fixed amount of risk. A massive company like Alphabet (Google) is perfectly willing to drop a few billion dollars on Waymo, in the hopes something awesome shakes out — I would be unwilling to spend a thousand dollars on speculative investments! We can see this in how large, institutional investors have more R&D funding and productivity, as I have written about here. Both the increase in funding and the increase in productivity may be due to insurance. Institutional investors, being very large, are close to risk neutral, and so managers can be allowed to pick projects which are more productive on average but have a greater risk of total failure. 

It is not only insurance which matters, but credit markets. Not everywhere has them. It is striking how big conglomerates are overwhelmingly in developing countries – the behemoths in the US and Europe get spun off. I think this is principally due to access to credit markets – why, we shall see in just a second. Because there may not be a functioning stock market, capital has to be accumulated by the firm, or borrowed from large investors. Maksimovic and Phillips (2002) find evidence for this. The individual segments of a conglomerate are less productive than a single-sector firm doing the same thing. The difference is that, as demand conditions change, the conglomerate is better able to reallocate spending to match this. These internal capital markets need only exist in the developing world!

ii. Management in the Developing World

I see the developing world as a place where there are persistent gaps in productivity between what is possible and what is achieved. Firms are primarily unproductive not due to their physical capital, nor even by the skill of their workers, but because of the poor management of their owners. I covered the unproductivity of firms in the developing world before, though I was mainly summarizing the Bloom/van Reenen line of literature of firm productivity. Changes in management can induce preposterous changes in productivity, and these gains are not simply the result of increasing capital. They are the result of doing more with the same. 

It is hard to train new managers. I think that people will be persistently different in management skill over time – some people are just extremely good, and there’s little you can do. There is mixed evidence on training. No one would reasonably deny that training provides no benefits. Bloom et al. found substantial changes from providing a few months of management training to Indian textile firms, for example. Nevertheless, the benefits aren’t all that large. Most studies, looked at individually, do not find significant benefits from training. Lumping them all together does create significant effects, but I am simply not convinced that doing so is an appropriate statistical practice. Moreover, most look at very short time horizons, and everything we know about the economics of education suggests that interventions are short lived. 

The best way to get better management is to change managers, not retrain. And the best way to align the incentives of those managers is to have them own the company. If some businessman can make an investment of time and effort on their part in order to create value, the only way to elicit the socially efficient amount of effort is for them to possess the whole residual. In the developed world, sticking unrelated firms together reduces value. There’s no reason for it. Investors can create the same asset by simply buying shares of unrelated companies. But when there is no stock market to speak of, and firms are far away from the production possibilities frontier, having one firm with a generalist manager may be better than trying to run them separately. It’s like how in the early days of sports leagues, the gap between the best and the worst was much larger than it is now. As we compete more, we converge to the best we can do, and the differences between players become smaller. There is evidence for the particular characteristics of firms causing differences in productivity. Henderson and Cockburn (1994) found that much of the differences between firms in pharmaceuticals can be attributed to firm fixed effects. I would imagine that a culture can be shared across divisions, and that some owners might specialize in creating it.

iii. Spillovers

On some level, the distinction between conglomerates and multiple firms owned by a group is specious. Suppose someone owns two companies. If they combine the companies, but appoint a manager for each of them, what has appreciably changed? I think it can be compared to two countries which are united by the rule of a common sovereign, as compared to two countries which are considered by all to be joined together. People might be, in theory, working for their common leader, but there is no belief that one works for the benefit of other territories. This is analogous to firms with a common owner. Especially when there are other investors involved, it may be in violation of their fiduciary duties to disclose trade secrets across companies. 

This is a story I’m skeptical of, because I can find little evidence for or against it happening. (Helpful suggestions from my knowledgeable readers would be much appreciated). The Henderson and Cockburn article mentioned earlier is suggestive evidence of a culture being shared across a company, which may not be able to spread across scattered holdings of an investment firm. Nevertheless, this is the weakest explanation, and the one that does the least to explain why conglomerates are so much more common in developing countries. If anything, it would suggest the opposite! Firms in developing countries are overwhelmingly imitators of technology made elsewhere, and are not on the frontier of production.

I have great hope for firms internalizing their innovation, and economic growth quickening, as I have written about before. (I think this article was really good, but hardly anyone read it. Alas!). I do not think, however, that this internalization will come through conglomerates. There is no need for them in the developed world. They are a vestige of imperfect institutions and insufficient development of human capital.