Why Do Managers Diversify Their Firms? Agency Reconsidered

We develop a contracting model between shareholders and managers in which managers diversify their firms for two reasons: to reduce idiosyncratic risk and to capture private benefits. We test the comparative static predictions of our model. In contrast to previous work, we find that diversification is positively related to managerial incentives. Further, the link between firm performance and managerial incentives is weaker for firms that experience changes in diversification than it is for firms that do not. Our findings suggest that managers diversify their firms in response to changes in private benefits rather than to reduce their exposure to risk.