The dark side of internal capital markets divisional rent-seeking and inefficient investmen.pdf

The Dark Side of Internal Capital Markets: Divisional Rent-Seeking and Ine±cient Investment David S. Scharfstein and Jeremy C. Stein* December 1999 Abstract We develop a two-tiered agency model that shows how rent-seeking behavior on the part of division managers can subvert the workings of an internal capital market. By rent-seeking, division mangers can raise their bargaining power and extract greater overall compensation from the CEO. And because the CEO is herself an agent of outside investors, this extra com- pensation may take the form not of cash wages, but rather of preferential capital budgeting allocations. One interesting feature of our model is that it implies a kind of \socialism in internal capital allocation, whereby weaker divisions get subsidized by stronger ones. * MIT Sloan School of Management and NBER. This paper is a completely overhauled version of our March 1997 NBER working paper (#5969) with the same title. We have received research support from the National Science Foundation and the Finance Research Center at MIT. We are grateful to Charlie Hadlock, Oliver Hart, Laurie Hodrick, Bengt Holmstr?om, Preston McAfee, Vik Nanda, Julio Rotemberg, Ren?e Stulz, Dimitri Vayanos, Luigi Zingales, Je? Zwiebel, the referees and seminar participants at Columbia, Harvard, Indiana, the NBER, Boston University, Utah, Ohio State, Stanford, Stockholm, Yale, the ASSA meetings, and the New York Fed for helpful comments. Thanks also to Melissa Cunni?e and Svetlana Sussman for help in preparing the manuscript. In recent years, it has become almost axiomatic among researchers in ˉnance and strategy that a policy of corporate diversiˉcation is typically value-reducing. A variety of empirical evidence lends support to this view. For example, diversiˉed ˉrms apparently trade at lower stock values than comparable portfolios of specialized ˉrms.1 Moreover, during the 1980s corporate acquirors systematically dismantled diversiˉed ˉrms with the view that the divisions wo