Why do Conglomerates Relax Financial Constraints? Diversification or Correlation

Résumé

The recent financial crisis calls the return of conglomerates to deal with credit crunch. The conventional wisdom is that conglomerates relax financial constraints thanks to diversification. However, conglomerates bring multiple projects under the same top manager, and therefore increase the correlation among projects. In order to reconcile these two seemingly contradictory facts, we propose a theory to argue that correlation, rather than diversification, is the main reason for conglomerates to relax financial constraints. In addition, we also find that when credit rationing is not an issue for firms, stand-alone firms are more prevalent if the likelihood of good managers to bad ones increases. These predictions fits quite well with the evolvement of corporate structure in the US during 1960s to 1980s.