Social Connections and Capital Allocation in Multidivisional Firms

ABSTRACT The inefficiency of internal capital allocation is considered one source of losses due to diversification. We use a hand‐collected sample of divisional managers in S&P 500 industrial conglomerates and find that social connections among divisional managers are associated with capital allocation improvements. Segments’ investments become more sensitive to segments’ growth opportunities when these segments are led by better‐connected managers. For connected managers, the probability of being assigned to a segment with low investment opportunities increases significantly with investment opportunities of connected segments. Firm‐level connectedness is associated with higher firm values primarily in firms with high diversity in segment investment opportunities, high dispersion of analyst earnings forecasts, and a low percentage of sales from non‐US markets. Connectedness is also linked to a reduction of internal information asymmetry between headquarters and divisions, as well as to a lower likelihood of earnings manipulation. Ultimately, our findings support the idea that connections help mitigate misallocation of funds by facilitating interdivisional cooperation and reducing internal information asymmetries.