The leader–member exchange (LMX) literature argues that leaders develop different quality dyadic relationships with members in the same team (i.e., LMX differentiation). Research has generally not found support for a linear (i.e., main effect) relationship between LMX differentiation and team performance; rather, moderators typically determine whether the relationship is significantly positive or negative. Examining linear effect moderators alone, however, does not account for (a) potential curvilinear (i.e., inverted U‐shaped) effects, (b) explanatory mechanisms of how LMX differentiation influences team performance, or (c) moderators of curvilinear effects. Integrating social identity theory with LMX differentiation research, we propose inverted U‐shaped relationships between LMX differentiation and both team coordination (as a mediator) and team performance (as an outcome), and we examine both team size and team power distance orientation as moderators. Using data from 928 employees in 145 teams in 3 organizations, we found an inverted U‐shaped relationship between LMX differentiation and team coordination, which, in turn, partially mediated LMX differentiation's inverted U‐shaped relationship with team performance. Larger teams, or those with higher team power distance orientation, benefit more from LMX differentiation. By integrating social identity theory with LMX differentiation research, we enhance the understanding of the processes by, and conditions under, which LMX differentiation affects team performance both positively and negatively.