Behind the curtain of international diversification: An agency theory perspective

• Author: Maurizio La Rocca,Pasquale Massimo Picone,Claudio Giachetti,Giovanni Battista Dagnino
• Date: 01 November 2019
• Published date: 01 November 2019
• DOI: http://doi.org/10.1002/gsj.1314

RESEARCH ARTICLE

Behind the curtain of international diversification:

An agency theory perspective

Giovanni Battista Dagnino

1

| Claudio Giachetti

2

| Maurizio La Rocca

3

|

Pasquale Massimo Picone

4

1

University of Rome LUMSA, Palermo Campus,

Palermo, Italy

2

Department of Management, Ca’Foscari

University of Venice, Venice, Italy

3

Department of Business Administration and Law,

University of Calabria, Rende, Italy

4

Department of Management, Economics and

Quantitative Methods, University of Bergamo,

Bergamo, Italy

Correspondence

Giovanni Battista Dagnino, University of Rome

LUMSA, Palermo Campus, Via Filippo Parlatore,

65, 90145, Palermo, Italy.

Email: g.dagnino@lumsa.it

Research Summary: This article dissects the antecedents

of international diversification through the lens of the

agency cost of free cash flow arguments. It explores

whether the partial convergence of interests among man-

agers, majority shareholders, and minority shareholders

affects a firm's choice to diversify internationally. Using a

sample panel of 60 Italian firms evaluated longitudinally

from 2004 to 2014, the study tests whether a firm's inter-

national diversification is affected by its free cash flow

(as the ultimate source of managerial discretion) and debt

(as the main constraint to managerial discretion), espe-

cially in firm contexts that exacerbate agency problems.

We find that the effects on international diversification of

free cash flow and debt are contingent on ownership con-

centration, family control, and growth opportunities.

Managerial Summary:This article studies the anteced-

ents of international diversification by considering the

conflicts of interest among managers, majority share-

holders, and minority shareholders. First, it shows that the

available cash flow (as the fundamental wellspring of

managerial discretion) and level of indebtedness (as a key

limitation to managerial discretion) have, respectively, a

positive and a negative effect on firms' international diver-

sification. Second, it shows that the effects of cash flow

and debt are particularly relevant when considering three

factors: (a) the concentration of firm ownership, leading to

conflicts of interest between majority and minority share-

holders; (b) family control, leading to conflicts of interest

between family members and other shareholders; and

(c) the potential to exploit growth opportunities, leading

to conflicts of interest between managers and

shareholders.

Received: 3 May 2017 Revised: 24 May 2018 Accepted: 26 May 2018

DOI: 10.1002/gsj.1314

Global Strategy Journal. 2019;9:555–594. wileyonlinelibrary.com/journal/gsj © 2018 Strategic Management Society 555

KEYWORDS

debt, free cash flow, growth opportunities, international

diversification, ownership concentration

1|INTRODUCTION

International business literature has identified various factors influencing a firm’s decision to diver-

sify its activities across different geographic areas. This stream of studies has advanced hypotheses

grounded on the resource-based view, the behavioral theory of the firm, and the transaction costs lit-

erature (Hitt, Bierman, Uhlenbruck, & Shimizu, 2006; Hitt, Tihanyi, Miller, & Connelly, 2006).

Implicitly, most scholars have essentially represented the key antecedents of international diversifica-

tion as a set of ownership, location, and risk-specific drivers consistent with the objectives of all

shareholders. Nonetheless, one might suppose the existence of different preferences and latent con-

flicts of interest among managers, large shareholders, and minority shareholders in international

diversification. For instance, Denis, Denis, and Yost (2002) argued that “global diversification repre-

sents a cost of the agency relationship that exists between managers and investors”(Denis et al.,

2002, p. 1997), and Sanders and Carpenter (1998) contended that the separation of the chairperson

and the CEO has a positive effect on international diversification. Along the same line of reasoning,

Ellstrand, Tihanyi, and Johnson (2002) showed that a connection exists between board composition,

CEO duality, and the level of international political risk that is present in a firm's portfolio of foreign

direct investments. Additionally, some scholars have recently expanded the scope of analysis by pay-

ing attention to principal-principal agency conflicts in international diversification. Large share-

holders, as in the case of family-controlled firms, can “use their growing control rights to compel the

management to conduct internationalization strategies”(Oesterle, Richta, & Fisch, 2013, p. 196) in

accordance with their private preferences vis-à-vis value creation for all shareholders (Chen, Hsu, &

Chang, 2014). Majocchi and Strange (2012) indicated that family ownership has a negative effect on

international diversification when commenting on the mixed empirical evidence regarding the ante-

cedents of international diversification. Actually, while D'Angelo, Majocchi, and Buck (2016, p. 2)

argued on “the diversity of governance mechanisms in family SMEs as a potential explanation for

some of the mixed and often contradictory results,”Kano and Verbeke (2018, p. 2) highlighted the

empirical “differences in how to operationalize both family firm governance and level of internation-

alization.”Finally, Tihanyi, Johnson, Hoskisson, and Hitt (2003) drew attention to institutional

owners' preferences in promoting international strategies.

While some recent studies have examined whether (or not) a firm's international diversification is

influenced by corporate governance variables, we believe that additional “agency-theoretic exa mina-

tions can potentially enhance prior […] explanations for international diversification”(Hitt, Tihanyi,

et al., 2006, p. 856). In fact, these studies have fallen short of focusing on the influence of a firm's

financial resource availability (i.e., free cash flow) and on the monitoring and managerial disciplinary

role of debt. Still, the lack or abundance of free cash flow as well as a moderate or large usage of debt

have been regarded as behaviors that can potentially foster or mitigate opportunism within the firm

(Jensen, 1986). We draw attention to Jensen's argument (1986) that free cash flow and debt, respec-

tively, increase and reduce managerial discretion and, thus, the possibility of implementing an agency-

556 DAGNINO ET AL.

driven international strategy. Accordingly, by analyzing a proprietary sample panel of 60 Italian firms

longitudinally from 2004 to 2014, this article assesses the explanatory power of the agency costs of free

cash flow arguments (Jensen, 1986; Jensen & Meckling, 1976) to disentangle the antecedents of inter-

national diversification. Furthermore, we explore whether free cash flow and debt may hamper or con-

strain managers' incentives to diversify internationally, especially when moderating factors, such as

ownership concentration,family ownership,andgrowth opportunities, are taken into con sideration.

This article complements the extant literature in three ways. First, we advance a set of hypotheses

on the effect of free cash flow and debt on a firm's decision to diversify its international operations.

Concerning free cash flow, a measure of firm financial performance, various studies in the strategy

and finance literature have examined it as an outcome of international diversification (Delios &

Beamish, 1999; Hitt, Hoskisson, & Kim, 1997; Lu & Beamish, 2004; Oh & Contractor, 2012). As

for debt, the literature has investigated whether internationally diversified firms are more indebted

than firms operating in a single country (Burgman, 1996; Chen, Cheng, He, & Kim, 1997; Chkir &

Cosset, 2001; Low & Chen, 2004). Notwithstanding that, we argue that free cash flow and debt can

be considered key determinants of international diversification. In other words, we see them as two

antecedents of international diversification that are likely to capture the attention of managers and

majority shareholders (especially family members), thereby affecting their conflicting positions in the

choice of how firms should move abroad. Interestingly, our empirical evidence enriches international

business literature that has theorized mostly a causal relationship in the opposing direction (i.e., free

cash flow and debt as consequences of international diversification). In fact, our empirical evidence

brings light that the issue of causality between financial fundamentals and international diversifica-

tion is more complex than previous inquiry has portrayed.

1

Second, we develophypotheses on the antecedents of international diversification by using explana-

tory variables that take the perspectives of majority shareholders, family shareholders, and managers

concurrently. We focus on variables that exacerbate corporate governance conflicts. Specifically, after

inspecting the direct effect of cash flow and debt on international diversification, we develop a set of

hypotheses on: (a) the moderating effect of ownership concentration, which often has been described

as a source of large shareholders' opportunism (Roe, 1990); (b) the moderating effect of family control,

because the family represents a particular type of large shareholder that various authors have noted as

potentially leading to opportunistic behaviors by family members vis-à-vis other shareholders (Chen

et al., 2014); and (c) the moderating effect of growth opportunities because, when the level of a firm's

growth opportunities is low, the firm's conduct is more likely to be observed asbeing inspired by mana-

gerial opportunism (Jensen, 1986; Opler & Titman, 1993). Our results suggest that free cash flow and

debt have divergent effects on the degree of international diversification, and the role of corporate gov-

ernance variables (such as ownership concentration, family control, and growth opportunities) amplifies

those effects. In sum, we offer some solid evidence on the effect of free cash flow and debt on interna-

tional diversification due to agency-related behavior. Accordingly, we argue that agency theory can

provide a powerful perspective for explaining internationalization behavior.

Third, by examining the joint influence of free cash flow and debt with corporate governance var-

iables, this article complements the existing studies on the agency costs of free cash flow in corporate

finance. While prior research has focused on product diversification (Martin & Sayrak, 2003), we

shed light on how a firm's cash availability or dependence on debtholders affects the decision to

diversify its assets internationally, depending on the mechanisms and relations by which it is con-

trolled and directed.

1

We thank an anonymous reviewer for drawing our attention to this issue.

DAGNINO ET AL.557