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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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A waste of money that rightly belongs to shareholdersThe ideal arrangement, the LBO Association, was a venture among three constituencies: the sponsoring boutique; senior management with a large equity stake; and the big institutional investors who fund the deals. Jensen also celebrated the great innovation pioneered by Drexel Burnham Lambert, the junk bond low-rated, high-risk, high-interest-rate debt that powered the celebrity deals of the 1980s. Thanks to Drexels distribution network, the ceaselessly innovative Michael Milken, sitting at his X-shaped desk in Beverly Hills, could invent a deal and place the bonds necessary to finance it in the Wall Street equivalent of overnight. His network of S&Ls, insurance companies, mutual funds, and rich individuals, supported in no small part by their Ponzi-like propensity for buying each others paper, was there for his tapping. KKR was the prototype for Jensens new corporate form. In the early years after its birth on May Day 1976, KKR did modest deals, focusing on smallish companies (Bartlett 1991).12 The partners would approach a firm, persuade the managers to borrow a bunch of money, and jointly buy the firm. They made sure there was plenty of daylight between the cash coming in and the interest payments going out. If all went well, the new owners, full of incentive and energy, would revive the company, and prepare it for sale some years down the road at vast profits. The scheme worked like magic. As the years progressed, the partners lusted after bigger and bigger deals. To swing those, they needed big outside backing, and they got it, though it took some time to convince the hypercautious that leverage could be so profitable. As early as five years after KKRs founding, their investors included Prudential, Aetna, GEs pension fund, Metropolitan Life, J.P. Morgan, and Northwest Mutual. Later on, theyd recruit the Oregon, Washington, and Wisconsin state pension funds, among others. So despite its guerrilla-ish image, KKR was backed by the innermost circles of finance joined by the retirement money of public sector workers. KKRs early years were spectacular. The five major buyout funds, organized over 1978-86, paid annual profits of over 32% to their investors (Bartlett 1991, p. 346). But the 1989 fund, which did the RJR buyout, was a turkey, returning a mere 4% (Sloan 1994). The new corporate form failed the crucial test: delivering sustained profits to its investors. The publication of Sarah Bartletts (1991) book, which portrayed KKR as putting its own interests far ahead of those of its investors and its stable of companies, to put it gently, did little to further the buyout boutiques reputation. Back, though, to Jensen and his manifesto. It drew a blizzard of responses, mainly from anti-Jensenites. One, from Peter Rna (1989), head of the IBJ Schroder Bank & Trust in New York, made several points worth quoting and Rnas position as a financier rather than an industrialist makes his comments especially interesting. First, Rna argued that Jensen grossly overstated the shareholders case. In return for limits on their liability (they can see the value of their stock wiped out, but the rest of their assets cant be attached), shareholders give up the right to dispose of corporate property on their own; they can sell the shares, but not the firms assets. By making the shareholder sacrosanct, Jensen preempted any thoughtful analysis of the very question that is at the heart of the issue what should be the rights and privileges of shareholders? Second, the LBO is based on the redistribution today of cash flows expected tomorrow and beyond; if these estimates are wrong, then the public shareholders who are bought out in an LBO have the cash and everyone else is left with a carcass. But shareholders are in the game only to maximize value; having consummated this goal, they take pretty much the same view of the corporation as the praying mantis does of her mate. Finally, Jensen assumed that shareholders are better judges of capital projects than are managers and corporate boards an ideologically inspired assertion that lacks empirical support. As Rna says, its hard to imagine how one would go about testing this empirically, but the burden is on Jensen to take on the task, since he has already reported the results. Jensens (1989b) response to Rna was evasive, offering little to rebut the charges against him. Jensen did, however, helpfully list some forces he viewed as obstacles to economic progress: striking Eastern Air Lines pilots, Pittston Coal miners, [and] New York Telephone employees, who seem perfectly content to destroy or damage their employers organization while attempting to serve their own interests. Ralph Naders consumer activist organization is another example. (Its a nice irony that public employee pension funds were used to smash some of Jensens impediments to progress.) The only subclass of Jensens society to have a claim on corporations, its clear, are shareholders; workers (managers among them) and consumers serve only at the owners pleasure. One of the most interesting statements Jensen made on the appropriateness of shareholders to this great social task is actually something he forgot to say. Defending the RJR Nabisco deal the bloated climax of the 1980s mania, testimony that his hero Henry Kravis was as vainglorious as any cash-burning CEO Jensen (1991) pointed to the firms immense waste of money on perks, sports promotions, and unproductive capital expenditures and organizational inefficiencies. To that phrase is appended footnote 4: As revealed in the book [Barbarians at the Gate (Burrough and Helyar 1990, pp. 370-371)], John Greeniaus, head of [CEO Ross] Johnsons baking unit, told KKR that if the earnings of this group go up 15 or 20%Id be in trouble. His charter was to spend the excess cash in his Nabisco division to limit earnings in order to produce moderate, but smoothly rising profits a strategy that would mask the potential profitability of the business. Sounds like a perfect example of managerial waste the kind of planned mediocrity evoked in Galbraiths New Industrial State. But curiously, Jensen failed to report the reason for this profit-masking, revealed right after the ellipsis: It was all done, Greeniaus explained, because Wall Street craved predictability. When unpredictable things happen, Wall Street comes unhinged efficient market theory, which Jensen once famously described as the best-established principle in all the social sciences, to the contrary. Shareholders were responsible for planned mediocrity at RJR Nabisco, something it would be very damaging for Jensen to admit. Three footnotes later, Jensen (1991, p. 15) got worked up over Susan Faludis (1990) Pulitzer-prize-winning13 Wall Street Journal piece on the LBO of Safeway, the grocery chain, another KKR deal. The deal, regarded as one of the leverage movements great successes, brought $28 million in stock profits and $100 million in options to top Safeway execs, $65 million to the investment bankers, another $25 million to lawyers, and $60 million in up-front fees for KKR and pay cuts and unemployment for Safeway workers. Faludis tales of suicide, heart attack, impoverishment, and despair among workers displaced after the buyout were nothing compared to long-run efficiency effects (Jensen 1991, p. 15). To Jude Wanniski (1990), the Faludi piece was pure and simple propaganda, the work of an ideologue using the Journals front page to propagate a specific opinion about how corporate America should conduct its affairs. Wanniski, of course, is the supply-side ideologue who once used the Journal editorial page to propagate a specific opinion on how America should conduct its fiscal affairs, one that all but a handful of unreconstructed maniacs now regard as a disaster. A more dispassionate study of a deal Jensen also loved, this one from a business school and not a business newspaper, also showed harsh effects on workers. Wayne Landsman and Douglas Shackelford (1993) reported that of the 2,209 workers who lost their jobs after the RJR buyout, 72% reentered the workforce at 47% of their pre-buyout wages, that women were more badly hurt than men, and older employees hurt more than younger. To the buyout apologist, these are not necessarily bad things; they would probably be taken as evidence that RJR was overstaffed and its workers overpaid, a waste of money that rightly belongs to shareholders. An LBO is a form of class struggle. Besides labor, nature too suffered from the buyout boom. In one study of 62 hostile takeover bids between 1984 and 1986, for example, an important target was lumber firms who were not cutting enough timber given the interest rate, the growth rate of trees, and the price path for timber. The infamous Maxxam takeover of Pacific Lumber was inspired by fallow old redwoods that the latter wouldnt cut. Maxxam, powered by junk, took over Pacific Lumber and liquidated the trees. Thinking like economists, Sanjai Bhagat, Andrei Shleifer, and Robert Vishny (1990, p. 54), declared that we have a case in which cutting the trees raises efficiency. And if trees are not sacrificed at the rate dictated by interest rates, then Wall Street is being cheated of free cash flow. Rising to a higher theoretical pitch in his early 1990s work, Jensen likened the new LBO associations those with a KKR-like boutique at the center to Japanese keiretsu, which are groups of associated firms with a large bank at their center (Jensen 1991). But there are important differences between keiretsu and the fabled constellation of LBOs. As Jensen conceded, Japanese managers dont own stock (and are quite modestly paid by U.S. standards), but in his LBO ideal, stock would be the main form of management compensation. Actually the ownership structure of keiretsu is quite intriguing, and something market socialists as well as social market types should study.14 There is a bank at the center of each group, but the bank is not the controlling factor ; group members are also heavy holders of their fellow groupmembers shares. There are also extensive board interlocks, with the main bank typically having a board presence as well. Though members do business even financial business with firms outside the group, they also do major business with each other. Clearly these are complex organizations with deep financial, personal, and technical ties, not the narrow owner-owned relation characteristic of Jensens LBO associations. These cross-holdings and interlocks bind the firms together, each keeping an eye on the others; they check for timeliness of delivery, product quality, level of investment real, telling signs of corporate health that would elude distant shareholders (Berglf and Perotti 1994) . In a crisis, group members come to the aid of a troubled firm, with the bank coming in only in case of a more serious crisis (typically solved through restructuring or forced merger). The Japanese term for reciprocal shareholdings, kabushiki mochiai, has the meaning of mutual help, shared interdependence, and stability. In the noneconomic literature, the shares are treated as expressions of mutual trust signs of the relationship, not the relationship itself. Despite the absence of the takeover threat, managers in troubled firms are neatly removed perhaps more so than the U.S. In the Japanese case, main banks also provide important finance the opposite emphasis of an LBO matrix, which exists to deliver a fat stream of interest payments to the sponsors. Berglf and Perotti also theorize that having the bank as the responsible party of last resort is an excellent discipline on the group, because the bank must worry about keeping deposits. If the firms under its eye do badly, then depositors may shift their money elsewhere.15 These ties are now loosening under the pressure of the long recession that hit Japan after its bubble burst in 1989. It will be interesting to see how an economic recovery combined with Japanese government commitments to further financial deregulation will transform corporate and financial structures in the late 1990s. In his more recent work, Jensen (1993) has increasingly emphasized fundamental technological, political, regulatory, and economic forces as the source of 20 years of intense business and social upheaval: deep reductions in the costs of production, deregulation, globalization, reduced growth rates in labor income, excess capacity, and ultimately downsizing and exit. Jensen explained the 1895-1904 merger boom as a form of such exit the destruction of capital through combination, as capacity was reduced through the consolidation and closure of marginal facilities in merged entities. Thats been happening again in the 1980s and 1990s. This is a gloomier message than his tale of the 1980s more emphasis is placed on shrinkage than revival but its probably a more accurate picture of what M&A is all about. His social message is even harsher. The stress of this New Industrial Revolution will place strainson worldwide social and political systems. Luddites or marching armies of the unemployed could threaten the beautiful revolution and might have to be met with same militia that subdued the Luddites. The harsh medicine must be taken: We need look no further than central and eastern Europe or Asia to see the effects of policies that protect organizations from foreign and domestic competition (Jensen 1993, p. 845). Unions must be broken, employment made more tenuous, plants must be closed and U.S. corporate governance structures are still not up to the task. The crushing of Drexel, the regulatory murder of the junk bond market, the political backlash against the leverage artists left a vacuum in the disciplinary structure. Despite his fatuous cheerleading and callous subordination of human lives to efficiency, it must be said again that Jensen really is onto something important in modern American capitalism, something that is often denied by his liberal and populist critics. There is constant pressure on older firms and given the weakened state of large parts of the mainframe computer business, older can be defined pretty liberally coming both from demanding rentiers and product market competition. Given the ownership and management structure of U.S. industry, theres a conflict among stockholders, managers, and workers over how to manage these strains. Wall Street would like to withdraw capital from these industries slim them down or eliminate them entirely and pocket the money. In high market theory, Wall Street can be relied upon to redeploy this liberated capital beneficently, and the squeezed industries will either discover a fountain of youth under the discipline of debt or die. Since the last 200 pages of this book have argued that Wall Street isnt up to that task, the whole finance and governance structure is called into serious question. The great advantage of Jensenism is that, when combined with an uncritical acceptance of the efficient market religion, it amounts to a unified field theory of economic regulation: all-knowing financial markets will guide real investment decisions towards their optimum, and with the proper set of incentives, owner-managers will follow this guidance without reservation. Many of Jensens critics, whether they know or mention him by name or simply refer to the 1980s or downsizing or corporate restructuring, have no coherent response to the problems of overcapacity, obsolescence, or furious competition. In a time when only the brave or foolish dare criticize capitalism itself, critiques only of a certain style of capitalism are all that can be uttered. In the 1990s, the rhetoric has changed; now its technology and globalization that are denounced but the analysis is still narrowly drawn and the tone of critique equally timorous. On a less grand note, another virtue of Jensens work is that it challenges the MM theorem. Whether you want to emphasize the positive aspects of debt its powers to inspire indebted managers or its negative ones the power to bankrupt otherwise healthy corporations financial structure clearly matters, and matters a lot. mergers and the market for corporate control |
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