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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Just because investors have money doesn't mean they have technical and organizational skillsJensenism Starting in the mid-1970s, Michael Jensen, Chicago-school fellow traveller now at Harvard, began developing a finance-based theory of corporate governance that would become influential in the 1980s. Though it took some time to evolve to full ripeness, Jensens argument is, in a phrase, that stockholders cant trust the managers theyve hired to run their corporations, and a radical realignment is in order. In 1976, Jensen and his collaborator William Meckling tried to build a formal model relating financial structure and managerial performance. As with most formal models, their indifference curves and ?B(X*)s were built on a series of simplifying assumptions. Listing those of Jensen and Meckling should remind lay readers just how strange these exercises can get (numbers omitted): All taxes are zero. No trade credit is available. All outside equity shares are non-voting. No complex financial claims such as convertible bonds or preferred stock or warrants can be issued. outside owner ever gains utility from ownership in a firm in any way other than through its effect on his wealth or cash flows. All dynamic aspects of the multiperiod nature of the problem are ignored by assuming there is only one production-financing decision to be made by the entrepreneur. The entrepreneur-managers money wages are held constant throughout the analysis. There exists a single manager (the peak coordinator) with ownership inter est in the firm. Every one of these assumptions violates reality. Among the more glaring violations: taxes exist prominently; net trade credit to nonfinancial corporations was over $340 billion at the end of 1995; its a rare corporation that issues nonvoting shares; time is continuous and endlessly complicating, since todays bad decision can haunt managers for years; there are many layers of management beneath the peak coordinator. Lets set these reservations aside, however, and explore Jensens world. No matter what you think of his answers, Jensen and his collaborators Meckling, here have asked some important questions about a social institution that is commonly accepted as part of the landscape, the large joint-stock corporation: How does it happen that millions of individuals are willing to turn over a significant fraction of their wealth to organizations run by managers who have so little interest in their welfare? What is even more remarkable, why are they willing to make these commitments purely as residual claimants, i.e., on the anticipation that managers will operate the firm so that there will be earnings which accrue to the stockholders? In plainer English, why, in a world that runs on self-interest, do individual and institutional shareholders entrust the management of the corporations that they legally own to strangers? And why do they arrange it so that they, as stockholders, are the last in line to be paid, after suppliers, creditors, and employees? Its a marriage of convenience, of course, and, the new critique aside, its been a successful one. For one, it makes sense for individual entrepreneurs who strike it rich to take their companies public, accumulate financial capital, and put their eggs into baskets other than their own.8 And just because investors have money doesnt mean they have technical and organizational skills; in an economy characterized by the relentless subdivision of labor, its no surprise they hire help to run the properties. But over time the rentier function has become institutionalized and the help has evolved into the professional managers of the modern transnational corporation. These two groups can be expected to have areas of disagreement. In the trade, this is known as principal-agent conflict. Jensen and Meckling spent a lot of time laying out the agency costs of the separation of ownership and control for large U.S. corporations. Managers will typically try to pamper themselves before passing along dividends to the legal owners; the Jensen-Meckling model actually formalizes this as X = {x1, x2,,xn} = a vector of quantities of all factors and activities within the firm from which the manager derives non-pecuniary benefits, such as office space, air conditioning, thickness of the carpets, friendliness of employee relations, etc. perks. Calling them perks would look unscientific; disguising them as a vector lends the prestige of mathematics to those easily seduced by subscripts. To minimize perk-grabbing, creditors and stockholders require explicit, frequent financial reporting and outside audits, and also tinker endlessly with the ways of paying senior managers so as to provide the right mix of punishment and reward. On the other hand, executives are suspicious that outside stockholders and creditors are always trying to second-guess them, or cramp their managerial style. Managers and claimants inevitably keep a wary eye on each other; the expense of doing so is known as agency costs. Managers, Jensen and Meckling argued, would manage in the interest of the outside claimants if they held bigger stakes in the companies. (Its assumed that stockholders interests are paramount.) Executives debt and stock holdings should be evenly balanced, to assure they never try to reward or screw one class of holders at the expense of the other (like risky ventures that might offer a big stock payoff, but could lead to default on the bonds, or cautious investments that guarantee steady interest payments but could bore stockholders). Jensens ultimate sympathies are with risk; in what would later become an obsession, he and Meckling argued that stock options should be an important part of a top managers pay, which in effect give him [sic] a claim on the upper tail of the outcome distribution a big personal payoff if the stock booms. Unspoken is the assumption that stock prices reliably price managerial decisions; Jensenite theories of governance rest on efficient market theory. If the market sets prices inefficiently, then companies will sometimes wrongly get taken over and managers will sometimes be unfairly overpaid (as opposed, I guess, to normal times when theyre fairly overpaid). But Jensen hadnt yet truly warmed to his subject. Despite all the words and formulas devoted to the costs of agency, his collaboration with Meckling ended with this defense of the status quo: The growth in the use of the corporate form as well as the growth in market value of established corporations suggests that at least, up to the present, creditors and investors have by and large not been disappointed with the results, despite the agency costs inherent in the corporate form. Earlier in the paper, the authors had dismissed what would later be called leveraged buyouts, a transaction whose primary academic celebrant was the later Jensen. It would be possible, Jensen and Meckling argued, to eliminate agency costs if shareholders sold firms to managers, who financed their purchase of 100% of the firms stock with debt and personal wealth. Since this rarely happens, they reasoned, there must be some compelling reasons why. Among those reasons, they concluded, were a rational wariness on the part of creditors, who would worry that managers would take big gambles, hoping for big payoffs that, should they not arrive, would greatly increase the risk of default, even bankruptcy. Preventing those risks would greatly increase the creditors agency costs, since theyd have to keep managers under constant scrutiny to make sure they werent playing roulette with the creditors money. Jensen changed his mind in the 1980s, becoming the scourge of the public corporation and the typical CEO. A paper written just seven years later with Richard Ruback (Jensen and Ruback 1983) celebrated the virtues of the market for corporate control as a market in which alternative managerial teams compete for the rights to manage corporate resources. This marked a shift, said Jensen and Ruback, from the classic view in which stockholders hired and fired management: [T]he managerial competition model instead views competing management teams as the primary activist entities, with stockholders (including institutions) playing a relatively passivejudicial role. [S]tockholders in this system have relatively little use for detailed knowledge about the firm or the plans of competing management teams beyond that normally used for the markets price setting function. Stockholders have no loyalty to incumbent managers; they simply choose the highest dollar value offer from those presented to them in a well-functioning market for corporate control. In this world, everything is constantly up for auction. It assumes that the market which its conceded is populated by players with no special expertise in the businesses they have at their mercy can value each management slates cash-generating potential presciently, and that this constant turmoil has no harmful effect on production. Why everyone should turn somersaults to satisfy passive, almost vestigial, stockholders is one of the great unexplored mysteries of Jensenism; the stock market is always axiomatically the ultimate arbiter of social good. Jensen (1986a) turned up the heat just three years later, arguing then that it wasnt enough to change managers; managers had to be put under a new disciplinary structure. Despite the pressures of competitive product markets, the bosses of big, public corporations waste money on unproductive (that is, unprofitable) expenditures like perks, investment, and R&D money that should instead be piped to shareholders. Free cash flow was the problem, and Jensens definition is worth quoting: Free cash flow is cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital. Conflicts of interest between shareholders and managers over payout policies are especially severe when the organization generates substantial cash flow. The problem is how to motivate managers to disgorge the cash rather than investing it at below the cost of capital or wasting it on organzation [sic] inefficiencies. Jensens definition sounds more precise than it really is. Cash flow and cost of capital are relatively easy to figure though different analysts will come up with different measures for each.9 Judging future projects is the really tricky bit; it assumes firms can know how much money a project can earn. Of course they never can. In practice, one can do little but extrapolate from the past, but thats not really the same thing. Still, quibbles aside, Jensen was really onto something. Many big firms have more money than they know what to do with or, more strictly speaking, have more money than they can invest in their basic businesses at a reasonable profit a more colloquial definition of free cash flow.10 Margaret Blair and Martha Schary (1993a and 1993b) estimated free cash flow for 18 and then 71 industrial sectors. They used historical data on profitability, which isnt pure Jensen, but thats about all you can do, since one cant divine the future. They found a sharp squeeze on firms, with profitability roughly flat but with a sharp increase in the cost of capital from the 1970s into the 1980s, the result mainly of sustained high interest rates. As the cost of capital rose the rate of return required by investors under orthodox finance theory firms could justify only the highestprofit (and one might assume quickest payback, though Blair and Schary dont say this) projects. As they put it, The expected profitability of future investments fell just as the profitability required by the capital markets climbed to unprecedented highs. [F]rom 1982 through 1989 the U.S. corporate sector was caught up in an epidemic of free cash flow (Blair and Schary 1993a, p. 128). In the mid-1990s, it looks like they are once again, but theyre doing different things with the money now from what they did in the 1980s. Jensens (1986a) answer was to load up these firms with debt a nice irony, since a broad and sustained demand for fresh debt will push interest rates higher than they would otherwise be, thereby making even more cash flow free. Jensen offered a nice rationale for Wall Streets liberation of ever more cash flow. Unlike stock, which allows managers to pay what they like to shareholders, high debt bills bond managers to pay out a steady stream of cash, rather than wasting resources on low-return projects. Managers should also receive a large share of their compensation in the form of stock, to make them think and act like shareholders. As the decade wore on, Jensen celebrated the advent of a new form the LBO (leveraged buyout) association (Jensen 1989a). The large public company was OK, Jensen said, in growing sectors like computers, biotech, and finance. But older industries tires, steel, chemicals, brewing, broadcasting, tobacco, pulp and paper products now, and aerospace, cars, banking, electric utilities, machinery in the future need to be transformed through leverage and ownership. In an LBO, a group of investors, often along with a firms senior management, take a company private by going deep into debt. The stock typically doesnt trade on a public exchange though occasionally a small stub of shares is left over and continues to trade openly but is held tightly by the circle of investors.11 The disci pline of debt and the potential vast rewards from holding the stock would inspire managers to heroic feats of accumulation. This is a marked turnabout from the Jensen of 1976, who had said (with Meckling) that the public corporation seemed to be here to stay, arguing even that LBOs were perverse and risky. Asked by email to explain this radical turn in his thinking, Jensen replied: What happened was that the data began to indicate quite clearly that the system was not working OK. That the inefficiencies were in fact just as we had seen them in theory, but the markets took a while to adjust. That adjustment is still taking place. Jensen especially celebrated LBOs engineered by boutiques like Kohlberg Kravis Roberts (KKR) and Clayton & Dubalier; entrepreneurs like Carl Icahn, Ronald Perelman, Irwin Jacobs, and Warren Buffett; merchant banking arms of Morgan Stanley and Lazard Frres; and families like the Pritzkers and Bronfmans. These fine people the forgotten stars of the largely forgotten 1980s should be trusted to run corporate America like a stock portfolio, from their thinly staffed (20 to 60 people) home offices, transforming the industrial cities of yesteryear into ghost towns. With all its vast increases in data, talent, and technology, Wall Street can allocate capital among competing businesses and monitor and discipline management more effectively than the CEO and headquarters staff of the typical diversified company. KKRs New York offices and Irwin Jacobs Minneapolis base are direct substitutes for corporate headquarters in Akron and Peoria. |
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