Diversification sounds like a good idea, spreading activities across multiple businesses should reduce risk and open new opportunities. Yet in practice, diversified firms often trade at a discount. Markets value them less than the sum of their parts because managing very different businesses can blur strategic focus, inflate coordination costs, and amplify managerial opportunism and inefficiencies stemming from information asymmetries between managers and shareholders. For investors, that kind of complexity creates ambiguity about where profits really come from, and in capital markets, ambiguity tends to mean lower value. The challenge, then, is clear: how can firms manage the complexity of diversification so that it becomes less detrimental to their value?

Yet not all diversified firms are punished equally. Evidence shows that ESG engagement (environmental, social, governance practices) can help neutralize or even reverse that discount. ESG does more than reduce risk: it signals to various stakeholder groups (employees, communities, regulators, investors) that the firm is committed to responsible and consistent behavior. This legitimacy helps firms manage the burden of complexity by creating trust and alignment across different groups that might otherwise pull in different directions. Consequently, the combination of business diversification (BD) and ESG within a firm may form a non-replicable tandem. It transforms a risk of inefficiency into a mechanism for risk management and long-term value creation. ESG acts as a strategic complement that enables diversified firms to extract value from their complexity rather than be penalized for it.

What’s striking is that this benefit seems to come directly. While diversification tends to lower firm-specific risk and ESG helps with market-wide risk, their combined effect on value is not mediated through total risk. In simpler terms: the value boost from combining diversification with ESG is not just about lowering volatility. Something more structural is at work.

So where does this extra value come from? Three conditions appear to strengthen the ESG + diversification payoff:

• In unrelated diversification, when a firm’s business units are quite different, ESG plays a bigger role. With business units that share fewer overlaps, coordination becomes harder and stakeholder demands more diverse. ESG helps bridge that diversity by enhancing stakeholder trust across very different operations.
• When analyst monitoring is high. Firms watched closely by financial analysts are under external pressure to be consistent, credible, and transparent. That scrutiny helps ensure ESG efforts aren’t superficial window dressing but genuine strategic commitments that support value creation.
• Under debt discipline. Creditors impose real constraints. When firms carry debt, financial discipline becomes stronger, making it riskier for managers to misuse diversification or ESG as a tool for self-interest. As a result, in highly leveraged firms, the interplay between ESG and diversification shows stronger value effects.

Diversification gives flexibility; ESG gives legitimacy. But legitimacy pays off most when a firm’s operations are diverse, external eyes are watching, and financial discipline is in place.

Takeaway for managers

Don’t see ESG as separate from growth strategy, especially in complex firms. ESG can help diversified organizations manage stakeholder complexity and convert what looks like a liability (diversification) into an advantage. That payoff shows up most when operations are less related, when external scrutiny is strong, and when financial discipline is maintained. In those environments, ESG + diversification isn’t just safe, it becomes a competitive tool.

Author: Margarita Ortiz - h.m.ortiz.almeyda@rug.nl

References:

de la Fuente, G., Ortiz, M., & Velasco, P. (2025). Business diversification and ESG engagement: Riding tandem to risk reduction and value creation. Journal of Business Research, 200, 115676.