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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Bankers who act as matchmakers make oodles of moneyJensenism is a special case of a broader concept known as the liquid market for corporate control. True religionists believe that while the stock market imposes a certain discipline on management if you believe in efficient market theory, then the stock price is a real-time report card on corporate management mere market prices are not enough in extreme cases. If the stock price gets low enough and management is unwilling or unable to respond, then the ultimate sanction for incompetence is a takeover, actual or threatened. An LBO can be thought of as one form of this discipline, but it can take many other forms. A landmark in the evolution of this line of thinking was Henry Mannes (1965) paper Mergers and the Market for Corporate Control. The second part of that title, often modified with liquid, was a commonplace of the 1980s popular and academic literature, almost all of it celebratory. The celebration reached an extraordinary pitch as the leverage boom peaked in 1989. One measure of that mania is a speech delivered in January of that year by Roberto Mendoza, then the VP for M&A at the Morgan Bank. The Morgan, once the epitome of white-shoe propriety, turned more aggressive as the 1980s wore on. After praising the liquid market in corporate control, Mendoza (1989) offered this reflection: We often read in the press of returns on equity of 800 to 900 percent over a two- or three-year period. Somehow the bias has taken hold that this is an excessive return, or that someone is being exploited. We believe that financial buyers are intelligently using the methodology that many strategic corporate buyers do not use, and that the returns are not excessive; in fact, they are very reasonable. The financial buyer is using leverage in a creative and intelligent manner. Whatever your moral philosophy, returns of 800-900% are not sustainable. But since Mendozas argument can be traced in part to Mannes article, lets take a look at it. Traced only in part, though; note Mendoza said that financial buyers rather than strategic corporate buyers that is, bankers and dealmakers, rather than firms in related industries. Mannes article was in large measure pitched as an attack on then-prevailing antitrust doctrine, which was inhibiting mergers among competitors. But Manne also had a larger point to make that an open season on corporate managers was a way of overcoming the problem of the separation of ownership and control. Mannes argument was based on efficient market theory before it really had that name, and the conflation of market and economic notions of efficiency: A fundamental premise underlying the market for corporate control is the existence of a high positive correlation between corporate managerial efficiency and the market price of shares of that company. Poor management makes for a depressed stock, which makes for ripeness for takeover. While acknowledging in a footnote that market prices are subject to what later would be called noise, Manne concluded, with the usual theological fervor, that over some period of time it would seem that the average market price of a companys shares must be the correct one. Those with the wit and capital (or at least a line of credit) to take advantage of this opportunity can make enormous returns from the successful takeover and revitalization of a poorly run company. Antitrust doctrine and other regulations, Manne claimed, were impeding the mobility of capital, and thereby a more efficient allocation of resources. Manne was a professor of law, and most of his citations are of the legal literature, but his reasoning relied on a theory as pure as that of Modigliani and Miller. Markets are efficient, and by God, anything that gets in their way is the enemy of human progress. But do mergers work the magic he was convinced they did? No, they dont seem to. First, a bit of history. Mergers are often grouped into four major waves from 1898 to 1904, when the modern giant corporation took shape, often assembled from many smaller firms in the same industry; the 1920s, a period of further consolidation (or monopolization, in some eyes); the 1960s, the period when conglomerates of unrelated businesses were fashionable; and the early 1980s to at least the moment in 1996 when these words were written, a period during which many of the conglomerates were broken apart, and combinations between firms in the same or related industries predominated. Why mergers should occur in waves is listed in Brealy and Myers (1991, p. 923) finance textbook as one of the 10 great unsolved mysteries of the field. Whatever the answer the orthodox dismiss explanations based on such woolly concepts as manias and bubbles, but that explanation seems just fine to me theres no question that mergers do tend to cluster. For a look at the historical record one could do no better than a special issue of the International Journal of Industrial Organization published in 1989. Bad M&A performance goes back a long long way. For example, despite Mannes complaints about post-1929 regulations interfering with the pure market in corporate control, a study of 134 combinations during the 1920s (Borg, Borg, and Leith 1989) found only modest success, with the average profitability measured by stock performance of the acquiring firms little different from mergers during the 1960s and 1970s, despite huge differences in the economic and legal environments, including the effective suspension of antitrust enforcement after 1920. The earlier mergers were hardly a model; Borg & Co. quote a 1921 evaluation of the turn-of-the-century merger wave that showed that in only five of 35 cases did profits meet or exceed the promises of the promoters in the decade following the combination. Studies of actual operating results in a more contemporary environment show similar disappointments. An examination of Federal Trade Commission records over the period from 1957 to 1977, which allows fairly detailed study of actual lines of business rather than entire firms, and for privately held firms with no publicly traded securities both exceptions to the rule for most merger studies showed that profits of acquired firms tended to decline sharply, a point confirmed by the high rate of subsequent divestitures for the gobbled-up units (Ravenscraft and Scherer 1989). That study also shows that profits of acquired units were often uncommonly high before the merger; thus, the authors conclude, there is no broad-gauged support for the inefficient management displacement hypothesis that acquired companies were subnormal performers. Ravenscraft and Scherer concluded, in typically understated academic style, that the evidence mandates considerable skepticism toward the claim that mergers are on average efficiency-enhancing. One reason mergers turn out badly is that acquiring firms pay too much. An examination of 137 acquisitions done between 1976 and 1984 showed that acquiring firms paid very optimistic prices for their prey; fair prices figured on the basis of prevailing rates of return showed that the performance gains necessary to justify the prices paid in takeovers were impossible to achieve in normal industrial experience (Alberts and Varaiya 1989). A broader review of the evidence by Richard Caves (1989) strengthens skepticism toward the claim that mergers are on average efficiency-enhancing. While theres no denying that the stockholders of target firms enjoy fat profits they gain from the buyers overpayments Caves concluded that acquirers realized little profit, and what they did obtain came mainly in a private but not a social form. That is, theres no serious evidence that mergers are good for the abstraction known as the economy, though parties to the deal occasionally make out like bandits. Caves also cites British studies showing little productivity gain and frequent losses coming from mergers something he attributes to transition costs, including managerial time taken to make the marriage work and the distractions to all employees while everyone conjectures on the course of the axes descent. Whatever their track record, mergers and takeovers do offer windfalls to stockholders of target companies. Where do the gains to stockholders in takeovers come from? The question is not as silly as it may seem at first. If the stock market were rationally valuing the target firm then why should buyers pay significantly more than the prevailing price? If acquirers do overpay, and shareholders of target firms reap a windfall, who, if anyone, loses? Many studies have come to many conclusions, but the study of hostile deals in the mid-1980s by Bhagat, Shleifer, and Vishny (1990) offered a pretty convincing array of possibilities. They attributed some role to layoffs important but notdominant; more important in their eyes were tax savings (a byproduct of increased indebtedness); less important were losses to shareholders of the buying firm (a penalty of overpayment) and cuts in investment by the target firm. The dismantling of conglomerates and mergers within industries, they argued, also resulted in improved performance that comes with specialization, and possibly even increased market power (that is, monopoly pricing power). Importantly, though, the takeover era was not typically a reflection of a change in the internal organization of the firm. Management buyouts and acquisitions by raiders are often a temporary step in the reallocation of assets; they are not a new permanent organizational form. The eventual holders of assets are large public corporations, which are not about to be eclipsed (Bhagat, Shleifer, and Vishny 1990, p. 57). The closing words are an allusion to Jensens (1989a) infamously wrong Harvard Business Review article Eclipse of the Public Corporation. If mergers have such a dismal record, why do they happen? There are several theories, many of them presented with the usual complexities, but they all can be boiled down into simple English. Empire-building. Managers feel richer and more powerful if their firm is growing, and if the business cant grow quickly on its own, then they can gobble up others. Related to this is the idea that while mergers may not result in a higher rate of return (profits divided by invested capital), they may result in a higher quantity of profits, that is more zeroes on the bottom line. Hubris. While the average merger may be a dog, every now and then one can be extraordinarily successful, and perpetrators are convinced they can be the lucky ones. Promoters interests. Bankers who act as matchmakers make oodles of money, with fees running around 1% of the value of a large merger (Du Boff and Herman 1989; Truell 1995); for a routine large merger, this means fees in the scores of millions, divided among a handful of bankers and lawyers for several weeks worth of admittedly intense work.16 Theoretical blindness. Economists repeat the Manne and Jensen mantras because they must be true, the market must be right, investors must be rational all music to investment bankers ears, of course. Or, maybe mergers are ways of managing decline, of withdrawing capital and players from a saggy sector. In this case it should be no surprise that mergers dont do well; even strong firms in a declining industry are still in a declining industry. The mystery is that stock investors still cant figure this out with a centurys track record to study. Far from figuring it out, Anglo-American capital markets seem more willing to fund growth by acquisition than through internal growth by established firms, and they are often shy about financing startups. This preference, which seems characteristic of Anglo-American style markets and governance structures, would, it seems reasonable to conclude, depress investment levels and economic growth rates. In a study of British firms, Manmohan S. Kumar (1984) found that firms financed their internal growth with internal resources, turning to external finance mainly for acquisitions acquisitions did not in the majority of cases have a favourable impact on profitability (p. 178). If the capital markets were exercising their advertised disciplinary function, that finance should not have been available, but it was. Saying the capital markets havent figured out the flimsiness of most merger rationales obscures the divisions between perpetrators and victims (the rich victims, not those beneath serious consideration, like displaced workers). Specifically, investment bankers do their best to zap the memories of their clients. Most M&A waves are powered by some financial fad: new issues of watered stock at the turn of the century to finance the trustification of whole industries; unsecured debt instruments called debentures (Chinese paper) used as the currency of conglomeratization in the 1960s; junk bonds used to finance the leveraged recapitalizations in the 1980s. The logic behind this odd and ever-changing flood of paper was explained by an anonymous investment banker quoted in The Deal Decade (Blair 1993, p. 298): Most mergers do not make sense. Therefore you have to use securities that the buyers do not understand and that are different from the last round of bad merger securities. Some readers may think Ive contradicted myself; having defended the growth of the giant corporation against the criminality hypothesis of the Robber Baron school, I now marshal evidence to show that mergers dont work very well. This apparent contradiction is easily resolved. First, merger isnt the only way to grow; it may be a second-best approach for firms that cant grow on their own. The computer industry today is populated by firms that didnt exist 20 years ago Dell and Compaq, for example. Acquisition had nothing to do with their entry into the Fortune 500; the firms grew like wildfire because they produced good machines and marketed them well. Japan has seen much lower levels of M&A than the U.S. or Britain; Japanese companies have historically relied heavily on internal growth, with concomitant benefits to the Japanese economy in the form of new investment and growth (Mueller 1989). Second, the efficiency of the professionally managed large corporation is a separate issue from growth through acquisition; in most cases, small firms are no match for the prowess of larger ones, though of course older giants like General Motors do stumble badly now and then. But most of GMs problems came from other giant firms, like Toyota, and not from plucky startups. And finally, under capitalism, money talks. Small firms dont have the access to capital or internally generated profits that big ones do. Big firms have so much money, in fact, that they can waste it on stupid acquisitions and still live to tell the story. Theres nothing criminal about that unless you consider the profit system itself criminal. LBOs were a special case of the market for corporate control, and enough time has gone by to pass rigorous judgment on how they worked out. There seems little doubt that LBO and other restructuring targets were in slow-growing industries, or underperformers within their industries (Blair and Schary 1993b, p. 201); most were in low- or mid-tech sectors. Studies that show cutbacks in investment or R&D by leverage targets may be showing the very intention of the restructurings to shift capital out of the hands of managers of slow-growing firms and into Wall Streets. William Long and David Ravenscraft (1993a) summarized their own and others findings on LBOs as follows.17 First, a firm was more likely to be a target during the 1980s if its free cash flow was high, or if management shareownership was high; it was less likely to be targeted if its valuation was high (price/earnings, Tobins q), or if did lots of R&D. Second, a good bit of the premiums paid to shareholders in excess of pre-deal market value came from tax savings. And third, LBOs improved operating income, though this largely got sucked away by high interest payments, and reduced capital expenditures and taxes paid. Fourth, employment at leveraged firms grew at a slower rate than the average of their relevant industrial sectors. And finally, LBOs experienced a great deal of financial distress, and fell deeply out of fashion. Long and Ravenscraft also showed a deterioration as the decade went on. Early-1980s (1981-84) LBOs showed good improvements in profitability); later deals showed a deterioration in performance, though not at statistically significant levels. Their studies at the plant level, however, showed no great improvements, meaning that overhead reductions were the source of most of the cost savings.18 Long and Ravenscraft also demonstrated that deals financed with bank debt greatly outperformed those done with junk a rather interesting finding, and one confirmed by Kaplan and Stein (1993). This is another blow to Jensenmania, and a stroke in favor of bank over market finance. Its true that average R&D spending by LBO targets was low, but that low average hides the fact that almost half the manufacturing LBOs in Long and Ravenscrafts (1993c) universe were considered large R&D performers by the National Science Foundation. In their sample, R&D declined by 40% after an LBO, and capital expenditures by 9%. Again, such cuts are perfectly in line with the Jensen strategy of transferring capital from corporate managers to portfolio managers; whether society is better off is another question. |
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