Why conglomerates thrive (Outside the U S)

Abstract

onglomerates may be regarded as dinosaurs in the developed world, but in emerging markets, diversified business groups continue to thrive. Despite the recent global economic slowdown, their sales rose rapidly during the past decade: by over 23% a year in China and India, and by 11% in South Korea. Business groups accounted for 45, 40, and 20 of the 50 biggest companies (excluding state-owned enterprises) in India, South Korea, and China, respectively, according to a recent McKinsey study. They may be called different things in different countries—qiye jituan in China, business houses in India, grupos económicos in Latin America, chaebol in South Korea, and holdings in Turkey. But no matter where they are, business groups are becoming increasingly diversified. On average, they set up a new company every 18 months, more than half the time in a sector unrelated to their existing operations. Most of them are profitable. In India, they deliver above-average performance: Companies belonging to the largest Indian business groups generated higher returns on assets from 1997 to 2011 than the rest of the companies listed on the Bombay Stock Exchange, according to a study we conducted, and more than 60% of those groups generated better returns than a comparable portfolio of standalone companies did.

The success of the business group—a network of independent companies, held together by a core owner—in most emerging markets is remarkable for several reasons. First, it defies history. Conglomerates were all the rage in the United States and Europe for decades, but hardly two dozen of them survive there today. By the early 1980s, they had been laid low by their poor performance, which led to the idea that focused enterprises were better at creating shareholder value than diversified companies were. Most conglomerates shrank into smaller, more specialized entities.

The multidivisional company is the dominant structure for managing multiple business lines in the West today. But it, too, faces challenges. Pioneered by DuPont and General Motors in the 1920s, the divisional structure was supposed to improve the parent’s ability to deal with diversification. But the problems associated with the structure—extra layers of senior executives, opaque accounting, the inability of headquarters to cope with different businesses, and so on—have often made the whole less valuable than the sum of its parts. If that isn’t happening with business groups, they must be more effective in some way—and it’s important for executives to understand how.

Second, the unbridled expansion of business groups challenges the conventional wisdom that they have succeeded in developing countries mostly because they’ve been able to compensate for institutional voids there and, in the process, catalyzed their own growth. Since the early 1990s, however, economic reforms in those nations have led to the creation of new institutions modeled along Anglo-American lines: Legal infrastructures and corporate governance requirements have been strengthened, and sophisticated market intermediaries have emerged. Although institutional voids have contracted, and markets have become relatively more efficient, business groups haven’t imploded, suggesting that making up for institutional inadequacies may not be their only raison d’être.

Of course, countries take generations to develop efficient markets and institutions, so it may be too early to conclude that. However, business groups are neither a temporary phenomenon nor found only in developing countries; many, such as the Tata Group in India (which dates back to 1868), Jardine Matheson in Hong Kong (1832), Doosan in South Korea (1896), and Mitsubishi in Japan (1870), were born over a century ago.

Third, business groups in developing countries have grown mainly through diversification, even though U.S. investors believe that diversification destroys value. On Wall Street the typical conglomerate discount ranges from 6% to 12%. That makes the structural choices today rather stark: If a CEO can convince Wall Street that a new business relates to the current one, it can be accommodated in the form of a division. Otherwise, the CEO will be compelled to divest or let go of the opportunity, regardless of its promise, in order to retain the benefits of a focused enterprise. Not surprisingly, in recent times conglomerates such as Fortune Brands, ITT, McGraw-Hill, and Tyco have all broken up into more focused entities. Business groups represent an alternative to this “divisionalize or divest” approach. We’ve done five years of research on them in India, and we’ve found that, because of the way they are structured, they can manage a portfolio of enterprises better than multidivisional companies can. Another major factor in their effectiveness, we’ve observed, is that their leaders have stopped relying on family members and associates to oversee companies and created a formal management layer, called the group center, which is organized around the office of the group chairperson. That mechanism is helping smart business groups spot more opportunities and capitalize on them while retaining their identity and values.