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FIRST, SOME DEFINITIONS. Corporate control means the power to make investment and financing decisions. A hostile takeover bid is an attempt to force a change in corporate control. In popular usage, corporate governance refers to the role of the board of directors, shareholder voting, proxy fights, and to other actions taken by shareholders to influence corporate decisions. In the last chapter we saw a striking example: Pressure from institutional shareholders helped force AMP Corporation to abandon its legal defenses and accept a takeover. Economists use the term governance more generally to cover all the mechanisms by which managers are led to act in the interests of the corporation’s owners. A perfect system of corporate governance would give managers all the right incentives to make value-maximizing investment and financing decisions. It would assure that cash is paid out to investors when the company runs out of positive-NPV investment opportunities. It would give managers and employees fair compensation but prevent excessive perks and other private benefits. This chapter considers control and governance in the United States and other industrialized countries. It picks up where the last chapter left off—mergers and acquisitions are, after all, changes in corporate control. We will cover other mechanisms for changing or exercising control, including leveraged buyouts (LBOs), spin-offs and carve-outs, and conglomerates versus private equity partnerships. The first section starts with yet another famous takeover battle, the leveraged buyout of RJR Nabisco. Then we move to a general evaluation of LBOs, leveraged restructurings, privatizations, and spin-offs. The main point of these transactions is not just to change control, although existing management is often booted out, but also to change incentives for managers and improve financial performance. Section 34.3 looks at conglomerates. “Conglomerate” usually means a large, public company with operations in several unrelated businesses or markets. We ask why conglomerates in the United States are a declining species, while in some other countries, for example Korea and India, they seem to be the dominant corporate form. Even in the United States, there are many successful temporary conglomerates, although they are not public companies.1 Section 34.4 shows how ownership and control vary internationally. We use Germany and Japan as the main examples. There is a common theme to these three sections. You can’t think about control and governance without thinking still more broadly about financial architecture, that is, about the financial organization of the business. Financial architecture is partly corporate control (who runs the business?) and partly governance (making sure managers act in shareholders’ interests). But it also includes the legal form of organization (e.g., corporation vs. partnership), sources of financing (e.g., public vs. private equity), and relationships with financial institutions. The financial architectures of LBOs and most public corporations are fundamentally different. The financial architecture of a Korean conglomerate (a chaebol) is fundamentally different from a conglomerate in the United States. Where financial architecture differs, governance and control are different too. Much of corporate finance (and much of this book) assumes a particular financial architecture— that of a public corporation with actively traded shares, dispersed ownership, and relatively easy access to financial markets. But there are other ways to organize and finance a business. Arrangements for ownership and control vary greatly country by country. Even in the United States many successful businesses are not corporations, many corporations are not public, and many public corporations have concentrated, not dispersed, ownership.
1
What’s a temporary conglomerate? Sorry, you’ll have to wait for the punch line.
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34.1 LEVERAGED BUYOUTS, SPIN-OFFS, AND RESTRUCTURINGS Leveraged buyouts differ from ordinary acquisitions in two immediately obvious ways. First, a large fraction of the purchase price is debt-financed. Some, often all, of this debt is junk, that is, below investment-grade. Second, the LBO goes private, and its shares no longer trade on the open market.2 The LBO’s stock is held by a partnership of (usually institutional) investors. When this group is led by the company’s management, the acquisition is called a management buyout (MBO). In the 1970s and 1980s many management buyouts were arranged for unwanted divisions of large, diversified companies. Smaller divisions outside the companies’ main lines of business sometimes lacked top management’s interest and commitment, and divisional management chafed under corporate bureaucracy. Many such divisions flowered when spun off as MBOs. Their managers, pushed by the need to generate cash for debt service and encouraged by a substantial personal stake in the business, found ways to cut costs and compete more effectively. In the 1980s MBO/LBO activity shifted to buyouts of entire businesses, including large, mature public corporations. Table 34.1 lists the largest LBOs of the 1980s plus examples of transactions from 1997 to 2001. More recent LBOs are generally smaller and not leveraged as aggressively as the deals of the 1980s. But LBO activity is still impressive in aggregate: Buyout firms raised over $60 billion in new capital in 2000.3
Acquirer
Target
Industry
Year
Price
KKR KKR KKR Thompson Co. Wings Holdings KKR TF Investments Macy Acquisitions Corp.
RJR Nabisco Beatrice Safeway Southland (7-11) NWA, Inc. Owens-Illinois Hospital Corp of America R. H. Macy & Co.
Food, tobacco Food Supermarkets Convenience stores Airlines Glass Hospitals Department stores
1989 1986 1986 1987 1989 1987 1989 1986
$24,720 6,250 4,240 4,000 3,690 3,690 3,690 3,500
Bain Capital Cyprus Group, with management* Clayton, Dubilier, & Rice Berkshire Partners Heartland Industrial Partners
Sealy Corp. WESCO Distribution, Inc.
Mattresses Data communications
1997 1998
811 1,100
North American Van Lines William Carter Co. Springs Industries
Trucking Children’s clothing Household textiles
1998 2001 2001
200 450 846
TA B L E 3 4 . 1 The 10 largest LBOs of the 1980s, plus examples of more recent deals. Price in $ millions. *Management participated in the buyout—a partial MBO. Source: A. Kaufman and E. J. Englander, “Kohlberg Kravis Roberts & Co. and the Restructuring of American Capitalism,” Business History Review 67 (Spring 1993), p. 78; Mergers and Acquisitions 33 (November/December 1998), p. 43, and various later issues.
2
Sometimes a small stub of stock is not acquired and continues to trade. LBO Signposts, Mergers & Acquisitions, March 2001, p. 24.
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Table 34.1 starts with the largest, most dramatic, and best-documented LBO of all time: the $25 billion takeover of RJR Nabisco by Kohlberg, Kravis, Roberts (KKR). The players, tactics, and controversies of LBOs are writ large in this case.
RJR Nabisco On October 28, 1988, the board of directors of RJR Nabisco revealed that Ross Johnson, the company’s chief executive officer, had formed a group of investors that was prepared to buy all RJR’s stock for $75 per share in cash and take the company private. Johnson’s group was backed up and advised by Shearson Lehman Hutton, the investment banking subsidiary of American Express. RJR’s share price immediately moved to about $75, handing shareholders a 36 percent gain over the previous day’s price of $56. At the same time RJR’s bonds fell, since it was clear that existing bondholders would soon have a lot more company.4 Johnson’s offer lifted RJR onto the auction block. Once the company was in play, its board of directors was obliged to consider other offers, which were not long in coming. Four days later KKR bid $90 per share, $79 in cash plus PIK preferred valued at $11. (PIK means “pay in kind.” The preferred dividends would be paid not in cash but in more preferred shares.)5 The resulting bidding contest had as many turns and surprises as a Dickens novel. In the end it was Johnson’s group against KKR. KKR offered $109 per share, after adding $1 per share (roughly $230 million) in the last hour.6 The KKR bid was $81 in cash, convertible subordinated debentures valued at about $10, and PIK preferred shares valued at about $18. Johnson’s group bid $112 in cash and securities. But the RJR board chose KKR. Although Johnson’s group had offered $3 per share more, its security valuations were viewed as “softer” and perhaps overstated. The Johnson group’s proposal also contained a management compensation package that seemed extremely generous and had generated an avalanche of bad press. But where did the merger benefits come from? What could justify offering $109 per share, about $25 billion in all, for a company that only 33 days previously was selling for $56 per share? KKR and the other bidders were betting on two things. First, they expected to generate billions in additional cash from interest tax shields, reduced capital expenditures, and sales of assets not strictly necessary to RJR’s core businesses. Asset sales alone were projected to generate $5 billion. Second, they expected to make the core businesses significantly more profitable, mainly by cutting back on expenses and bureaucracy. Apparently there was plenty to cut, including the RJR “Air Force,” which at one point included 10 corporate jets. In the year after KKR took over, new management was installed that sold assets and cut back operating expenses and capital spending. There were also layoffs. As expected, high interest charges meant a net loss of $976 million for 1989, but pretax operating income actually increased, despite extensive asset sales, including the sale of RJR’s European food operations. Inside the firm, things were going well. But outside there was confusion, and prices in the junk bond market were rapidly declining, implying much higher future
4
N. Mohan and C. R. Chen track the abnormal returns of RJR securities in “A Review of the RJR Nabisco Buyout,” Journal of Applied Corporate Finance 3 (Summer 1990), pp. 102–108. 5 See Section 25.8. 6 The whole story is reconstructed by B. Burrough and J. Helyar in Barbarians at the Gate: The Fall of RJR Nabisco, Harper & Row, New York, 1990—see especially Ch. 18—and in a movie with the same title.
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interest charges for RJR and stricter terms on any refinancing. In mid-1990 KKR made an additional equity investment, and in December 1990 it announced an offer of cash and new shares in exchange for $753 million of junk bonds. RJR’s chief financial officer described the exchange offer as “one further step in the deleveraging of the company.”7 For RJR, the world’s largest LBO, it seemed that high debt was a temporary, not permanent, virtue. RJR, like many other firms that were taken private through LBOs, enjoyed only a short period as a private company. In 1991 RJR went public again with the sale of $1.1 billion of stock.8 KKR progressively sold off its investment, and its remaining stake in the company was sold in 1995 at roughly the original purchase price.
Barbarians at the Gate? The RJR Nabisco LBO crystallized views on LBOs, the junk bond market, and the takeover business. For many it exemplified all that was wrong with finance in the 1980s, especially the willingness of “raiders” to carve up established companies, leaving them with enormous debt burdens, basically in order to get rich quick. There was plenty of confusion, stupidity, and greed in the LBO business. Not all the people involved were nice. On the other hand, LBOs generated enormous increases in market value, and most of the gains went to the selling stockholders, not to the raiders. For example, the biggest winners in the RJR Nabisco LBO were the company’s stockholders. The most important sources of added value came from making RJR Nabisco leaner and meaner. The company’s new management was obliged to pay out massive amounts of cash to service the LBO debt. It also had an equity stake in the business and therefore had strong incentives to sell off nonessential assets, cut costs, and improve operating profits. LBOs are almost by definition diet deals. But there were other motives. Here are some of them. The Junk Bond Markets LBOs and debt-financed takeovers may have been driven by artificially cheap funding from the junk bond markets. With hindsight, it seems that investors in junk bonds underestimated the risks of default in junk bonds. Default rates climbed painfully from 1988 through 1991, when 10 percent of outstanding junk bonds with a face value of $18.9 billion defaulted.9 The junk bond market also became much less liquid after the demise in 1990 of Drexel Burnham, the chief market maker, although the market recovered in the mid-1990s. Leverage and Taxes Borrowing money saves taxes, as we explained in Chapter 18. But taxes were not the main driving force behind LBOs. The value of interest tax shields was just not big enough to explain the observed gains in market value.10 7
G. Andress, “RJR Swallows Hard, Offers $5-a-Share Stock,” The Wall Street Journal, December 18, 1990, pp. C1–C2. 8 Northwest Airlines, Safeway Stores, Kaiser Aluminum, and Burlington Industries are other examples of LBOs that reverted to being public companies. 9 See R. A. Waldman, E. I. Altman, and A. R. Ginsberg, “Defaults and Returns on High Yield Bonds: Analysis through 1997,” Salomon Smith Barney, New York, January 30, 1998. See also Section 24.5. 10 Moreover, there are some tax costs to LBOs. For example, selling shareholders realize capital gains and pay taxes that otherwise could be deferred. See L. Stiglin, S. N. Kaplan, and M. C. Jensen, “Effects of LBOs on Tax Revenues of the U.S. Treasury,” Tax Notes 42 (February 6, 1989), pp. 727–733.
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CHAPTER 34 Control, Governance, and Financial Architecture For example, Richard Ruback estimated the present value of additional interest tax shields generated by the RJR LBO at $1.8 billion.11 But the gain in market value to RJR stockholders was about $8 billion. Of course, if interest tax shields were the main motive for LBOs’ high debt, then LBO managers would not be so concerned to pay off debt. We saw that this was one of the first tasks facing RJR Nabisco’s new management. Other Stakeholders We should look at the total gain to all investors in an LBO, not just to the selling stockholders. It’s possible that the latter’s gain is just someone else’s loss and that no value is generated overall. Bondholders are the obvious losers. The debt they thought was well secured may turn into junk when the borrower goes through an LBO. We noted how market prices of RJR Nabisco debt fell sharply when Ross Johnson’s first LBO offer was announced. But again, the value losses suffered by bondholders in LBOs are not nearly large enough to explain stockholder gains. For example, Mohan and Chen’s estimate12 of losses to RJR bondholders was at most $575 million—painful to the bondholders, but far below the stockholders’ gain. Leverage and Incentives Managers and employees of LBOs work harder and often smarter. They have to generate cash for debt service. Moreover, managers’ personal fortunes are riding on the LBO’s success. They become owners rather than organization men and women. It’s hard to measure the payoff from better incentives, but there is some preliminary evidence of improved operating efficiency in LBOs. Kaplan, who studied 48 MBOs between 1980 and 1986, found average increases in operating income of 24 percent three years after the LBO. Ratios of operating income and net cash flow to assets and sales increased dramatically. He observed cutbacks in capital expenditures but not in employment. Kaplan suggests that these “operating changes are due to improved incentives rather than layoffs or managerial exploitation of shareholders through inside information.”13 We have reviewed several motives for LBOs. We do not say that all LBOs are good. On the contrary, there have been many mistakes, and even soundly motivated LBOs are dangerous, at least for the buyers, as the bankruptcies of Campeau, Revco, National Gypsum, and other highly leveraged transactions (HLTs) proved. Yet, we do quarrel with those who portray LBOs solely as undertaken by Wall Street barbarians breaking up the traditional strengths of corporate America.
Leveraged Restructurings The essence of a leveraged buyout is of course leverage. Why not take on the leverage and dispense with the buyout? We reviewed one prominent example in the last chapter. Phillips Petroleum was attacked by Boone Pickens and Mesa Petroleum. Phillips dodged the takeover with a leveraged restructuring. It borrowed $4.5 billion and repurchased one-half of its outstanding shares. To service this debt, it sold assets for $2 billion and cut back 11
R. S. Ruback, “RJR Nabisco,” case study, Harvard Business School, Cambridge, MA, 1989. Mohan and Chen, op. cit. 13 S. Kaplan, “The Effects of Management Buyouts on Operating Performance and Value,” Journal of Financial Economics 24 (October 1989), pp. 217–254. 12
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PART X Mergers, Corporate Control, and Governance capital expenditure and operating costs. It put itself on a cash diet. The demands of servicing $4.5 billion of extra debt made sure it stayed on the diet. Let’s look at another diet deal. Sealed Air’s Leveraged Restructuring14 In 1989 Sealed Air Corporation undertook a leveraged restructuring. It borrowed the money to pay a $328 million special cash dividend. In one stroke the company’s debt increased 10 times. Its book equity (accounting net worth) went from $162 million to minus $161 million. Debt went from 13 percent of total book assets to 136 percent. Sealed Air was a profitable company. The problem was that its profits were coming too easily because its main products were protected by patents. When the patents expired, strong competition was inevitable, and the company was not ready for it. In the meantime, there was too much financial slack: We didn’t need to manufacture efficiently; we didn’t need to worry about cash. At Sealed Air, capital tended to have limited value attached to it—cash was perceived as being free and abundant.
So the leveraged recap was used to “disrupt the status quo, promote internal change,” and simulate “the pressures of Sealed Air’s more competitive future.” This shakeup was reinforced by new performance measures and incentives, including increases in stock ownership by employees. It worked. Sales and operating profits increased steadily without major new capital investments, and net working capital fell by half, releasing cash to help service the company’s debt. The company’s stock price quadrupled in the five years after the restructuring. Sealed Air’s restructuring was not typical. It is an exemplar chosen with hindsight. It was also undertaken by a successful firm under no outside pressure. But it clearly shows the motive for most leveraged restructurings. They are designed to force mature, successful, but overweight companies to disgorge cash, reduce operating costs, and use assets more efficiently.
Financial Architecture of LBOs and Leveraged Restructurings The financial structures of LBOs and leveraged restructurings are similar. The three main characteristics of LBOs are 1. High debt. The debt is not intended to be permanent. It is designed to be paid down. The requirement to generate cash for debt service is designed to curb wasteful investment and force improvements in operating efficiency. 2. Incentives. Managers are given a greater stake in the business via stock options or direct ownership of shares. 3. Private ownership. The LBO goes private. It is owned by a partnership of private investors who monitor performance and can act right away if something goes awry. But private ownership is not intended to be permanent. The most successful LBOs go public again as soon as debt has been paid down sufficiently and improvements in operating performance have been demonstrated. Leveraged restructurings share the first two characteristics but continue as public companies. 14
See K. H. Wruck, “Financial Policy as a Catalyst for Organizational Change: Sealed Air’s Leveraged Special Dividend,” Journal of Applied Corporate Finance 7 (Winter 1995), pp. 20–37.
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34.2 FUSION AND FISSION IN CORPORATE FINANCE Figure 34.1 shows some of AT&T’s acquisitions and divestitures. Prior to 1984, AT&T controlled most of the local, and virtually all of the long-distance telephone service in the United States. (Customers used to speak of the ubiquitous “Ma [Mother] Bell.”) In 1984 the company accepted an antitrust settlement requiring local telephone service to be spun off to seven new, independent companies.15 AT&T was left with its long-distance business plus Bell Laboratories, Western Electric (telecommunications manufacturing), and various other assets. As the communications industry became increasingly competitive, AT&T acquired several other businesses, notably in computers, cellular telephone service, and cable television. Some of these acquisitions are shown as the burgundy incoming arrows in Figure 34.1. AT&T was an unusually active acquirer. It was a giant company trying to respond to rapidly changing technologies and markets. But AT&T was simultaneously divesting dozens of other businesses. For example, its credit card operations (the AT&T Universal Card) were sold to Citicorp. In 1996, AT&T created two new companies by spinning off Lucent (incorporating Bell Laboratories and Western Electric) and its computer business (NCR). AT&T had paid $7.5 billion to acquire NCR in 1990. These and several other important divestitures are shown as the burgundy outgoing arrows in Figure 34.1. In the market for corporate control, fusion—mergers and acquisitions—gets the most publicity. But fission—the separation of assets and operations from the whole—can be just as important. We will now see how these separations are carried out by spin-offs, carve-outs, asset sales, and privatizations.
Spin-offs A spin-off is a new, independent company created by detaching part of a parent company’s assets and operations. Shares in the new company are distributed to the parent company’s stockholders. Here are some recent examples. • Sears Roebuck spun off Allstate, its insurance subsidiary, in 1995. • In 1998 the Brazilian government completed privatization of Telebras, the Brazilian national telecommunications company. Before the final auction, the company was split into 12 separate pieces—one long-distance, three local, and eight wireless communications companies. In other words, 12 companies were spun out of the one original. • In 2001 Thermo Electron spun off its healthcare and paper machinery and systems divisions as two new companies, Viasys and Kadant, respectively. • In 2001 Canadian Pacific Ltd. spun off its oil and gas, shipping, coal mining, and hotel businesses as four new companies traded on the Toronto stock exchange. Spin-offs are not taxed so long as shareholders in the parent are given at least 80 percent of the shares in the new company.16 15
Subsequent mergers reduced these seven companies to four: Bell South, SBC Communications, Qwest, and Verizon. 16 If less than 80 percent of the shares are distributed, the value of the distribution is taxed as a dividend to the investor.
969
970
U.S. West
Southwestern Bell
Pacific Telesis
NYNEX
McCaw Cellular, 1994
LIN Broadcasting, 1995
AT&T Capital, 1993, 1996
AT&T Universal Card, 1998
Global Network TCI, Media One, (from IBM), 1999 2000 1998, 1999 Vanguard At Home Corp. Cellular, (Excite@Home), 1999 2000
AT&T Submarine Systems, 1997
NCR, 1996
Mergers and Acquisitions
Lucent, 1996
AT&T Broadband, 2001
34. Control Governance, and Financial Architecture
The effects of AT&T’s antitrust settlement in 1984, and a few of AT&T’s acquisitions and divestitures from 1991 to 2001. Divestitures are shown by the outgoing burgundy arrows. When two years are given, the transaction was completed in two steps.
Teradata, 1991
NCR, 1991
Unix System Labs, 1991,1995
Divestitures
X. Mergers, Corporate Control, and Governance
FIGURE 34.1
AT&T
AT&T
Bell South
Bell Atlantic
Ameritech
1984 Antitrust Settlement
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Spin-offs widen investors’ choice by allowing them to invest in just one part of the business. More important, spin-offs can improve incentives for managers. Companies sometimes refer to divisions or lines of business as “poor fits.” By spinning these businesses off, management of the parent company can concentrate on its main activity.17 If the businesses are independent, it is easier to see the value and performance of each and reward managers accordingly. Managers can be given stock or stock options in the spun-off company. Also, spin-offs relieve investors of the worry that funds will be siphoned from one business to support unprofitable capital investments in another. Announcement of a spin-off is generally greeted as good news by investors.18 Investors in U.S. companies seem to reward focus and penalize diversification. Consider the dissolution of John D. Rockefeller’s Standard Oil trust in 1911. The company he founded, Standard Oil of New Jersey, was split up into seven separate corporations. Within a year of the breakup, the combined value of the successor companies’ shares had more than doubled, increasing Rockefeller’s personal fortune to about $900 million (about $15 billion in 2002 dollars). Theodore Roosevelt, who as president had led the trustbusters, ran again for president in 1912:19 “The price of stock has gone up over 100 percent, so that Mr. Rockefeller and his associates have actually seen their fortunes doubled,” he thundered during the campaign. “No wonder that Wall Street’s prayer now is: ‘Oh Merciful Providence, give us another dissolution.’ ”
Why is the value of the parts so often greater than the value of the whole? The best place to look for an answer to that question is in the financial architecture of conglomerates. But first, we take a brief look at carve-outs, asset sales, and privatizations.
Carve-outs Carve-outs are similar to spin-offs, except that shares in the new company are not given to existing shareholders but are sold in a public offering. Recent carve-outs include Pharmacia’s sale of part of its Monsanto subsidiary, and Philip Morris’s sale of part of its Kraft Foods subsidiary. The latter sale raised $8.7 billion. Most carve-outs leave the parent with majority control of the subsidiary, usually about 80 percent ownership.20 This may not reassure investors who worry about 17
The other way of getting rid of “poor fits” is to sell them to another company. One study found that over 30 percent of assets acquired in a sample of hostile takeovers from 1984 to 1986 were subsequently sold. See S. Bhagat, A. Shleifer, and R. Vishny, “Hostile Takeovers in the 1980s: The Return to Corporate Specialization,” Brookings Papers on Economic Activity: Microeconomics (1990), pp. 1–12. 18 Research on spin-offs includes K. Schipper and A. Smith, “Effects of Recontracting on Shareholder Wealth: The Case of Voluntary Spin-offs,” Journal of Financial Economics 12 (December 1983), pp. 409–436; G. Hite and J. Owers, “Security Price Reactions around Corporate Spin-off Announcements,” Journal of Financial Economics 12 (December 1983), pp. 437–467; and J. Miles and J. Rosenfeld, “An Empirical Analysis of the Effects of Spin-off Announcements on Shareholder Wealth,” Journal of Finance 38 (December 1983), pp. 1597–1615. P. Cusatis, J. Miles, and J. R. Woolridge report improvements of operating performance in spun-off companies. See “Some New Evidence that Spin-offs Create Value,” Journal of Applied Corporate Finance 7 (Summer 1994), pp. 100–107. 19 D. Yergin: The Prize, Simon & Schuster, New York, 1991, p. 113. 20 The parent must retain an 80 percent interest to consolidate the subsidiary with the parent’s tax accounts. Otherwise the subsidiary is taxed as a freestanding corporation.
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PART X Mergers, Corporate Control, and Governance lack of focus or a poor fit, but it does allow the parent to set managers’ compensation based on the performance of the subsidiary’s stock price. Some companies carve out a minority interest in a subsidiary and later sell or spin off the remaining shares. For example, Sara Lee, the food company, carved out a 19.5 percent stake in the luxury leather goods retailer Coach in 2000. The remaining 80.5 percent of the Coach shares were sold to Sara Lee stockholders in 2001.21 Perhaps the most enthusiastic carver-outer of the 1980s and 1990s was Thermo Electron, with operations in healthcare, power generation equipment, instrumentation, environmental monitoring and cleanup, and various other areas. At yearend 1997, it had seven publicly traded subsidiaries, which in turn had carved out 15 further public companies. The 15 were grandchildren of the ultimate parent, Thermo Electron.22 Some companies have distributed tracking stock tied to the performance of particular divisions. This does not require a spin-off or carve-out, only the creation of a new class of common stock. For example, in 1997 Georgia Pacific distributed a special class of shares tied to the performance of its Timber Group. The company noted that having two classes of shares “provides the opportunity to structure incentives for employees of each Group that are tied directly to the share price performance of that Group.”23
Asset Sales The simplest way to divest an asset is to sell it. Asset sale refers to the acquisition of part of one firm by another. The record asset sale is Comcast’s acquisition of AT&T Broadband, AT&T’s cable television division, for $42 billion in 2001. We have mentioned the sale of AT&T’s credit card division to Citibank. Asset sales are common in the credit card business. The largest credit card issuers, including Citibank, MBNA, and First USA, grew during the 1980s and 1990s by acquiring the credit card operations of hundreds of smaller banks. Asset sales are also common in manufacturing. Maksimovic and Phillips examined a sample of about 50,000 U.S. manufacturing plants each year from 1974 to 1992. About 35,000 plants in the sample changed hands during that period. About one-half of the ownership changes were the result of mergers or acquisitions of entire firms. The other half of the ownership changes came about by asset sales, that is, sale of part or all of a division. On average, about 4 percent of the plants in the sample changed hands each year, about 2 percent by merger or acquisition, and about 2 percent by asset sales.24 21
Sara Lee stockholders were allowed to exchange Sara Lee shares for Coach shares. The terms of the exchange gave Sara Lee’s stockholders the opportunity to get Coach shares at a discount, so all of the Coach shares were issued in short order. 22 In 1998 Thermo Electron announced a plan to consolidate several of its children and grandchildren in order to move to a less complicated structure. In 2001, it began to spin off some of its peripheral operations as separate companies. 23 Georgia Pacific Corporation, Proxy Statement and Prospectus, November 11, 1997, p. 35. The Timber Group was sold to Plum Creek Timber Company in 2001. Timber Group tracking stock was exchanged for Plum Creek shares. 24 V. Maksimovic and G. Phillips, “The Market for Corporate Assets: Who Engages in Mergers and Asset Sales and Are There Efficiency Gains?” Journal of Finance 56 (December 2001), Table I, p. 2030.
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Announcements of asset sales are good news for investors in the selling firm, and productivity of the assets sold increases, on average, after the sale.25 It appears that asset sales transfer business units to the companies that can manage them most effectively.
Privatization A privatization is a sale of a government-owned company to private investors. For example, the government of Germany originally owned Volkswagen but sold it in 1961. Britain sold British Telecom in 1984. The United States sold Conrail in 1987. Most privatizations are more like carve-outs than spin-offs, because shares are sold for cash, not distributed to the ultimate “shareholders,” that is, to the people of the selling country. But several former Communist countries, including Russia, Poland, and the Czech Republic, privatized by means of vouchers distributed to citizens. The vouchers could be used to bid for shares in newly privatized companies. Thus the companies were not sold for cash, but for vouchers.26 Privatizations raised enormous sums for selling governments. France raised $17.6 billion in two share issues for France Telecom in 1997 and 1998. Japan raised over $80 billion in the privatization of NTT (Nippon Telephone and Telegraph) in 1987 and 1988. Privatizations have also been common in airlines (e.g., Japan Airlines and Air New Zealand) and banking (e.g., the French bank Paribas). The motives for privatization seem to boil down to the following three points: 1. Increased efficiency. Through privatization, the enterprise is exposed to the discipline of competition and insulated from political influence on investment and operating decisions. Managers and employees can be given stronger incentives to cut costs and add economic value. 2. Share ownership. Privatizations encourage share ownership. Many privatizations give special terms or allotments to employees or small investors. 3. Revenue for the government. Last but not least! There were fears that privatizations would lead to massive layoffs and unemployment, but that does not appear to be the case. While it is true that privatized companies operate more efficiently and thus reduce employment, they also grow faster as privatized companies, which increases employment. In many cases the net effect on employment is positive. On other dimensions, the impact of privatization is almost always positive. A review of research on privatization concludes that privatized firms “almost always become more efficient, more profitable, . . . financially healthier and increase their capital investment spending.”27 It seems clear that changing from state to private ownership is in general a valuable change in financial architecture. 25
See Maksimovic and Phillips, op. cit. There is extensive research on voucher privatizations. See, for example, M. Boyco, A. Shleifer, and R. Vishny, “Voucher Privatizations,” Journal of Financial Economics 35 (April 1994), pp. 249–266; and R. Aggarwal and J. T. Harper, “Equity Valuation in the Czech Voucher Privatization Auctions,” Financial Management 29 (Winter 2000), pp. 77–100. 27 W. L. Megginson and J. M. Netter, “From State to Market: A Survey of Empirical Studies on Privatization,” Journal of Economic Literature 39 (June 2001), p. 381. 26
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34.3 CONGLOMERATES We now examine a different form of financial architecture, the conglomerate. Conglomerates are firms investing in several unrelated industries. Large public conglomerates are now rare in the United States, though common elsewhere. We will try to figure out why. We will also examine the financial architecture of the private conglomerates that invest in venture capital and LBOs.
Pros and (Mostly) Cons of U.S. Conglomerates Conglomerates were the corporate celebrities of the 1960s. They grew by leaps and bounds through aggressive programs of acquisitions in unrelated industries. By the 1970s, the largest conglomerates had achieved amazing scopes and spans. Table 34.2 shows that by 1979 ITT was operating in 38 different industries and ranked eighth in total sales among U.S. corporations. In 1995 ITT, which had already sold or spun off several lines of business, split its remaining operations into three separate firms. One acquired ITT’s interests in hotels and gambling; a second took over ITT’s automotive parts, defense, and electronics businesses; and a third specialized in insurance and financial services (ITT Hartford). Most of the conglomerates created in the 1960s were broken up in the 1980s and early 1990s; however, a few successful new conglomerates have sprung up. Tyco International, AMP’s white knight, is one of these.28 What advantages were claimed for conglomerates? First, diversification across industries was supposed to stabilize earnings and reduce risk. That’s hardly compelling, because shareholders can diversify much more efficiently and flexibly on their own.29 Second, and more important, was the idea that good managers were fungible; in other words, that modern management would work as well in the manufacture of auto parts as in running a hotel chain. Neil Jacoby, writing in 1969, argued that computers and new methods of quantitative, scientific management had “created opportunities for profits through mergers that remove assets from the
TA B L E 3 4 . 2
Sales Rank
The largest U.S. conglomerates in 1979, ranked by sales compared to all U.S. industrial corporations. Most of these companies have been broken up. Source: A. Chandler and R. S. Tetlow, eds., The Coming of Managerial Capitalism, Richard D. Irwin, Inc., Homewood, IL, 1985, p. 772; see also J. Baskin and P. J. Miranti, Jr., A History of Corporate Finance, Cambridge University Press, Cambridge, UK: 1997, chap. 7.
28
8 15 42 51 66 73 103 104 128
See Section 33.5. See the Appendix to Chapter 33.
29
Company
Number of Industries
International Telephone & Telegraph (ITT) Tenneco Gulf & Western Industries Litton Industries LTV Illinois Central Industries Textron Greyhound Martin Marietta
38 28 41 19 18 26 16 19 14
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inefficient control of old-fashioned managers and place them under men schooled in the new management science.”30 There was some truth in this. The most successful early conglomerates did force dramatic improvements in some mature and slackly managed businesses. The problem is, of course, that a company doesn’t need to be diversified to take over and improve a lagging business. Third, conglomerates’ wide diversification meant that their top managements could operate an internal capital market. Free cash flow generated by divisions in mature industries could be funneled within the company to other divisions with profitable growth opportunities. There was no need for fast-growing divisions to raise financing from outside investors. There are some good arguments for internal capital markets. The company’s own managers probably know more about its investment opportunities than do outside investors, and transaction costs of issuing securities are avoided. Nevertheless, it appears that attempts by conglomerates to allocate capital investment across many unrelated industries are more likely to subtract value than add it. Trouble is, internal capital markets are not really markets but combinations of central planning (by the conglomerates’ top management and financial staff) and intracompany bargaining. Divisional capital budgets depend on politics as well as pure economics. Large, profitable divisions with plenty of free cash flow may have more bargaining power than growth opportunities; they may get generous capital budgets while smaller divisions with good prospects but less bargaining power are reined in. Berger and Ofek estimate the average conglomerate discount at 12 to 15 percent.31 Conglomerate discount means that the market value of the whole conglomerate is less than the sum of the values of its parts. The chief cause of this discount, at least in Berger and Ofek’s sample, seemed to be overinvestment and misallocation of investment. In other words, investors were marking down the value of the conglomerates’ shares from worry that their managements would make negativeNPV investments in mature divisions and forego positive-NPV opportunities elsewhere. Conglomerates face further problems. Their divisions’ market values can’t be observed independently, and it is difficult to set incentives for division managers. This is particularly serious when managers are asked to commit to risky ventures. For example, how would a biotech startup fare as a division of a traditional conglomerate? Would the conglomerate be as patient and risk-tolerant as investors in the stock market? How are the scientists and clinicians doing the biotech R&D rewarded if they succeed? We don’t mean to say that high-tech innovation and risktaking is impossible in public conglomerates, but the difficulties are evident. Internal Capital Markets in the Oil Business Misallocations in internal capital markets are not restricted to pure conglomerates. For example, Lamont found that, when oil prices fell by half in 1986, diversified oil companies cut back capital investment in their non-oil divisions.32 The non-oil divisions were forced to “share 30 Quoted in A. Chandler and R. S. Tetlow, eds., The Coming of Managerial Capitalism, Richard D. Irwin, Inc., Homewood, IL: 1985, p. 746. 31 P. Berger and E. Ofek, “Diversification’s Effect on Firm Value,” Journal of Financial Economics 37 (January 1995), pp. 39–65. 32 O. Lamont, “Cash Flow and Investment: Evidence from Internal Capital Markets,” Journal of Finance 52 (March 1997), pp. 83–109.
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the pain,” even though the drop in oil prices did not diminish their investment opportunities. The Wall Street Journal reported one example:33 Chevron Corp. cut its planned 1986 capital and exploratory budget by about 30 percent because of the plunge in oil prices . . . A Chevron spokesman said that spending cuts would be across the board and that no particular operations will bear the brunt. About 65 percent of the $3.5 billion budget will be spent on oil and gas exploration and production—about the same proportion as before the budget revision. Chevron also will cut spending for refining and marketing, oil and natural gas pipelines, minerals, chemicals, and shipping operations.
Why cut back on capital outlays for minerals, say, or chemicals? Low oil prices are generally good news, not bad, for chemical manufacturing, because oil distillates are an important raw material. By the way, most of the oil companies in Lamont’s sample were large, blue-chip companies. They could have raised additional capital from investors to maintain spending in their non-oil divisions. They chose not to. We do not understand why. All large companies must allocate capital among divisions or lines of business. Therefore they all have internal capital markets and must worry about mistakes and misallocations. But this danger probably increases as a company moves from a focus on one, or a few related industries, to unrelated conglomerate diversification. Look again at Table 34.2: How could the top management of ITT keep accurate track of investment opportunities in 38 different industries?
Fifteen Years after Reading this Chapter You have just seized control of Establishment Industries, the blue-chip conglomerate, after a high-stakes, high-profile takeover battle. You are a financial celebrity, hounded by business reporters every time you step out of your stretch limo. You’re contemplating a Ferrari and a trophy spouse. Fundraisers from your college or university are suddenly very attentive. But first you’ve got to deliver on promises to add shareholder value to your renamed New Establishment Corporation. Fortunately you remember Principles of Corporate Finance. First you identify New Establishment’s neglected divisions—the poor fits that have not received their share of capital or top management attention. These you spin off; no more internal capital market. As independent companies, these divisions can set their own capital budgets, but to obtain financing, they have to convince outside investors that their growth opportunities are truly positive-NPV. The managers of these spun-off companies can buy stock or be given stock options as part of their compensation packages. Therefore incentives to maximize value are stronger. Investors understand this, so New Establishment’s stock price jumps as soon as the spin-offs are announced. Establishment Industries also has some large, mature, cash-cow businesses. You add still more value by selling some of these divisions to LBO partnerships. You bargain hard and get a good price, so the stock price jumps again. The remaining divisions will be the core of New Establishment. You consider pushing through a leveraged restructuring of these core activities to make sure that free cash flow is paid out to investors rather than invested in negative-NPV ventures. But you decide instead to implement a performance measurement and com-
33
Cited in Lamont, op. cit., pp. 89–90.
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pensation system based on residual income.34 You also make sure managers and key employees have significant equity stakes. You take over as CEO, and New Establishment survives and prospers. Your celebrity status fades away, except that once a year you are listed in Forbes magazine’s annual compilation of the 400 wealthiest executives and investors. It could happen.
Financial Architecture of Traditional U.S. Conglomerates This fanciful tale sums up the argument for focus and against conglomerate diversification. We must be careful not to push the argument too far, however. GE, an exceptionally successful company, operates in a wide range of unrelated industries, including jet engines, equipment leasing, broadcasting, home appliances, and medical equipment. But we can confidently identify the challenges set by the financial architecture of conglomerates. To add value in the long run, the conglomerate structure sets two tasks for top management: (1) Make sure divisional management and operating performance are better than could be achieved if the divisions were independent and (2) operate an internal capital market that beats the external capital market. In other words, conglomerate management has to make better capital investment decisions than could be achieved by independent companies responsible for their own financing. Task (1) is difficult because divisions’ market values can’t be observed separately, and it is difficult to set incentives for divisional managers. Task (2) is difficult because the conglomerate’s central planners have to fully understand investment opportunities in many different industries and because internal capital markets are prone to allocations by bargaining and politics. Now we turn to a class of conglomerates that does seem to add value. We will find, however, that they have a different financial architecture.
Temporary Conglomerates Table 34.3 lists the businesses in which a Kohlberg, Kravis, Roberts (KKR) LBO fund operated in 1998. Looks like a conglomerate, right? But this fund is not a public company. It is a private partnership.
Books, cards, other publishing (2 companies) Communications Consumer services (Kindercare Learning Centers) Fiber optics (coupling and connections) General food products Golf and healthcare products (1 company) Hospital and institutional management Insurance (in Canada) Other consumer products (1 company) Printing and binding Transportation equipment and parts
34
That is, on EVA. See Section 12.4.
TA B L E 3 4 . 3 KKR formed an LBO partnership in 1993. By 1998 this fund held companies in the following industries. The partnership was a (temporary) conglomerate.
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Investment Phase
Payout Phase
General partners put up 1% of capital
General partners get carried interest in 20% of profits
Management fees
Limited partners put in 99% of capital
Partnership
Partnership
Limited partners get investment back, then 80% of profits
Company 1 Company 2 Company 3 Investment in diversified portfolio of companies
• • •
Sale or IPO of companies
Company N
FIGURE 34.2 Organization of a typical private equity partnership. The limited partners, having put up almost all of the money, get first crack at the proceeds from sale or IPO of the portfolio companies. Once their investment is returned, they get 80 percent of any profits. The general partners, who organize and manage the partnership, get a 20 percent carried interest in profits.
This KKR fund is a private investment partnership and a temporary conglomerate. It buys up companies, generally in unrelated industries, but it does not buy and hold. It tries to buy, fix, and sell. It buys to restructure, to dispose of incidental assets, and to improve operations and management. If the program of improvement is a success, it sells out, either by taking the company public again or by selling it to another firm. KKR is famous for LBOs. But its financial structure is shared by venture capital partnerships formed to invest in startup companies and by partnerships formed to buy up private companies without LBO financing. These are all private equity partnerships. Figure 34.2 shows how such a partnership is organized. The general partners organize and manage the venture. The limited partners35 put up most of the 35
Limited partners enjoy limited liability. See Section 14.2.
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money. Limited partners are generally institutional investors, such as pension funds, endowments, and insurance companies. Wealthy individuals or families may also participate. Once the partnership is formed, the general partners seek out companies to invest in. Venture capital partnerships look for high-tech startups, LBO partnerships for mature businesses with ample free cash flow and a need for new or reinvigorated management. Some partnerships specialize in particular industries, for example biotechnology or real estate. But most end up with a portfolio of companies in different industries. The partnership agreement has a limited term, 10 years or less. The portfolio companies must be sold and the proceeds must be distributed. The general partners cannot reinvest the limited partners’ money. Of course, once a fund is proved successful, the general partners can usually go back to the limited partners, or to other institutional investors, and form another one. The general partners get a management fee, typically 1 or 2 percent of capital committed, plus a carried interest, usually 20 percent of the fund’s profits. In other words the limited partners get paid off first, but then get only 80 percent of any further returns. (The general partners have a call option on 20 percent of the partnership’s value, with an exercise price equal to the limited partners’ investment.) Table 34.4 summarizes a comparison by Baker and Montgomery of the financial structures of an LBO fund and a typical public conglomerate. Both are diversified, but the fund’s limited partners do not have to worry that free cash flow will be plowed back into unprofitable investments. The fund has no internal capital market. Monitoring and compensation of management also differ. In the LBO fund, each company is run as a separate business. The managers report directly to the owners, the fund’s partners. Each company’s managers own shares or stock options in that company, not in the fund. Their compensation depends on their company’s market value in a sale or IPO. In a public conglomerate, these businesses would be divisions, not freestanding companies. Ownership of the conglomerate would be dispersed, not concentrated. The divisions would not be valued by investors in the stock market, but by the conglomerate’s corporate staff, the very people who run the internal capital market.
LBO Partnerships
Public Conglomerates
Widely diversified, investment in unrelated industries
Widely diversified, investment in unrelated industries
Limited-life partnership forces sale of portfolio companies. No financial links or transfers between portfolio companies General partners “do the deal,” then monitor; lenders also monitor. Managers’ compensation depends on exit value of company.
Public corporations designed to operate divisions for the long run Internal capital market Hierarchy of corporate staff evaluates divisions’ plans and performance. Divisional managers’ compensation depends mostly on earnings—“smaller upside, softer downside.”
TA B L E 3 4 . 4 LBO funds vs. public conglomerates. Both diversify, investing in a portfolio of unrelated businesses, but their financial structures are otherwise fundamentally different. Source: Adapted from G. Baker and C. Montgomery, “Conglomerates and LBO Associations: A Comparison of Organizational Forms,” working paper, Harvard Business School, Cambridge, MA, July 1996.
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PART X Mergers, Corporate Control, and Governance Managers’ compensation wouldn’t depend on divisions’ market values because no shares in the divisions would be traded and plans for sale or spin-off would not be part of the conglomerate’s financial architecture. The advantages of LBO partnerships are obvious: strong incentives to managers, concentrated ownership (no separation of ownership and control), and limited life, which reassures limited partners that cash flow will not be reinvested wastefully. These advantages carry over to other types of private equity partnerships, including venture capital funds. We do not say that this financial structure is appropriate for most businesses. It is designed for change, not for the long run. But traditional conglomerates don’t seem to work well for the long run, either.
Conglomerates around the World Nevertheless, conglomerates are common outside the United States. In some emerging economies, they are the dominant financial structure. In Korea, for example, the 10 largest conglomerates control roughly two-thirds of the corporate economy. These chaebols are also strong exporters so that names like Samsung and Hyundai are recognized worldwide. Conglomerates are common in Latin America. One of the more successful, the holding company36 Quinenco, is in a dizzying variety of businesses, including hotels and brewing in Chile, pasta making in Peru, and the manufacture of copper and fiber optic cable in Brazil. Why are conglomerates so common in such countries? There are several possible reasons. Size You can’t be big and focused in a small, closed economy: The scale of oneindustry companies is limited by the local market. Scale may require diversification. There are various reasons why size can be an advantage. For example, larger companies have easier access to international financial markets. This is important if local financial markets are inefficient. Size means political power; this is especially important in managed economies or in countries where the government economic policy is unpredictable. In Korea, for example, the government has controlled access to bank loans. Bank lending has been directed to government-approved uses. The Korean conglomerate chaebols have usually been first in line. Undeveloped Financial Markets If a country’s financial markets are substandard, an internal capital market may not be so bad after all. “Substandard” does not just mean lack of scale or trading activity. It may mean government regulations limiting access to bank financing or requiring government approval before bonds or shares are issued.37 It may mean information inefficiency: If accounting standards are loose and companies are secretive, monitoring by outside investors becomes especially costly and difficult, and agency costs proliferate. 36
A holding company owns controlling blocks of shares in two or more subsidiary companies. The holding company and its subsidiaries operate as a group under common top management. 37 In the United States, the SEC does not have the power to deny share issues. Its mandate is only to assure that investors are given adequate information.
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In many countries, including some advanced economies, minority investors are not well protected by law and securities regulation. Sometimes there are blatant transfers of wealth from outside shareholders to insiders’ pockets. It’s no surprise that financial markets in such countries are relatively small. Recent research by Rafael LaPorta and his colleagues finds a strong association between legal systems and the development of financial markets and the volume of external finance.38 Minority shareholders seem to be best protected in common-law systems such as those in the United States, Great Britain, and other English-speaking countries. Civil-law systems, such as those in France and Spanish-speaking countries, offer less effective protection; consequently, financial markets are less important in such countries. The volume of external financing is low. Financing tends to flow instead through banks, within large, diversified companies, or among members of groups of associated companies. Many of these companies or groups are controlled by families.
The Bottom Line on Conglomerates Are conglomerates good or bad? Does corporate diversification make sense? It depends on the task at hand and on the business, financial, and legal environments. If the task is fundamental change, then the required management skills and knowledge may not be industry-specific. For example, the general partners in LBO funds are not industry experts. They specialize in identifying potential diet deals, negotiating financing, buying and selling assets, setting incentives, and choosing and monitoring management. It’s no surprise that LBO funds end up with diversified portfolios; they invest wherever opportunities crop up. But these same skills are not best for long-run operation and growth. Thus LBO funds and other private equity partnerships are designed to force the managers of change to hand over the reins once change is accomplished. If the task is managing for the long run, and the company has access to wellfunctioning financial markets, then focus usually beats diversification. Conglomerates have a hard time setting the right incentives for divisional managers and avoiding cross-subsidies and overinvestment in the internal capital market. In less developed countries, conglomerates can be effective. Local history and practice have led to diversified companies or groups of companies. Also, diversification means scale, and size counts when local financial markets are small or undeveloped, when the company needs to attract the best professional managers, and when assistance or protection from the government is required.
34.4 GOVERNANCE AND CONTROL IN THE UNITED STATES, GERMANY, AND JAPAN For public corporations in the United States, the agency problems created by the separation of ownership and control are offset by • Incentives for management, particularly compensation tied to changes in earnings and stock price. 38
R. LaPorta, F. Lopez-de-Silanes, A. Shleifer, and R. Vishny, “Law and Finance,” Journal of Political Economy 106 (December 1998), pp. 1113–1155 and “Legal Determinants of External Finance,” Journal of Finance 52 (July 1997), pp. 1131–1150.
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PART X Mergers, Corporate Control, and Governance • The legal duty of managers and directors to act in shareholders’ interest, backed up by monitoring by auditors, lenders, security analysts, and large institutional investors. • The threat of a takeover, either by another public company or a private investment partnership. But don’t assume that ownership and control are always separated. A large block of shares may give effective control even when there is no majority owner.39 For example, Bill Gates owns over 20 percent of Microsoft. Barring some extreme catastrophe, that block means that he can run the company as he wants to and as long as he wants to. Henry Ford’s descendants still hold a class of Ford Motor Company shares with extra voting rights and thereby retain great power should they decide to exercise it.40 Nevertheless, the concentration of ownership of public U.S. corporations is much less than in some other industrialized countries. The differences are not so apparent in Canada, Britain, Australia, and other English-speaking countries, but there are dramatic differences in Japan and continental Europe. We start with Germany.
Ownership and Control in Germany Figure 34.3 summarizes the ownership in 1990 of Daimler-Benz, one of the largest German companies. The immediate owners were Deutsche Bank, the largest German bank, with 28 percent; Mercedes Automobil Holding, with 25 percent; and the Kuwait government, with 14 percent. The remaining 32 percent of the shares were widely held by about 300,000 individual and institutional investors. But this was only the top layer. Mercedes Automobil Holding was half owned by two holding companies, “Stella” and “Stern” for short. The rest of its shares were widely held. Stella’s shares were in turn split four ways: between two banks; Robert Bosch, an industrial company; and another holding company, “Komet.” Stern’s ownership was split four ways too, but we ran out of space.41 The differences between German and U.S. ownership patterns leap out from Figure 34.3. Note the concentration of ownership of Daimler-Benz shares in large blocks and the several layers of owners. A similar figure for General Motors would just say, “General Motors, 100 percent widely held.” In Germany these blocks are often held by other companies—a cross-holding of shares—or by holding companies for families. Franks and Mayer, who examined the ownership of 171 large German companies in 1990, found 47 with blocks of 39
A surprising number of public U.S. corporations do have majority owners. A study by Clifford Holderness and Dennis Sheehan identified over 650. See “The Role of Majority Shareholders in Publicly Held Corporations: An Exploratory Analysis,” Journal of Financial Economics 20 (January/March 1988), pp. 317–346. 40 You would predict that companies with concentrated ownership would show better financial performance simply because the blockholders face less of a free-rider problem when they represent shareholders’ interests. This prediction appears to be true. However, investors who accumulate very large stakes and gain effective control of the firm may act in their own interests and against the interests of the remaining minority shareholders. See R. Morck, A. Shleifer, and R. Vishny, “Management Ownership and Market Valuation: An Empirical Analysis,” Journal of Financial Economics 20 (January/March 1988), pp. 293–315. 41 A five-layer ownership tree for Daimler-Benz is given in S. Prowse, “Corporate Governance in an International Perspective: A Survey of Corporate Control Mechanisms among Large Firms in the U.S., U.K., Japan and Germany,” Financial Markets, Institutions, and Instruments 4 (February 1995), Table 16.
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FIGURE 34.3 Ownership of Daimler-Benz, 1990.
Daimler-Benz AG
28.3%
Deutsche Bank
14%
25.23%
Kuwait Government
25% Widely held
Stern Automobil Beteiligungsges. mbH
25%
Bayerische Landesbank
25%
Robert Bosch GmbH
32.37%
Mercedes Automobil Holding AG
25%
Widely held about 300,000 shareholders 50%
Stella Automobil Beteiligungsges. mbH
25% Komet Automobil Beteiligungsges. mbH
Widely held
25%
Dresdner Bank
shares held by other companies and 35 with blocks owned by families. Only 26 of the companies did not have a substantial block of stock held by some company or institution.42 Note also the bank ownership of Daimler-Benz. This would be impossible in the United States, where federal law prohibits equity investments by banks in nonfinancial corporations. Germany’s universal banking system allows such investments. Moreover, German banks customarily hold shares for safekeeping on behalf of individual and institutional investors and often acquire proxies to vote these shares on the investors’ behalf. For example, Deutsche Bank held 28 percent of Daimler-Benz for its own account and had proxies for 14 percent more. Therefore it voted 42 percent, which approaches a majority. The ownership structures illustrated in Figure 34.3 are common for large German corporations. Control rests mainly with banks and blockholders, not with ordinary stockholders. Corporate control is achieved by buying or assembling blocks of shares. When control changes, selling blockholders receive premiums of 9 to 16 percent over the trading price of the shares. That price increases by 2 or 3 percent 42 See J. Franks and C. Mayer, “The Ownership and Control of German Corporations,” Review of Financial Studies 14 (Winter 2001), Table 1, p. 947. A block was defined as at least 25 percent ownership. In Germany, a block of this size can veto certain corporate actions, including share issues and changes in corporate charters.
Source: J. Franks and C. Mayer, “The Ownership and Control of German Corporations,” Review of Financial Studies 14 (Winter 2001), Figure 1, p. 949.
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PART X Mergers, Corporate Control, and Governance only, so the gains to ordinary stockholders from changes in control are small.43 In the United States, by contrast, the big winners in acquisitions are usually the selling firm’s ordinary stockholders. Blockholders in Germany do not have unchecked power, however. Large German companies have two boards of directors: the supervisory board (Aufsichtsrat) and management board (Vorstand). Half of the supervisory board’s members are elected by employees, including management and staff as well as labor unions. The other half represents stockholders, often including bank executives. (There is also a chairman who can cast tie-breaking votes if necessary.) The supervisory board oversees strategy and elects and monitors the management board which operates the company. Thus control of shares does not mean control of the company—100 percent ownership controls only half of the supervisory board. This two-tier governance structure reflects a belief, widespread in Europe, that the firm should act in the interests of all its stakeholders, including its employees and the public at large, and not just seek to maximize shareholder value. This structure does not mean poor financial performance or an easy life for management— poor performance leads to management turnover, just as in the United States,44 and the German economy has, in general, thrived over the last 50 years. One may ask, however, whether German companies which undertake extensive international operations, and seek financing in international capital markets, are best served by a financial architecture that skimps on protection for outside minority investors and discourages attempts to maximize the market value of the firm. Daimler-Benz, now DaimlerChrysler, is an interesting case study. In the mid1990s it reversed an unsuccessful diversification strategy that had led it into several other industries, including aerospace and defense. In 1998 it took over Chrysler. It listed its shares on the New York Stock Exchange and issued financial statements conforming to U.S. accounting standards. It turned to international capital markets for financing, including a share issue in the U.S. At the same time Deutsche Bank was reducing its stake in the company. DaimlerChrysler has formally announced a commitment to increasing shareholder value.
. . . And in Japan Japan’s system of corporate governance is in some ways in between the systems of Germany and the United States and in other ways different from both. The most notable feature of Japanese corporate finance is the keiretsu. A keiretsu is a network of companies, usually organized around a major bank. There are long-standing business relationships between the group companies; a manufacturing company might buy a substantial part of its raw materials from group suppliers and in turn sell much of its output to other group companies. The bank and other financial institutions at the keiretsu’s center own shares in most of the group companies (though a commercial bank in Japan is limited to 5 percent ownership of each company). Those companies may in turn hold the bank’s shares or each others’ shares. Here are the cross-holdings at the end of 1991 between Sumitomo Bank; the Sumitomo Corporation, a trading company; and Sumitomo Trust, which concentrates on investment management: 43
Franks and Mayer, op. cit., Table 9, p. 969. See Franks and Mayer, op. cit.; and S. Kaplan, “Top Executives, Turnover and Firm Performance in Germany,” Journal of Law and Economics 10 (1994), pp. 142–159. 44
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3.4% 4.8% Sumitomo Corporation
3.4% Sumitomo Bank
1.8%
Sumitomo Trust 2.4%
5.9%
Thus the bank owns 4.8 percent of Sumitomo Corporation, which owns 1.8 percent of the bank. Both own shares in Sumitomo Trust . . . and so on. Table 34.5 illustrates the myriad of cross-holdings in a keiretsu. Because of the cross-holdings, the supply of shares available for purchase by outside investors is much less than the total number outstanding. The keiretsu is tied together in other ways. Most debt financing comes from the keiretsu’s banks or from elsewhere in the group. (Until the mid-1980s, all but a handful of Japanese companies were forbidden access to public debt markets. The fraction of debt provided by banks is still much greater than that in the United States.) Managers may sit on the boards of directors of other group companies, and a “presidents’ council” of the CEOs of the most important group companies meets regularly. Think of the keiretsu as a system of corporate governance, where power is split between the main bank, the largest companies, and the group as a whole. This confers certain financial advantages. First, firms have access to additional “internal” financing—internal to the group, that is. Thus a company with capital budgets exceeding
Percentage of Shares Held in:
Shareholder S. Bank S. Metal Industries S. Chemical S. Trust S. Corporation NEC Other† Total†
Sumitomo Bank
Sumitomo Metal Industries
Sumitomo Chemical
Sumitomo Trust
Sumitomo Corporation
NEC
— * * 2.4 1.8 * 9.7 13.9
4.1 — * 5.9 1.6 * 4.8 16.4
4.6 * — 4.4 * * 9.8 18.8
3.4 2.5 * — 3.4 2.9 10.4 22.6
4.8 2.8 * 5.9 — 3.7 9.5 26.7
5.0 * * 5.8 2.2 — 11.6 24.6
TA B L E 3 4 . 5 Cross-holdings of common stock between six companies in the Sumitomo group in 1991. Read down the columns to see holdings of each of the companies by the five others. Thus 4.6 percent of Sumitomo Chemical was owned by Sumitomo Bank, 4.4 percent by Sumitomo Trust, and 9.8 percent by other Sumitomo companies. These figures were compiled by examining the 10 largest shareholders of each company. Smaller cross-holdings are not reflected. *
Cross-holding does not appear in the 10 largest shareholdings. Based on the 10 largest shareholdings in 1991. Source: Compiled from Dodwell Marketing Consultants, Industrial Groupings in Japan, 10th ed., Tokyo, 1992.
†
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PART X Mergers, Corporate Control, and Governance operating cash flows can turn to the main bank or other keiretsu companies for financing. This avoids the cost or possible bad-news signal of a public sale of securities. Second, when a keiretsu firm falls into financial distress, with insufficient cash to pay bills or fund necessary capital investments, a “workout” can usually be arranged. New management can be brought in from elsewhere in the group, and financing can be obtained, again “internally.” Hoshi, Kashyap, and Scharfstein tracked capital expenditure programs of a large sample of Japanese firms—many, but not all, members of keiretsus. The keiretsu companies’ investments were more stable and less exposed to the ups and downs of operating cash flows or to episodes of financial distress.45 It seems that the financial support of the keiretsus enabled their members to invest for the long run. The Japanese system of corporate control has its disadvantages too, notably for outside investors, who have very little influence. Japanese managers’ compensation is rarely tied to shareholder returns. Takeovers are unthinkable. Japanese companies have been particularly stingy with cash dividends; this was hardly a concern when growth was rapid and stock prices were stratospheric but is a serious issue for the future.
Corporate Ownership around the World The theory of modern finance is most readily applied to public corporations with shares traded in active and efficient capital markets. The theory assumes that stockholders’ interests are protected, so that ownership can be dispersed across thousands of minority stockholders. The protection comes from managers’ incentives, particularly compensation tied to stock price; from supervision by the board of directors; and by the threat of hostile takeover of poorly performing companies. This is a reasonable description of the corporate sector in the U.S., UK, and other “Anglo-Saxon” countries such as Canada and Australia. But as Germany and Japan illustrate, it is not an accurate description elsewhere. Corporate ownership in Germany is typical of continental Europe. The ownership diagram for a large French company would resemble Figure 34.3.46 The financial architecture of public companies in “Anglo-Saxon” economies may be the exception, not the rule. La Porta, Lopez-de-Silanes, and Shleifer surveyed the ownership of the largest companies in 27 developed countries. They found that “except in economies with very good shareholder protection, relatively few of these firms are widely held. Rather these firms are typically controlled by families or the State,” or in some cases by financial institutions.47 This finding has various possible interpretations. The first is obvious: Protection for outside minority stockholders is a prerequisite for dispersed ownership and a broad and active stock market. Second, in countries that lack effective legal protection for minority stockholders, concentrated ownership may be the only feasible financial architecture. 45
T. Hoshi, A. Kashyap, and D. Scharfstein, “Corporate Structure, Liquidity and Investment: Evidence from Japanese Industrial Groups,” Quarterly Journal of Economics 106 (February 1991), pp. 33–60, and “The Role of Banks in Reducing the Costs of Financial Distress in Japan,” Journal of Financial Economics 27 (September 1990), pp. 67–88. 46 See J. Franks and C. Mayer, “Corporate Ownership and Control in the U. K., Germany and France,” Journal of Applied Corporate Finance 9 (Winter 1997), pp. 30–45. 47 R. La Porta, F. Lopez-de-Silanes, and A. Shleifer, “Corporate Ownership around the World,” Journal of Finance 59 (April 1999), pp. 471–517.
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We started with LBOs. An LBO is a takeover or buyout financed mostly with debt. The LBO is owned privately, usually by an investment partnership. Debt financing is not the objective of most LBOs; it is a means to an end. Most LBOs are diet deals. The cash requirements for debt service force managers to shed unneeded assets, improve operating efficiency, and forego wasteful capital expenditure. The managers and key employees are given a significant equity stake in the business, so they have strong incentives to make these improvements. Leveraged restructurings are in many ways similar to LBOs. Large amounts of debt are added and the proceeds are paid out. The company is forced to generate cash to cover debt service, but there is no change in control and the company stays public. Most investments in LBOs are made by private equity partnerships. We called these temporary conglomerates. They are conglomerates because they assemble a portfolio of companies in several unrelated industries. They are temporary because the partnership has limited life, usually about 10 years. At the end of this period, the partnership’s investments must be sold or taken public again in IPOs. Private equity funds do not buy and hold; they buy, fix, and sell. Investors in the partnership therefore do not have to worry about wasteful reinvestment of free cash flow. LBO managers know that they will be able to cash out their equity stakes if their company succeeds in improving efficiency and paying down debt. The private equity partnership (or fund) is also common in venture capital and other areas of private investment. The limited partners, who put up almost all of the money, are mostly institutional investors such as pension funds, endowments, and insurance companies. The limited partners are first in line when the partnership’s investments are sold. The general partners, who organize and manage the fund, get a carried interest in the fund’s profits. The private equity market has been growing steadily. In contrast to these temporary conglomerates, public conglomerates have been declining in the United States. In public companies, unrelated diversification seems to destroy value—the whole is worth less than the sum of its parts. There are two possible reasons for this conglomerate discount. First, the value of the parts can’t be observed separately and it is difficult to set incentives for divisional managers. Second, conglomerates’ internal capital markets are inefficient. It is difficult for management to appreciate investment opportunities in many different industries, and internal capital markets are prone to overinvestment and cross-subsidies. The difficulties of running internal capital markets are not restricted to pure conglomerates, but they are most acute there. Of course corporations shed assets as well as acquire them. Divisions are divested by asset sales, carve-outs, or spin-offs. These divestitures are generally good news to investors; it appears that the divisions are moving to better homes, where they can be better managed and more profitable. The same improvements in efficiency and profitability are observed in privatizations, which are spin-offs or carve-outs of businesses owned by governments. Although conglomerates are a declining species in the United States, they are common elsewhere, particularly in emerging economies. An internal capital market can make sense when a country’s financial markets are not well developed. Diversification also brings scale, which may make it easier to attract professional management, to gain access to international financial markets, or to gain political power in countries where the government tries to manage the economy or where laws and regulations are erratically enforced. We wonder, though, whether some of these emerging-market conglomerates will be temporary rather than permanent. In a rapidly growing and modernizing
SUMMARY
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economy, opportunities to buy and fix are spread across many industries. If these investments are successful, the next logical step may be to sell and focus on one or a few core businesses. Our discussion of LBOs, private equity partnerships, and conglomerates illustrates how much financial architecture varies and how it depends on the financial and business environment and on the task at hand. The conglomerate financial architecture thrives in much of the world but not in the United States. LBOs are designed to force change in mature businesses. Private equity partnerships eliminate the separation of ownership and control and make sure that the general partners have strong incentives to achieve high exit values for the partnership’s investments. We also sketched typical arrangements for ownership and control in Germany and Japan. We did so especially for readers in the United States, who may regard their system as natural. In some circumstances the German or Japanese system can work better. Here are two key differences. First, corporate finance in the United States, Britain, and the other Englishspeaking countries relies more on financial markets and less on banks or other financial intermediaries than is the case in most other countries. United States corporations routinely issue publicly traded debt in situations where Japanese or European companies borrow from banks. Second, U.S.-style corporate finance puts fewer buffers between managers and the stock market. The block holdings and layered ownership structure of German companies are rare in the United States, and of course there is nothing remotely like a Japanese keiretsu. So CEOs and CFOs in the United States usually find their paychecks tied to stockholder returns. Negative returns may bring insomnia or bad dreams about takeovers. These international comparisons illustrate different approaches to the problem of corporate governance—the problem of ensuring that managers act in shareholders’ interest.
FURTHER READING
Some of the ideas in this chapter were drawn from: S. C. Myers: “Financial Architecture,” European Financial Management, 5:133–142 (July 1999). The papers by Kaplan and by Kaplan and Stein provide evidence on the evolution and performance of LBOs; Jensen, the chief proponent of the free-cash-flow theory of takeovers, gives a spirited and controversial defense of LBOs: S. N. Kaplan: “The Effects of Management Buyouts on Operating Performance and Value,” Journal of Financial Economics, 24:217–254 (October 1989). S. N. Kaplan and J. C. Stein: “The Evolution of Buyout Pricing and Financial Structure (Or, What Went Wrong) in the 1980s,” Journal of Applied Corporate Finance, 6:72–88 (Spring 1993). M. C. Jensen: “The Eclipse of the Public Corporation,” Harvard Business Review, 67:61–74 (September/October 1989). Privatization is reviewed in: W. L. Megginson and J. M. Nutter: “From State to Market: A Survey of Empirical Studies on Privatization,” Journal of Economic Literature, 39:321–389 (June 2001). The Winter 1997 issue of the Journal of Applied Corporate Finance contains several articles on governance and control in different countries. See also the following survey article:
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A. Shleifer and R. Vishny: “A Survey of Corporate Governance,” Journal of Finance, 52:737–783 (June 1997). Here are five useful articles on corporate finance in Germany and Japan: S. Prowse: “Corporate Governance in an International Perspective: A Survey of Corporate Control Mechanisms among Large Firms in the U.S., U.K., Japan and Germany,” Financial Markets, Institutions, and Investments, 4:1–63 (1995). J. Franks and C. Mayer: “Ownership and Control of German Corporations,” Review of Financial Studies, 14:943–977 (Winter 2001). T. Jenkinson and A. Ljungqvist: “The Role of Hostile Stakes in German Corporate Performance,” Journal of Corporate Finance, 7:397–446 (December 2001). D. E. Logue and J. K. Seward: “Anatomy of a Governance Transformation: The Case of Daimler-Benz,” Law and Contemporary Problems, 62:87–111 (Summer 1999).
Here are some interesting case studies pertinent to this chapter. J. Allen: “Reinventing the Corporation: The Satellite Structure of Thermo Electron,” Journal of Applied Corporate Finance, 11:38–47 (Summer 1998). R. Parrino: “Spinoffs and Wealth Transfers: the Marriott Case,” Journal of Financial Economics, 43:241–274 (February 1997). C. Eckel, D. Eckel, and V. Singal: “Privatization and Efficiency: Industry Effects of the Sale of British Airways,” Journal of Financial Economics, 43:275–298 (February 1997). B. Burrough and J. Helyar: Barbarians at the Gate: The Fall of RJR Nabisco, Harper & Row, New York, 1990. G. P. Baker: “Beatrice: A Study in the Creation and Destruction of Value,” Journal of Finance, 47:1081–1120 (July 1992). D. J. Denis: “Organizational Form and the Consequences of Highly Leveraged Transactions,” Journal of Financial Economics, 36:193–224 (October 1994).
1. Define the following terms: (a) LBO, (b) MBO, (c) spin-off, (d) carve-out, (e) asset sale, (f) privatization, and (g) leveraged restructuring. 2. True or false? a. One of the first tasks of an LBO’s financial manager is to pay down debt. b. Once an LBO or MBO goes private it almost always stays private. c. Privatizations are generally followed by massive layoffs. d. On average, privatization seems to improve efficiency and add value. e. Targets for LBOs in the 1980s tended to be profitable companies in mature industries. f. “Carried interest” refers to the deferral of interest payments on LBO debt. g. By the late 1990s, new LBO transactions were extremely rare. 3. What are the government’s motives in a privatization? 4. a. List the disadvantages of a traditional conglomerate in the United States. b. What advantages might a conglomerate have in other countries, particularly lessdeveloped economies? List some examples. 5. What are the chief differences in the role of banks in corporate governance in the United States, Germany, and Japan? 6. What is meant by a “temporary conglomerate”? Give an example.
QUIZ
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E. Berglof and E. Perotti: “The Governance Structure of the Japanese Keiretsu,” Journal of Financial Economics, 36:259–284 (October 1994).
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PRACTICE QUESTIONS
1. True, false, or “It depends on . . .”? a. Most large corporations are controlled by families, governments, or financial institutions. b. Top managers in Germany are much more secure in their jobs than managers in the U.S. because German shareholders have less power than U.S. shareholders. c. Carve-out or spin-off of a division improves incentives for the division’s managers. d. Private-equity partnerships have limited lives. The main purpose is to force the general partners to seek out quick-payout investments. e. Managers of private-equity partnerships have an incentive to make risky investments. 2. For what kinds of companies would an LBO or MBO transaction not be productive? 3. What was the common theme in both the Phillips Petroleum restructuring and the RJR Nabisco LBO? Why was financial leverage a necessary part of both deals? 4. Outline the similarities and differences between the RJR Nabisco LBO and the Sealed Air leveraged restructuring. Were the economic motives the same? Were the results the same? Do you think it was an advantage for Sealed Air to remain a public company?
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5. Examine some recent examples of divestitures and spin-offs. What do you think were the underlying reasons for them? How did investors react to the news? 6. Read Barbarians at the Gate (Further Reading). What agency costs can you identify? Hint: See Chapter 12. Do you think the LBO was well designed to reduce these costs? 7. Explain the financial architecture of a private-equity partnership. Pay particular attention to incentives and compensation. What types of investments were such partnerships designed to make? 8. Traditional conglomerates are now rare in the United States, but in many other countries, conglomerates are the dominant firms. Explain why. 9. What is meant by an internal capital market? When would you expect such a market to add value? When and why would it be expected to misallocate capital?
CHALLENGE QUESTION
1. We devoted considerable space in this chapter to the problems encountered in the financial management of conglomerates. Could these problems be cured by basing performance measurement and compensation on residual income or EVA? See Chapter 12.
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The sites that provide market commentary (see list at end of Part One) contain material on recent mergers. Other sites concerned with mergers include:
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www.mergernetwork.com (information on businesses for sale) www.mergerstat.com (articles and some data on merger activity)
PART TEN RELATED WEBSITES
RELATED WEBSITES
www.thedeal.com
