Date Added: Jul 2010
The authors propose that when managers require external investment to expand, higher skilled firms will diversify on average, even though managers can exploit asymmetric information about their ability to raise money from investors. They formalize this intuition in an equilibrium model and test the predictions using a large panel dataset on the hedge fund industry 1977-2006. They show that excess returns fall following diversification - defined as the launch of new fund - but are 11 basis points per month higher in diversified firms compared to a matched sample of focused firms. The results provide large sample empirical evidence that agency effects and firm capabilities both influence diversification decisions.