Topic: SKILL, LUCK AND THE MULTIPRODUCT FIRM: EVIDENCE FROM HEDGE FUNDS

We propose that when managers require external investment to expand, higher skilled firms will be more likely to diversify, even though managers can exploit asymmetric information about their ability to raise capital from investors. We formalize this intuition in an equilibrium model and test our predictions using a large survivor-bias-free panel dataset on the hedge fund industry 1994-2006. We show that excess returns fall following diversification—defined as the launch of new fund—but are six basis points higher per month per unit of risk in diversified firms compared to a matched sample of focused firms. The evidence suggests that managers exploit asymmetric information about their own ability to time diversification decisions, but the discipline of markets ensures that better firms diversify on average. The results provide large sample empirical evidence that agency effects and firm capabilities both influence diversification decisions.