Value Maximization, Stakeholder theory, and the Corporate Objective Function 32 Michael Jensen, Harvard Business School the Modern industrial Revolution, Exit, and the Failure of int
Trang 1VOLUME 22 | NUMBER 1 | WiNtER 2010
APPLIED CORPORATE FINANCE
Journal of
A M O R G A N S T A N L E Y P U B L I C A T I O N
In This Issue: Honoring Michael Jensen
Baylor University Roundtable on
the Corporate Mission, CEO Pay, and improving the Dialogue with investors
8 Panelists: Michael Jensen, Harvard Business School; Ron Naples, Quaker Chemical Corporation; Trevor Harris, Columbia University; and Don Chew, Morgan Stanley Moderated by John Martin, Baylor University
Value Maximization, Stakeholder theory, and the
Corporate Objective Function
32 Michael Jensen, Harvard Business School
the Modern industrial Revolution, Exit, and
the Failure of internal Control Systems
43 Michael Jensen, Harvard Business School
Just Say No to Wall Street: Putting a Stop to the Earnings Game 59 Joseph Fuller, Monitor Group, and Michael Jensen,
Harvard Business School
Kevin Murphy, University of Southern California
Venture Capital in Canada: Lessons for Building (or Restoring) National Wealth 86 Reuven Brenner, McGill University, and
Gabrielle A Brenner, HEC Montreal
Executive Compensation: An Overview of Research on Corporate Practices
and Proposed Reforms
107 Michael Faulkender, Dalida Kadyrzhanova, N Prabhala, and Lemma Senbet, University of Maryland
Promotion incentives and Corporate Performance:
is there a Bright Side to “Overpaying” the CEO?
119 Jayant Kale, Georgia State University, Ebru Reis, Bentley University, and Anand Venkateswaran, Northeastern University
Trang 2The Modern Industrial Revolution, Exit,
and the Failure of Internal Control Systems
1 This is a shortened version of a paper by the same title that was originally
pub-lished in the Journal of Finance (July 1993), which was based in turn on my Presidential
Address to the American Finance Association in January 1993 It is reprinted here by
permission of the American Finance Association I wish to express my appreciation for
the research assistance of Chris Allen, Brian Barry, Susan Brumfield, Karin Monsler, and
particularly Donna Feinberg, the support of the Division of Research of the Harvard
Busi-ness School, and the comments of and discussions with George Baker, Carliss Baldwin,
Joe Bower, Alfred Chandler, Harry and Linda DeAngelo, Ben Esty, Takashi Hikino, Steve
Kaplan, Nancy Koehn, Claudio Loderer, George Lodge, John Long, Kevin Murphy, Mal-colm Salter, Rene Stulz, Richard Tedlow, and, especially, Robert Hall, Richard Hackman, and Karen Wruck.
2 Walter W Price, We Have Recovered Before! (Harper & Brothers: New York,
1933), p 6.
3 Donald L., McMurray, Coxey’s Army: A Study of the Industrial Army Movement of
1894 (Little, Brown: Boston, 1929), p 7.
B F undamental technological, political, regulatory,
and economic forces are radically changing the
worldwide competitive environment We have
not seen such a metamorphosis of the economic
landscape since the industrial revolution of the 19th century
The scope and pace of the changes over the past two decades
qualify this period as a modern industrial revolution, and I
predict it will take decades more for these forces to be worked
out fully in the worldwide economy
Although the current and 19th-century transformations
of the U.S economy are separated by almost 100 years, there
are striking parallels between them—most notably, rapid
technological and organizational change leading to
declin-ing production costs and increasdeclin-ing average (but decreasdeclin-ing
marginal) productivity of labor During both periods,
moreover, these developments resulted in widespread excess
capacity, reduced rates of growth in labor income, and,
ultimately, downsizing and exit
The capital markets played a major role in eliminating
excess capacity both in the late 19th century and in the 1980s
The merger boom of the 1890s brought about a massive
consolidation of independent firms and closure of marginal
facilities In the 1980s, the capital markets helped eliminate
excess capacity through leveraged acquisitions, stock buybacks,
hostile takeovers, leveraged buyouts, and divisional sales
And much as the takeover specialists of the 1980s were
disparaged by managers, policymakers, and the press, their
19th-century counterparts were vilified as “robber barons.”
In both cases, the popular reaction against “financiers” was
followed by public policy changes that restricted the capital
markets The turn of the century saw the passage of antitrust
laws that restricted business combinations; the late 1980s gave
rise to re-regulation of the credit markets, antitakeover
legisla-tion, and court decisions that all but shut down the market
for corporate control
Although the vast increases in productivity associated
with the 19th-century industrial revolution increased
aggre-gate welfare, the resulting obsolescence of human and physical capital caused great hardship, misunderstanding, and bitter-ness As noted in 1873 by Henry Ward Beecher, a well-known commentator and influential clergyman of the time:
The present period will always be memorable in the dark days
of commerce in America We have had commercial darkness at other times There have been these depressions, but none so obsti-nate and none so universal…Great Britain has felt it; France has felt it; all Austria and her neighborhood has experienced it It is cosmopolitan It is distinguished by its obstinacy from former like periods of commercial depression Remedies have no effect Party confidence, all stimulating persuasion, have not lifted the pall, and practical men have waited, feeling that if they could tide over
a year they could get along; but they could not tide over the year
If only one or two years could elapse they could save themselves The years have lapsed, and they were worse off than they were before What is the matter? What has happened? Why, from the very height
of prosperity without any visible warning, without even a cloud the size of a man’s hand visible on the horizon, has the cloud gathered,
as it were, from the center first, spreading all over the sky?2 Almost 20 years later, on July 4, 1892, the Populist Party platform adopted at the party’s first convention in Omaha reflected continuing unrest while pointing to financiers as the cause of the current problems:
We meet in the midst of a nation brought to the verge of moral, political, and material ruin…The fruits of the toil of millions are boldly stolen to build up colossal fortunes for the few, unprecedented in the history of mankind; and the possessors of these in turn despise the republic and endanger liberty From the same prolific womb of government injustice are bred two great classes of tramps and millionaires.3
Technological and other developments that began in the mid-20th century have culminated in the past two decades
by Michael C Jensen, Harvard Business School1
Trang 34 For a rare study of exit in the finance literature, see the analysis of the retrenchment
of the U.S steel industry in Harry DeAngelo and Linda DeAngelo, “Union Negotiations
and Corporate Policy: A Study of Labor Concessions in the Domestic Steel Industry
dur-ing the 1980s,” Journal of Financial Economics 30 (1991), 3–43 See also Pankaj
Ghemawat and Barry Nalebuff, “Exit,” Rand Journal of Economics 16 (Summer, 1985),
184–194 For a detailed comparison of U.S and Japanese retrenchment in the 1970s
and early 1980s, see Douglas Anderson, “Managing Retreat: Disinvestment Policy,” in
Thomas K McCraw, ed., America Versus Japan (Harvard Business School Press:
Bos-ton, 1986), 337–372 Joseph L Bower analyzes the private and political responses to
decline in the petrochemical industry in When Markets Quake (Harvard Business School
Press: Boston, 1986) Kathryn Harrigan presents detailed firm and industry studies in
two of her books: Managing Maturing Businesses: Restructuring Declining Industries
and Revitalizing Troubled Operations (Lexington Books, 1988) and Strategies for
De-clining Businesses (Lexington Books, 1980).
5 Joseph A., Schumpeter, Capitalism, Socialism, and Democracy (Harper Torchbook
Edition: New York, 1976), p 83.
6 This section draws extensively on excellent discussions of the period by Alfred Chan-dler, Thomas McCraw, and Naomi Lamoreux See the following works by Chandler: “The Emergence of Managerial Capitalism,” Harvard Business School #9–384–081, revised by
Thomas J McCraw, July 1, 1992; Scale and Scope, The Dynamics of Industrial
Capital-ism (Harvard University Press, 1990); and The Visible Hand: The Managerial Revolution in American Business (Harvard University Press, 1977) See also Naomi R Lamoreaux, The Great Merger Movement in American Business, 1895–1904 (Cambridge University Press:
Cambridge, England, 1985); and Thomas K McCraw, “Antitrust: The Perceptions and Re-ality in Coping with Big Business,” Harvard Business School #N9–391–292 (1992), and
“Rethinking the Trust Question,” in T McCraw, ed., Regulation in Perspective (Harvard
Uni-versity Press, 1981).
7 McCraw (1981), p 3.
8 McCraw (1981), p 3.
At the close of the paper, I offer suggestions for reforming U.S internal corporate control mechanisms In particular, I hold up several features of venture capital and LBO firms such
as Kleiner Perkins and KKR for emulation by large, public companies—notably (1) smaller, more active, and better informed boards; and (2) significant equity ownership by board members as well as managers I also urge boards and managers to encourage larger holdings and greater participa-tion by people I call “active” investors
The Second Industrial Revolution6
The Industrial Revolution was distinguished by a shift to capi-tal-intensive production, rapid growth in productivity and living standards, the formation of large corporate hierarchies, overcapacity, and, eventually, closure of facilities Originating in Britain in the late 18th century, the First Industrial Revolution witnessed the application of new energy sources to methods of production The mid-19th century saw another wave of massive change with the birth of modern transportation and commu-nication facilities, including the railroad, telegraph, steamship, and cable systems Coupled with the invention of high-speed consumer packaging technology, these innovations gave rise to the mass production and distribution systems of the late 19th and early 20th centuries—the Second Industrial Revolution The dramatic changes that occurred from the middle to the end of the century clearly warrant the term “revolution.” Inven-tions such as the McCormick reaper in the 1830s, the sewing machine in 1844, and high-volume canning and packaging devices in the 1880s exemplified a worldwide surge in produc-tivity that “substituted machine tools for human craftsmen, interchangeable parts for hand-tooled components, and the energy of coal for that of wood, water, and animals.”7 New technology in the paper industry allowed wood pulp to replace rags as the primary input material Continuous rod rolling transformed the wire industry: within a decade, wire nails replaced cut nails as the main source of supply Worsted textiles resulting from advances in combing technology changed the woolen textile industry Between 1869 and 1899, the capital invested per American manufacturer grew from about $700 to
$2,000; and, in the period 1889–1919, the annual growth of total factor productivity was almost six times higher than that which had occurred for most of the 19th century.8
in a similar situation: rapidly improving productivity, the
creation of overcapacity, and, consequently, the requirement
for exit Although efficient exit has profound import for
productivity and social wealth, research on the topic4 has
been relatively sparse since the 1942 publication of Joseph
Schumpeter’s famous description of capitalism as a process
of “creative destruction.” In Schumpeter’s words,
Every piece of business strategy…must be seen in its role in
the perennial gale of creative destruction…The usual theorist’s
paper and the usual government commission’s report practically
never try to see that behavior…as an attempt by those firms to
keep on their feet, on ground that is slipping away from under
them In other words, the problem that is usually being visualized
is how capitalism administers existing structures, whereas the
relevant problem is how it creates and destroys them.5
Current technological and political changes are
bring-ing the question of efficient exit to the forefront, and the
adjustments necessary to cope with such changes will
receive renewed attention from managers, policymakers, and
researchers in the coming decade
In this paper, I begin by reviewing the industrial
revolu-tion of the 19th century to shed light on current economic
trends Drawing parallels with the 1800s, I discuss in some
detail worldwide changes driving the demand for exit in
today’s economy I also describe the barriers to efficient exit
in the U.S economy, and the role of the market for corporate
control—takeovers, LBOs, and other leveraged
restructur-ings—in surmounting those barriers during the 1980s
With the shutdown of the capital markets in the 1990s, the
challenge of accomplishing efficient exit has been transferred
to corporate internal control systems With few exceptions,
however, U.S managements and boards have failed to bring
about timely exit and downsizing without external pressure
Although product market competition will eventually eliminate
overcapacity, this solution generates huge unnecessary costs
(The costs of this solution have now become especially
appar-ent in Japan, where a virtual breakdown of the internal control
systems, coupled with a complete absence of capital market
influence, has resulted in enormous overcapacity—a problem
that Japanese companies are only beginning to address.)
Trang 49 For most of the examples of cost reduction cited in this paragraph, see
Chandler (1992), pp 4–6.
10 Lamoreux (1985), p i.
11 Measured by multifactor productivity, as reported in Table 3 of U.S Department
of Labor, Bureau of Labor Statistics, 1990, Multifactor Productivity Measures, Report
#USDL 91–412 Manufacturing labor productivity also grew at an annual rate of 3.8%
in 1981–1990, as compared to 2.3% in the period 1950–1981 (U S Department of
Labor, 1990, Table 3) By contrast, productivity growth in the overall (or “non-farm”)
business sector actually fell from 1.9% in the 1950–1981 period to 1.1% in the 1981–
1990 period (U S Department of Labor, 1990, Table 2) The reason for the fall
appar-ently lies in the relatively large growth in the service sector relative to the manufacturing
sector and the low measured productivity growth in services But there is considerable
controversy over the adequacy of the measurement of productivity in the service sector
For example, the U.S Department of Labor has no productivity measures for services
employing nearly 70% of service workers, including, among others, health care, real
estate, and securities brokerage In addition, many believe that service sector
productiv-ity growth measures are downward biased Service sector price measurements, for
ex-ample, take no account of the improved productivity and lower prices of discount outlet
clubs such as Sam’s Club As another example, the Commerce Department measures the
output of financial services as the value of labor used to produce it Because labor
pro-ductivity is defined as the value of total output divided by total labor inputs, it is
impos-sible for measured productivity to grow Between 1973 and 1987, however, total equity
shares traded daily grew from 5.7 million to 63.8 million, while employment only
dou-bled, thus implying considerably more productivity growth than the zero growth reflected
in the statistics.
12 Nominal and real hourly compensation, Economic Report of the President, Table
B42 (1993).
13 U.S Department of Labor, Bureau of Labor Statistics, 1991, International
Com-parisons of Manufacturing Productivity and Unit Labor Cost Trends, Report #USDL
92–752.
14 U.S Department of Labor (1990) Trends in U.S productivity have been contro-versial issues in academic and policy circles in the last decade One reason, I believe, is that it takes time for these complicated changes to show up in the aggregate statistics For example, in their recent book Baumol, Blackman, and Wolff changed their formerly pes-simistic position In their words: “This book is perhaps most easily summed up as a compendium of evidence demonstrating the error of our previous ways The main change that was forced upon our views by careful examination of the long-run data was abandon-ment of our earlier gloomy assessabandon-ment of American productivity performance It has been replaced by the guarded optimism that pervades this book This does not mean that we believe retention of American leadership will be automatic or easy Yet the statistical evi-dence did drive us to conclude that the many writers who have suggested that the demise
of America’s traditional position has already occurred or was close at hand were, like the author of Mark Twain’s obituary, a bit premature It should, incidentally, be acknowl-edged that a number of distinguished economists have also been driven to a similar
evaluation ” William Baumol, Sue Anne Beattey Blackman, and Edward Wolff,
Produc-tivity and American Leadership (MIT Press, Boston, 1989), pp ix–x
To appreciate the challenge facing current control systems
in light of this change, we must understand more about these general forces sweeping the world economy, and why they are generating excess capacity and thus the requirement for exit What has generally been referred to as the “decade of the ’80s” in the United States actually began in the early 1970s, with the 10-fold increase in energy prices from 1973
to 1979, and the emergence of the modern market for corpo-rate control and high-yield, non-investment-grade (“junk”) bonds in the mid-1970s These events were associated with the beginnings of the Third Industrial Revolution which—if
I were to pick a particular date—would be the time of the oil price increases beginning in 1973
The Decade of the ’80s: Capital Markets Provide an Early Response to the Modern Industrial Revolution
The macroeconomic data for the 1980s show major produc-tivity gains In fact, 1981 was a watershed year Total factor productivity growth in the manufacturing sector more than doubled after 1981, from 1.4% per year in the period
1950-1981 (including a period of zero growth from 1973-1980) to 3.3% in the period 1981-1990.11 Over the same period, nomi-nal unit labor costs stopped their 17-year rise, and real unit labor costs declined by 25% These lower labor costs came not from reduced wages or employment, but from increased productivity: nominal and real hourly compensation increased
by a total of 4.2% and 0.3% per year, respectively, over the 1981-1989 period.12 Manufacturing employment reached a low in 1983, but by 1989 had experienced a small cumula-tive increase of 5.5%.13 Meanwhile, the annual growth in labor productivity increased from 2.3% between 1950-1981
to 3.8% between 1981-1990, while a 30-year decline in capi-tal productivity was reversed when the annual change in the productivity of capital increased from -1.0% between
1950-1981 to 2.0% between 1950-1981-1990.14 Reflecting these increases in the productivity of U.S
As productivity climbed steadily, production costs and prices
fell dramatically The 1882 formation of the Standard Oil Trust,
which concentrated nearly 25% of the world’s kerosene
produc-tion into three refineries, reduced the average cost of a gallon
of kerosene by 70% between 1882 and 1885 In tobacco, the
invention of the Bonsack machine in the early 1880s reduced
the labor costs of cigarette production by 98% The Bessemer
process reduced the cost of steel rails by 88% from the early
1870s to the late 1890s, and the electrolytic refining process
invented in the 1880s reduced the price of aluminum by 96%
between 1888 and 1895 In chemicals, the mass production of
synthetic dyes, alkalis, nitrates, fibers, plastics, and film occurred
rapidly after 1880 Production costs of synthetic blue dye, for
example, fell by 95% from the 1870s to 1886.9
Such sharp declines in production costs and prices led
to widespread excess capacity—a problem that was
exacer-bated by the fall in demand that accompanied the recession
and panic of 1893 Although attempts were made to
elimi-nate excess capacity through pools, associations, and cartels,
the problem was not substantially resolved until the capital
markets facilitated exit by means of the 1890s’ wave of
mergers and acquisitions Capacity was reduced through
consolidation and the closing of marginal facilities in the
merged entities From 1895 to 1904, over 1,800 firms were
bought or combined by merger into 157 firms.10
The Modern Industrial Revolution
The major restructuring of the American business community
that began in the 1970s and continues in the 1990s is being
driven by a variety of factors, including changes in
physi-cal and management technology, global competition, new
regulation and taxes, and the conversion of formerly closed,
centrally planned socialist and communist economies to
capi-talism, along with open participation in international trade
These changes are significant in scope and effect; indeed, they
are bringing about the Third Industrial Revolution
Trang 515 As measured by the Wilshire 5,000 index of all publicly held equities.
16 Bureau of the Census, Housing and Household Economic Statistics Division
(1991).
17 Business Week Annual R&D Scoreboard, 1991.
18 “Out of the Ivory Tower,” The Economist, February 3, 1990
19 Mergerstat Review, 1991, Merrill Lynch, Schaumburg, Illinois.
20 Martin Lipton, “Corporate Governance: Major Issues for the 1990’s,” Address to
the Third Annual Corporate Finance Forum at the J Ira Harris Center for the Study of
Corporate Finance, University of Michigan School of Business, April 6, 1989, p 2.
21 For a list of such studies, see the Appendix at the end of this article
22 Measured in 1992 dollars On average, selling-firm shareholders in all M&A
trans-actions in the period 1976–1990 were paid premiums over market value of 41%
An-nual premiums reported by Mergerstat Review (1991, Fig 5) were weighted by value of
transactions in the year for this estimate.
In arriving at my estimate of $750 billion of shareholder gains, I also assumed that all
transactions without publicly disclosed prices had a value equal to 20% of the value of
the average publicly disclosed transaction in the same year, and that they had average
premiums equal to those for publicly disclosed transactions.
23 In cases where buyers overpay, such overpayment does not represent an
effi-ciency gain, but rather only a wealth transfer from the buying firm’s claimants to those
of the selling firm My method of calculating total shareholder gains effectively assumes
that the losses to buyers are large enough to offset all gains (including those of the
“raid-ers” whose allegedly massive “paper profits” became a favorite target of the media).
24 A 1992 study by Healy, Palepu, and Ruback estimates the total gains to buying-
and selling-firm shareholders in the 50 largest mergers in the period 1979–1984 at
9.1% of the total equity value of both companies Because buyers in such cases were
typically much larger than sellers, such gains are roughly consistent with 40% acquisi-tion premiums They also find a strong positive cross-secacquisi-tional relaacquisi-tion between the value change and the operating cash flow changes resulting from the merger See Paul Healy, Krishna Palepu, and Richard Ruback, “Does Corporate Performance Improve After
Mergers?,” Journal of Financial Economics 31, vol 2 (1992), 135–175.
25 A 1989 study by Laura Stiglin, Steven Kaplan, and myself demonstrates that, contrary to popular assertions, LBO transactions resulted in increased tax revenues to the
U S Treasury—increases that average about 60% per annum on a permanent basis under the 1986 IRS code (Michael C Jensen, Steven Kaplan, Laura Stiglin, “Effects of
LBOs on Tax Revenues of the U.S Treasury,” Tax Notes, Vol 42, No 6 (February 6,
1989), pp 727–733.) The data presented by a study of pension fund reversions reveal that only about 1%
of the premiums paid in all takeovers can be explained by reversions of pension plans in the target firms (although the authors of the study do not present this calculation them-selves) (Jeffrey Pontiff, Andrei Shleifer, and Michael S Weisbach, “Reversions of Excess
Pension Assets after Takeovers,” Rand Journal of Economics, Vol 21, No 4 (Winter
1990), pp 600–613.) Joshua Rosett, in analyzing over 5,000 union contracts in over 1,000 listed compa-nies in the period 1973 to 1987, shows that less than 2% of the takeover premiums can
be explained by reductions in union wages in the first six years after the change in con-trol Pushing the estimation period out to 18 years after the change in control increases the percentage to only 5.4% of the premium For hostile takeovers only, union wages
increase by 3% and 6% for the two time intervals (Joshua G Rosett, “Do Union Wealth
Concessions Explain Takeover Premiums? The Evidence on Contract Wages,” Journal of
Financial Economics, Vol 27, No 1 (September 1990), pp 263–282.)
as a whole Based on this research,21 my estimates indicate that over the 14-year period from 1976 to 1990, the $1.8 trillion volume of corporate control transactions—that is, mergers, tender offers, divestitures, and LBOs—generated over $750 billion in market value “premiums”22 for selling investors Given a reasonably efficient market, such premiums (the amounts buyers are willing to pay sellers over current market values) represent, in effect, the minimum increases
in value forecast by the buyers This $750 billion estimate
of total shareholder gains thus neither includes the gains (or the losses)23 to the buyers in such transactions, nor does it account for the value of efficiency improvements by compa-nies pressured by control market activity into reforming without a visible control transaction
Important sources of the expected gains from takeovers and leveraged restructurings include synergies from combin-ing the assets of two or more organizations in the same or related industries (especially those with excess capacity) and the replacement of inefficient managers or governance systems.24 Another possible source of the premiums, however, are transfers of wealth from other corporate stakeholders such
as employees, bondholders, and the IRS To the extent the value gains are merely wealth transfers, they do not repre-sent efficiency improvements But little evidence has been found to date to support substantial wealth transfers from any group,25 and thus most of the reported gains appear to represent increases in efficiency
Part of the attack on M&A and LBO transactions has been directed at the high-yield (or “junk”) bond market Besides helping to provide capital for corporate newcomers
to compete with existing firms in the product markets, junk bonds also eliminated mere size as an effective takeover deter-rent This opened America’s largest companies to monitoring and discipline from the capital markets The following
state-industry, the real value of public corporations’ equity more
than doubled during the 1980s, from $1.4 to $3 trillion.15 In
addition, real median income increased at the rate of 1.8%
per year between 1982 and 1989, reversing the 1.0% per year
decline that occurred from 1973 to 1982.16 Contrary to
gener-ally held beliefs, real R&D expenditures set record levels every
year from 1975 to 1990, growing at an average annual rate of
5.8%.17 In one of the media’s few accurate portrayals of this
period, a 1990 issue of The Economist noted that from 1980 to
1985, “American industry went on an R&D spending spree,
with few big successes to show for it.”18
Regardless of the gains in productivity, efficiency, and
welfare, the 1980s are generally portrayed by politicians, the
media, and others as a “decade of greed and excess.” The
media attack focused with special intensity on M&A
trans-actions, 35,000 of which occurred from 1976 to 1990, with
a total value of $2.6 trillion (in 1992 dollars) Contrary to
common belief, only 364 of these offers were contested, and
of those only 172 resulted in successful hostile takeovers.19
The popular verdict on takeovers was pronounced by
promi-nent takeover defense lawyer Martin Lipton, when he said,
The takeover activity in the U.S has imposed short-term
profit maximization strategies on American business at the
expense of research, development, and capital investment This
is minimizing our ability to compete in world markets and still
maintain a growing standard of living at home.20
But the evidence provided by financial economists, which
I summarize briefly below, is starkly inconsistent with this
view The most careful academic research strongly suggests
that takeovers—along with leveraged restructurings prompted
(in many, if not most cases) by the threat of takeover—have
produced large gains for shareholders and for the economy
Trang 626 J Richard Munro, “Takeovers: The Myths Behind the Mystique,” May 15, 1989,
published in Vital Speeches, p 472.
27 See the collection of articles on the “credit crunch” in Vol 4 No 1 (Spring 1991)
of the Journal of Applied Corporate Finance.
28 I make this case in “Corporate Control and the Politics of Finance,” Journal of Applied Corporate Finance (Summer, 1991), 13–33 See also Karen Wruck, “Financial
Distress, Reorganization, and Organizational Efficiency,” Journal of Financial Economics
27 (1990), 420–444.
29 Its high of $139.50 occurred on 2/19/91 and it closed at $50.38 at the end of 1992.
corporate America, and doing it before the companies faced serious trouble in the product markets They were providing,
in effect, an early warning system that motivated healthy adjustments to the excess capacity that was building in many sectors of the worldwide economy
Causes of Excess Capacity
Excess capacity can arise in at least four ways, the most obvi-ous of which occurs when market demand falls below the level required to yield returns that will support the currently
installed production capacity This demand-reduction scenario
is most familiarly associated with recession episodes in the business cycle
Excess capacity can also arise from two types of
techno-logical change The first type, capacity-expanding technotechno-logical
change, increases the output of a given capital stock and organization An example of the capacity-expanding type of change is the Reduced Instruction Set CPU (RISC) proces-sor innovation in the computer workstation market RISC processors have brought about a ten-fold increase in power, but can be produced by adapting the current production technology With no increase in the quantity demanded, this change implies that production capacity must fall by 90% Of course, such price declines increase the quantity demanded in these situations, thereby reducing the extent of the capacity adjustment that would otherwise be required Nevertheless, the new workstation technology has dramatically increased the effective output of existing production facilities, thereby generating excess capacity
The second type is obsolescence-creating change—change
that makes obsolete the current capital stock and organiza-tion For example, Wal-Mart and the wholesale clubs that are revolutionizing retailing are dominating old-line depart-ment stores, thereby eliminating the need for much current retail capacity When Wal-Mart enters a new market, total retail capacity expands, and some of the existing high-cost retail operations must go out of business More intensive use
of information and other technologies, direct dealing with manufacturers, and the replacement of high-cost, restrictive work-rule union labor are several sources of the competitive advantage of these new organizations
Finally, excess capacity also results when many competi-tors simultaneously rush to implement new, highly productive technologies without considering whether the aggregate effects of all such investment will be greater capacity than can be supported by demand in the final product market The Winchester disk drive industry provides an example Between
1977 and 1984, venture capitalists invested over $400 million
ment by Richard Munro, while Chairman and CEO of Time
Inc., is representative of top management’s hostile response
to junk bonds and takeovers:
Notwithstanding television ads to the contrary, junk bonds
are designed as the currency of ‘casino economics’…they’ve been
used not to create new plants or jobs or products but to do the
opposite: to dismantle existing companies so the players can make
their profit…This isn’t the Seventh Cavalry coming to the rescue
It’s a scalping party.26
As critics of leveraged restructuring have suggested, the
high leverage incurred in the 1980s did contribute to a sharp
increase in the bankruptcy rate of large firms in the early
1990s Not widely recognized, however, is the major role
played by other, external factors in these bankruptcies First,
the recession that helped put many highly leveraged firms
into financial distress can be attributed at least in part to new
regulatory restrictions on credit markets such as FIRREA—
restrictions that were implemented in late 1989 and 1990 to
offset the trend toward higher leverage.27 And when
compa-nies did get into financial trouble, revisions in bankruptcy
procedures and the tax code made it much more difficult
to reorganize outside the courts, thereby encouraging many
firms to file Chapter 11 and increasing the “costs of financial
distress.”28
But, even with such interference by public policy and
the courts with the normal process of private adjustment
to financial distress, the general economic consequences of
financial distress in the high-yield markets have been greatly
exaggerated While precise numbers are difficult to come
by, I estimate that the total bankruptcy losses to junk bond
and bank HLT loans from inception of the market in the
mid-1970s through 1990 amounted to less than $50 billion
(In comparison, IBM alone lost $51 billion—almost 65% of
the total market value of its equity—from its 1991 high to
its 1992 close.)29 Perhaps the most telling evidence that losses
have been exaggerated, however, is the current condition of
the high-yield market, which is now financing record levels
of new issues
Of course, mistakes were made in the takeover activity
of the 1980s Indeed, given the far-reaching nature of the
restructuring, it would have been surprising if there were
none But the popular negative assessment of leveraged
restructuring is dramatically inconsistent with both the
empirical evidence and the near-universal view of finance
scholars who have studied the phenomenon In fact, takeover
activities were addressing an important set of problems in
Trang 7ing” movement that still continues to accelerate throughout the world.)
Since the oil price increases of the 1970s, we have again seen systematic overcapacity problems in many industries similar to those of the 19th century While the reasons for this overcapacity appear to differ somewhat among industries, there are a few common underlying causes
Macro Policies. Major deregulation of the American economy (including trucking, rail, airlines, telecommunica-tions, banking, and financial services industries) under President Carter contributed to the requirement for exit in these indus-tries, as did important changes in the U.S tax laws that reduced tax advantages to real estate development, construction, and other activities The end of the Cold War has had obvious consequences for the defense industry and its suppliers In addition, I suspect that two generations of managerial focus
on growth as a recipe for success has caused many firms to overshoot their optimal capacity, thus setting the stage for
cutbacks In the decade from 1979 to 1989, Fortune 100 firms
lost 1.5 million employees, or 14% of their workforce.33
Technology Massive changes in technology are clearly part of the cause of the current industrial revolution and its associated excess capacity Both within and across indus-tries, technological developments have had far-reaching impact To give some examples, the widespread acceptance
of radial tires (which last three to five times longer than the older bias ply technology and provide better gas mileage) caused excess capacity in the tire industry; the personal computer revolution forced contraction of the market for mainframes; the advent of aluminum and plastic alterna-tives reduced demand for steel and glass containers; and fiber optic, satellite, digital (ISDN), and new compression technologies dramatically increased capacity in telecom-munication Wireless personal communication such as cellular phones and their replacements promise further to extend this dramatic change
The changes in computer technology, including miniatur-ization, have not only revamped the computer industry, but also redefined the capabilities of countless other industries Some estimates indicate the price of computing capacity fell
by a factor of 1,000 over the last decade This means that computer production lines now produce boxes with 1,000 times the capacity for a given price Consequently, comput-ers are becoming commonplace—in cars, toastcomput-ers, cameras, stereos, ovens, and so on Nevertheless, the increase in quantity demanded has not been sufficient to avoid overca-pacity, and we are therefore witnessing a dramatic shutdown
of production lines in the industry—a force that has wracked
in 43 different manufacturers of Winchester disk drives;
initial public offerings of common stock infused additional
capital in excess of $800 million In mid-1983, the capital
markets assigned a value of $5.4 billion to twelve publicly-
traded, venture-capital-backed hard disk drive manufacturers
Yet, by the end of 1984, overcapacity had caused the value
assigned to those companies to plummet to $1.4 billion My
Harvard colleagues William Sahlman and Howard Stevenson
have attributed this overcapacity to an “investment mania”
based on implicit assumptions about long-run growth and
profitability “ for each individual company [that,] had they
been stated explicitly, would not have been acceptable to the
rational investor.”30
Such “overshooting” has by no means been confined to
the Winchester disk drive industry.31 Indeed, the 1980s saw
boom-and-bust cycles in the venture capital market
gener-ally, and also in commercial real estate and LBO markets
As Sahlman and Stevenson have also suggested, something
more than “investment mania” and excessive “animal
spirits” was at work here Stated as simply as possible, my
own analysis traces such overshooting to a gross
misalign-ment of incentives between the “dealmakers” who promoted
the transactions and the lenders, limited partners, and other
investors who funded them.32 During the mid to late ’80s,
venture capitalists, LBO promoters, and real estate
develop-ers were all effectively being rewarded simply for doing deals
rather than for putting together successful deals
Reform-ing the “contracts” between dealmaker and investor—most
directly, by reducing front-end-loaded fees and requiring the
dealmakers to put up significant equity—would go far toward
solving the problem of too many deals (As I argue later,
public corporations in mature industries face an analogous,
though potentially far more costly (in terms of shareholder
value destroyed and social resources wasted), distortion of
investment priorities and incentives when their managers and
directors do not have significant stock ownership.)
Current Forces Leading to Excess Capacity and Exit
The ten-fold increase in crude oil prices between 1973–1979
had ubiquitous effects, forcing contraction in oil, chemicals,
steel, aluminum, and international shipping, among other
industries In addition, the sharp crude oil price increases that
motivated major changes to economize on energy had other,
longer-lasting consequences The general corporate
re-evalu-ation of organizre-evalu-ational processes stimulated by the oil shock
led to dramatic increases in efficiency above and beyond the
original energy-saving projects (In fact, I view the oil shock
as the initial impetus for the corporate “process
re-engineer-30 See William A Sahlman and Howard H Stevenson, “Capital Market Myopia,”
Journal of Business Venturing 1 (1985), p 7.
31 Or to the 1980s There is evidence of such behavior in the 19th century, and in
other periods of U.S history.
32 Stated more precisely, my argument attributes overshooting to “incentive,
infor-mation, and contracting” problems For more on this, see Jensen (1991), cited in note
27, pp 26–27 For some supporting evidence, see Steven N Kaplan and Jeremy Stein,
1993, “The Evolution of Buyout Pricing and Financial Structure in the 1980s, Quarterly
Journal of Economics 108, no 2, 313–358 For a shorter, less technical version of the
same article, see Vol 6 No 1 (Spring 1993) of the Journal of Applied Corporate
Fi-nance.
33 Source: Compustat.
Trang 8of organizations where they have been successfully imple-mented throughout the world Some experts argue that such new management techniques can reduce defects and spoilage
by an order of magnitude These changes in managing and organizing principles have contributed significantly to the productivity of the world’s capital stock and economized on the use of labor and raw materials, thus also contributing to excess capacity
Globalization of Trade. Over the last several decades, the entry of Japan and other Pacific Rim countries such as Hong Kong, Taiwan, Singapore, Thailand, Korea, Malaysia, and China into worldwide product markets has contributed to the required adjustments in Western economies And competi-tion from new entrants to the world product markets promises only to intensify
With the globalization of markets, excess capacity tends
to occur worldwide The Japanese economy, for example, is currently suffering from enormous overcapacity caused in large part by what I view as the “breakdown” of its corporate control system.36 As a consequence, Japan now faces a massive and long overdue restructuring—one that includes the prospect of unprecedented (for Japanese companies) layoffs,
a pronounced shift of corporate focus from market share to profitability, and even the adoption of pay-for-performance executive compensation contracts (something heretofore believed to be profoundly “un-Japanese”)
Yet even if the requirement for exit were isolated in just Japan and the U.S, the interdependency of today’s world economy would ensure that such overcapacity would have global implica-tions For example, the rise of efficient high-quality producers
of steel and autos in Japan and Korea has contributed to excess capacity in those industries worldwide Between 1973 and
1990, total capacity in the U.S steel industry fell by 38% from
157 to 97 million tons, and total employment fell over 50% from 509,000 to 252,000 (and had fallen further to 160,000
by 1993) From 1985 to 1989 multifactor productivity in the industry increased at an annual rate of 5.3%, as compared to 1.3% for the period 1958 to 1989.37
Revolution in Political Economy The rapid pace of the development of capitalism, the opening of closed
econo-IBM as a high-cost producer A change of similar
magni-tude in auto production technology would have reduced the
price of a $20,000 auto in 1980 to under $20 today Such
increases in capacity and productivity in a basic technology
have unavoidably massive implications for the organization
of work and society
Fiber-optic and other telecommunications technologies
such as compression algorithms are bringing about similarly
vast increases in worldwide capacity and functionality A Bell
Laboratories study of excess capacity indicates, for example,
that, given three years and an additional expenditure of $3.1
billion, three of AT&T’s new competitors (MCI, Sprint, and
National Telecommunications Network) would be able to
absorb the entire long-distance switched service that was
supplied by AT&T in 1990.34
Organizational Innovation. Overcapacity can be caused not
only by changes in physical technology, but also by changes
in organizational practices and management technology
The vast improvements in telecommunications,
includ-ing computer networks, electronic mail, teleconferencinclud-ing,
and facsimile transmission are changing the workplace in
major ways that affect the manner in which people work
and interact It is far less valuable for people to be in the
same geographical location to work together effectively, and
this is encouraging smaller, more efficient, entrepreneurial
organizing units that cooperate through technology.35 This
in turn leads to even more fundamental changes Through
competition, “virtual organizations”—networked or
transi-tory organizations in which people come together temporarily
to complete a task, then separate to pursue their individual
specialties—are changing the structure of the standard large
bureaucratic organization and contributing to its shrinkage
Virtual organizations tap talented specialists, avoid many of
the regulatory costs imposed on permanent structures, and
bypass the inefficient work rules and high wages imposed
by unions In so doing, they increase efficiency and thereby
further contribute to excess capacity
In addition, Japanese management techniques such as
total quality management, just-in-time production, and
flexi-ble manufacturing have significantly increased the efficiency
34 Federal Communications Commission, Competition in the Interstate
Interex-change Marketplace, FCC 91–251 (Sept 16, 1991), p 1140.
35 The Journal of Financial Economics, which I have been editing with several
oth-ers since 1973, is an example The JFE is now edited by seven faculty memboth-ers with
offices at three universities in different states, and the main editorial administrative office
is located in yet another state The publisher, North Holland, is located in Amsterdam,
the printing is done in India, and mailing and billing is executed in Switzerland This
“networked organization” would have been extremely inefficient two decades ago without
fax machines, high-speed modems, electronic mail, and overnight delivery services.
36 A collapse I predicted in print as early as 1989 (See Michael C Jensen, “Eclipse
of the Public Corporation,” Harvard Business Review, Vol 89, No 5
(September-Octo-ber, 1989), pp 61–74.)
In a 1991 article published in this journal, I wrote the following: “As our system has
begun to look more like the Japanese, the Japanese economy is undergoing changes that
are reducing the role of large active investors and thus making their system resemble
ours With the progressive development of U.S.-like capital markets, Japanese managers
have been able to loosen the controls once exercised by the banks So successful have
they been in bypassing banks that the top third of Japanese companies are no longer net
bank borrowers As a result of their past success in product market competition, Japa-nese companies are now “flooded” with free cash flow Their competitive position today reminds me of the position of American companies in the late 1960s And, like their U.S counterparts in the 60s, Japanese companies today appear to be in the process of creat-ing conglomerates
My prediction is that, unless unmonitored Japanese managers prove to be much more capable than American executives of managing large, sprawling organizations, the Japa-nese economy is likely to produce large numbers of those conglomerates that U.S capi-tal markets have spent the last 10 years trying to pull apart And if I am right, then Japan
is likely to experience its own leveraged restructuring movement.” (“Corporate Control
and the Politics of Finance,” Journal of Applied Corporate Finance, Vol 4 No 2, p 24,
fn 47.) For some interesting observations attesting to the severity of the Japanese overinvest-ment or “free cash flow” problem, see Carl Kester, “The Hidden Costs of Japanese
Suc-cess,” Journal of Applied Corporate Finance (Volume 3 Number 4, Winter 1990).
37 See James D Burnham, Changes and Challenges: The Transformation of the U.S Steel Industry, Policy Study No 115 (Center for the Study of American Business, Wash-ington University: St Louis, 1993), Table 1 and p 15.
Trang 9important role in forcing managers to address this problem In the absence of capital market pressures, competition in product markets will eventually bring about exit But when left to the product markets, the adjustment process is greatly protracted and ends up generating enormous additional costs This is the clear lesson held out by the most recent restructuring of the U.S auto industry— and it’s one that many sectors of the Japanese economy are now experiencing firsthand
The Difficulty of Exit
The Asymmetry Between Growth and Decline
Exit problems appear to be particularly severe in companies that for long periods enjoyed rapid growth, commanding market positions, and high cash flow and profits In these situations, the culture of the organization and the mindset
of managers seem to make it extremely difficult for adjust-ment to take place until long after the problems have become severe and, in some cases, even unsolvable In a fundamen-tal sense, there is an “asymmetry” between the growth stage and the contraction stage in the corporate life cycle Finan-cial economists have spent little time thinking about how to manage the contracting stage efficiently or, more important, how to manage the growth stage to avoid sowing the seeds
of decline
In industry after industry with excess capacity, managers fail to recognize that they themselves must downsize; instead they leave the exit to others while they continue to invest When all managers behave this way, exit is significantly delayed at substantial cost of real resources to society The tire industry is an example Widespread consumer acceptance of radial tires meant that worldwide tire capacity had to shrink
by two thirds (because radials last 3 to 5 times longer than bias ply tires) Nonetheless, the response by the managers of individual companies was often equivalent to: “This business
is going through some rough times We must invest so that
we will have a chair when the music stops.”
The Case of Gencorp. William Reynolds, Chairman and CEO of GenCorp, the maker of General Tires, illustrates this reaction in his 1988 testimony before the U.S House Committee on Energy and Commerce:
The tire business was the largest piece of GenCorp, both in terms of annual revenues and its asset base Yet General Tire was not GenCorp’s strongest performer Its relatively poor earnings performance was due in part to conditions affecting all of the tire industry… In 1985 worldwide tire manufacturing capacity substantially exceeded demand At the same time, due to a series of technological improvements in the design of tires and the materi-als used to make them, the product life of tires had lengthened significantly… The economic pressure on our tire business was substantial Because our unit volume was far below others in the industry, we had less competitive flexibility… We made several moves to improve our competitive position: We increased our
invest-mies, and the dismantling of central control in communist
and socialist states is occurring in various degrees in Eastern
Europe, China, India, Indonesia, other Asian economies,
and Africa In Asia and Africa alone, this development will
place a potential labor force of almost a billion people—
whose current average income is less than $2 per day—on
world markets The opening of Mexico and other Latin
American countries and the transition of some socialist
Eastern European economies to open capitalist systems
could add almost 200 million more laborers with average
incomes of less than $10 per day to the world market
To put these numbers into perspective, the average daily
U.S income per worker is slightly over $90, and the total
labor force numbers about 117 million, and the European
Economic Community average wage is about $80 per day
with a total labor force of about 130 million The labor forces
that have affected world trade extensively in the last several
decades (those in Hong Kong, Japan, Korea, Malaysia,
Singa-pore, and Taiwan) total about 90 million
While the changes associated with bringing a potential 1.2
billion low-cost laborers onto world markets will significantly
increase average living standards throughout the world, they
will also bring massive obsolescence of capital (manifested
in the form of excess capacity) in Western economies as the
adjustments sweep through the system Such adjustments
will include a major redirection of Western labor and capital
away from low-skilled, labor-intensive industries and toward
activities where they have a comparative advantage While
the opposition to such adjustments will be strong, the forces
driving them will prove irresistible in this day of rapid and
inexpensive communication, transportation, miniaturization,
and migration
One can also confidently forecast that the transition to
open capitalist economies will generate great conflict over
international trade as special interests in individual countries
try to insulate themselves from competition and the required
exit And the U.S., despite its long-professed commitment to
“free trade,” will prove no exception Just as U.S managers
and employees demanded protection from the capital markets
in the 1980s, some are now demanding protection from
inter-national competition in the product markets, generally under
the guise of protecting jobs The dispute over NAFTA is but
one general example of conflicts that are also occurring in
the steel, automobile, computer chip, computer screen, and
textile industries It would not even surprise me to see a return
to demands for protection from domestic competition This is
currently happening in the deregulated airline industry, an
industry faced with significant excess capacity
The bottom line, then, is that with worldwide excess
capac-ity and thus greater requirement for exit, the strains put on the
internal control mechanisms of Western corporations are likely
to worsen for decades to come The experience of the U.S in
the 1980s demonstrated that the capital markets can play an
Trang 10losing capacity—situations that illustrate vividly what I call the “agency costs of free cash flow.”40
Contracting Problems
Explicit and implicit contracts in the organization can become major obstacles to efficient exit Unionization, restrictive work rules, and lucrative employee compensation and bene-fits are other ways in which the agency costs of free cash flow can manifest themselves in a growing, cash-rich organiza-tion Formerly dominant firms became unionized in their heyday (or effectively unionized in organizations like IBM and Kodak) when managers spent some of the organization’s free cash flow to buy labor peace Faced with technical inno-vation and worldwide competition—often from new, more flexible, and non-union organizations—these dominant firms have not adjusted quickly enough to maintain their market dominance Part of the problem is managerial and organi-zational defensiveness that inhibits learning and prevents managers from changing their model of the business Implicit contracts with unions, other employees, suppli-ers, and communities add to formal union barriers to change
by reinforcing organizational defensiveness and delaying change long beyond the optimal time—often even beyond the survival point for the organization While casual breach
of implicit contracts will destroy trust in an organization and seriously reduce efficiency, all organizations must retain the flexibility to modify contracts that are no longer optimal.41
In the current environment, it takes nothing less than a major shock to bring about necessary change
The Role of the Market for Corporate Control
The Four Control Forces Operating on the Corporation
There are four basic control forces bearing on the corporation that act to bring about a convergence of managers’ decisions with those that are optimal from society’s standpoint They are (1) the capital markets, (2) the legal, political, and regu-latory system, (3) the product and factor markets, and (4) the internal control system headed by the board of directors The capital markets were relatively constrained by law and regulatory practice from about 1940 until their resurrection through hostile tender offers in the 1970s Prior to the 1970s, capital market discipline took place primarily through the proxy process
The legal/political/regulatory system is far too blunt an instrument to handle the problems of wasteful managerial
ment in research and development We increased our involvement
in the high performance and light truck tire categories, two market
segments which offered faster growth opportunities We developed
new tire products for those segments and invested heavily in an
aggressive marketing program designed to enhance our presence
in both markets We made the difficult decision to reduce our
overall manufacturing capacity by closing one of our older, less
modern plants… I believe that the General Tire example illustrates
that we were taking a rational, long-term approach to improving
GenCorp’s overall performance and shareholder value…
Like so many U.S CEOs, Reynolds then goes on to blame
the capital markets for bringing about what he fails to recognize
is a solution to the industry’s problem of excess capacity:
As a result of the takeover attempt…[and] to meet the
principal and interest payments on our vastly increased
corpo-rate debt, GenCorp had to quickly sell off valuable assets and
abruptly lay off approximately 550 important employees.38
Without questioning the genuineness of Reynolds’
concerns about his company and employees, it
neverthe-less now seems clear that GenCorp’s increased investment
was neither going to maximize the value of the firm nor
to be a socially optimal response in a declining industry
with excess capacity In 1987, GenCorp ended up selling its
General Tire subsidiary to Continental AG of Hannover,
thus furthering the process of consolidation necessary to
reduce overcapacity
Information Problems
Information problems hinder exit because the high-cost
capacity in the industry must be eliminated if resources are to
be used efficiently Firms often do not have good information
about their own costs, much less the costs of their
competi-tors Thus, it is sometimes unclear to managers that they are
the high-cost firm that should exit the industry.39
But even when managers do acknowledge the
require-ment for exit, it is often difficult for them to accept and
initiate the shutdown For the managers who must
imple-ment these decisions, shutting plants or liquidating the firm
causes personal pain, creates uncertainty, and interrupts or
sidetracks careers Rather than confronting this pain,
manag-ers generally resist such actions as long as they have the cash
flow to subsidize the losing operations Indeed, firms with
large positive cash flow will often invest in even more
money-38 A William Reynolds, in testimony before the Subcommittee on Oversight and
Investigations, U.S House Committee on Energy and Commerce, February 8, 1988.
39 Total quality management programs strongly encourage managers to benchmark
their firm’s operations against the most successful worldwide competitors, and good cost
systems and competitive benchmarking are becoming more common in well-managed
firms.
40 Briefly stated, the “agency costs of free cash flow” means the loss in value caused
by the tendency of managements of large public companies in slow growth industries to
reinvest corporate cash flow in projects with expected returns below the cost of capital
See Michael Jensen, “The Agency Costs of Free Cash Flow: Corporate Finance and
Take-overs,” American Economic Review 76, no 2 (May, 1986), 323–329.
41 Much press coverage and official policy seems to be based on the notion that all
implicit contracts should be immutable and rigidly enforced But while I agree that the security of property rights and the enforceability of contracts are essential to the growth
of real output and efficiency, it is also clear that, given unexpected and unforeseeable
events, not all contracts, whether explicit or implicit, can (or even should) be fulfilled
(For example, bankruptcy is essentially a state-supervised system for breaking (or, more politely, rewriting) explicit contracts that have become unenforceable All developed economies devise such a system.) Implicit contracts, besides avoiding the costs incurred
in the writing process, provide the opportunity to revise the obligation if circumstances change; presumably, this is a major reason for their existence.