Risk diversification, especially into diverse business sectors, has often been stated as a reason for undertaking mergers and acquisitions (M&As). Like individuals holding well-diversified portfolios, a company with a number of subsidiaries in different sectors could reduce its exposure to unsystematic risk. Another possible benefit of diversification is sometimes argued to be a reduction in the volatility of cash flows, which may lead to a better credit rating and a lower cost of capital.
The argument against this states that since individual investors can undertake this level of risk diversification both quickly and cheaply themselves, there is little reason for companies to do so. Indeed, research suggests that markets do not reward this risk diversification.
Nevertheless, for Nahara Co, undertaking M&As may have beneficial outcomes, especially if the sovereign fund has its entire investment in the holding company and is not well-diversified itself. In such a situation unsystematic risk reduction can be beneficial. The case study does not state whether or not the sovereign funds are invested elsewhere and therefore a definitive conclusion cannot be reached.
If Nahara Co is able to identify undervalued companies and after purchasing the company can increase the value for the holding company overall, by increasing the value of the undervalued companies, then such M&As activity would have a beneficial impact on the funds invested. However, for this strategy to work, Nahara Co must:
(i) Possess a superior capability or knowledge in identifying bargain buys ahead of its competitor companies. To achieve this, it must have access to better information, which it can tap into quicker, and/or have superior analytical tools. Nahara Co should assess whether or not it does possess such capabilities, otherwise its claim is not valid;
(ii) Ensure that it has quick access to the necessary funds to pursue an undervalued acquisition. Even if Nahara Co possesses superior knowledge, it is unlikely that this will last for a long time before its competitors find out; therefore it needs to have the funds ready, to move quickly. Given that it has access to sovereign funds from a wealthy source, access to funds is probably not a problem;
(iii) Set a maximum ceiling for the price it is willing to pay and should not go over this amount, or the potential value created will be reduced.
If, in its assessment, Nahara Co is able to show that it meets all the above conditions, then the strategy of identifying and pursuing undervalued companies may be valid.
