Unrelated Industrial Diversification:

The Effects of Human Capital

Abstract

Industrial diversification through M&A activities has been reviewed by

many scholars so far. There are various views about related and
unrelated diversification, their performance, and possible reasons. This
paper attempts to give a further insight into the effects of human capital in
related and unrelated diversification performance.

Gne Aydoan
2016

1. Introduction
There are a lot of motives which drive companies to engage in Merger and
Acquisition (M&A) activities. These include increasing capabilities, gaining a larger
market share or being the market leader, cost cutting or even survival reasons. Also,
diversification can be considered one of the most important reasons for M&A activities.
There are two types of diversification in literature: Geographical diversification (cross
cultural) and industrial diversification (cross industries). This paper is going to focus in
Industrial diversification, which occurs when a company purchases the controlling shares
of another company to expand their operations, product and service offerings. As the name
suggests, in this type of M&A activities acquirer and target firms should be from different
industries. In practice, mostly SIC codes are used to determine which company is included
in which industry. Diversification acquisition, like the other types of M&As, aims to
capture the value arising from the synergies between acquirer and target.
However, in M&A literature, diversification is a debatable issue in terms of value
creation since shareholders themselves could diversify their portfolios away without
paying any premium. There are some research showing that diversification ends up with
lower value for shareholders. Berger and Ofek (1995) state that firms diversifying their
operations over the period 1986 1995 gave rise to a depreciation in their firm value. On
the other hand, there are some views saying that firms can capture value from
diversification if acquirer and target firms are, in a way, related in terms of their business
field.
However, relatedness can be expressed in different ways. SIC Codes can be used to
determine relatedness. As another measure, Fan and Lang (2000) suggest to use inputoutput data. Morck, Shliefer, and Vishny (1988) provide the evidence that related
diversification generates positive returns while unrelated diversification generates
negative returns. This view is supported by other scholars such as Miller et al. (2000):
Related diversifiers outperform both single-business firms and unrelated diversifiers.
A variety of reasons could be affecting these negative returns. Our hypothesis suggests
that one of the most important reasons for unrelated diversification generates negative
returns is the ineffective transfer of human capabilities between companies.

2.

Human Capital Effect

Hitt et al. (2000) state that human capital moderates the relationship between strategy

and firm performance, therefore it has a strategic importance for firms. Consequently,
human capital is a very important source that should be taken into account as a factor in
M&A activities. However, companies directly based on human capital, such as advisory
firms, show different dynamics in M&A processes.
Disneys implication of 3 very successful acquisitions in last 10 years is a motive to
look for more evidences about the effects of human capital in M&A success. Starting
from 2006, Disney acquired Pixar, Marvel and LucasFilm, which are based on human
creativity as core asset, respectively. Success of these M&As can be explained through
one recent example: The movie Star Wars: Force Awakens, which was released in 2015
by Disney after the acquisition of LucasFilm in 2012, generated a franchise revenue of
$9.6 Billion which is almost on third of the total franchise revenue generated by 8 Star
Wars productions by LucasFilm before. ($34 Billion inflation adjusted). Although there
can be a lot of reasons affecting huge success of Disney in Star Wars: Force Awakens, one
of them is synergy created between Disney and LucasFilm surely. Beginning
In contrast to Disney example, some companies, which are not based on human
capital, may want to engage in diversification acquisition to operate in human-capital
based industries. Human capital often cannot be acquired in efficient labor markets due to
poor information or firm-specific skills that develop over time. Since such knowledge may
be critical to firms building a strategic capability, it is not surprising that many
acquisitions occur in human capital-intensive industries. (Coff,2002)
As stated before, unrelated M&As are more likely to produce negative outcomes.
Acquisition of a human-capital based company by a non-human based reinforces this
effect due to the problem of employee retention.
The resource-based view argues that acquisitions can build competitive advantage
partially through retention of valuable human capital of the target firm. However, these
capabilities are likely to be embedded to a large degree in the tacit and socially complex
knowledge of the acquired firms individual and collective human capital. This presents a

dilemma for acquirers because, unlike tangible or financial assets, the acquired firms
valuable human assets cannot be purchased or owned outright. Second, retaining key
employees throughout the acquired organizations (not just at the level of top management)
appears to be a critical prerequisite to promote the successful transfer of their technologies
and capabilities to the acquiring firms. Losing the employees may end up with a poorer
performance. (Ranft&Lord, 2000)
According to Coff, one of the most important motives to retain the employees of the
target is status of the acquirer. Moreover, only retaining the employees is not enough.
Acquirer should be able to engage them in the company procedure and motivate them. In
Disney example, since both parties are based on human-capital, retention and motivation
of employees will be easier, which increases the possibility of having positive outcomes.
Coff also argues that the uncertainty associated with human capital increases the risk
of overbidding. And irrelevance between human and non-human based firm increases this
uncertainty which ends up with a poor performance
3. Conclusion & Discussion
Diversification is one the most appealing motives of the M&A activities. However,
there are a lot counter-arguments in the literate saying that since industrial diversification
can be easily achieved by individual investors, companies need not to engage in such
diversification activities. On the other hand, there is a discussion between related and
unrelated diversification in which most scholars argue that unrelated diversification is
more likely to end up with negative returns.
In M&A activities, according to the resource-based view, human capital is very
important as one of the most important resources of the companies. To be able to create
positive outcomes acquiring firm should retain the human capital of the target and their
tacit, implicit knowledge and experience as well. Also, motivation of these employees is
very important even if the acquirer is managed to retain them.
This process is even more complicated when the acquirer is from a non-human capital
based industry. It increases the complexity of employee retention and motivation problem.
Acquirer may have a problem about understanding the needs and motivations of the
human resources of the target which causes losing the most important resources of the

target. Hence, we can discuss the result that; the more companies are human-oriented, the
more likely they experience negative returns from unrelated diversification acquisitions.
4. Further Research
In human capital based industries, creative industries require a special attention. Creative
industries are identified and classified by European Commission in 2010 as follows;
industries which use culture as an input and have a cultural dimension, although their outputs
are mainly functional. They include architecture and design, which integrate creative elements
into wider processes, as well as subsectors such as graphic design, fashion design or
advertising.
Creative industries need a special attention due to two reasons:
1) These industries are extreme forms of human-oriented industries. Almost all activities
of these industries are triggered by human resources, human creativity.
2) According to Pflanz (2015) creative companies mostly merge with or acquire noncreative companies. Only 30% percent of the creative acquirers buy creative
companies, in Europe between 2000 and 2014 (Which we call semi-creative M&As).
Our findings suggest that, however, in creative industries unrelated M&As tend to end up
with value destruction. However, there are no studies in the literature that analyses this
hypothesis through quantitative analyses. Additionally, is interesting to observe if creative
companies tend to create better synergies when they acquire or merge with again creative
companies. There are available 3 mean reasons in the literature to support that hypothesis;
1) Findings suggest that similar expertise is particularly important when acquiring human
capital-intensive targets. Transactions involving unrelated buyers of such targets are
less likely to close. (Coff, 2002)
2) Human creativity is the core asset of creative industries. Cross-sectoral M&As should
be less successful in value creation from synergies since in creative M&As, companies
are getting together their most important assets: Human Mind.
3) One of the other most important assets of creative companies is intellectual property
which is very hard to price. If both parties are creative companies then there will be
more complexity.
Therefore, whether creative M&As definitely create more value when compared to the semicreative M&As can be a subject of another quantitative research.

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Myth-Making.

(n.d.).

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