982PART X Mergers, Corporate Control, and Governance
•The legal duty of managers and directors to act in shareholders’ interest, backed up by monitoring by auditors, lenders, security analysts, and large institutional investors.
•The threat of a takeover, either by another public company or a private investment partnership.
But don’t assume that ownership and control are always separated. A large block of shares may give effective control even when there is no majority owner.39 For example, Bill Gates owns over 20 percent of Microsoft. Barring some extreme catastrophe, that block means that he can run the company as he wants to and as long as he wants to. Henry Ford’s descendants still hold a class of Ford Motor Company shares with extra voting rights and thereby retain great power should they decide to exercise it.40
Nevertheless, the concentration of ownership of public U.S. corporations is much less than in some other industrialized countries. The differences are not so apparent in Canada, Britain, Australia, and other English-speaking countries, but there are dramatic differences in Japan and continental Europe. We start with Germany.
Ownership and Control in Germany
Figure 34.3 summarizes the ownership in 1990 of Daimler-Benz, one of the largest German companies. The immediate owners were Deutsche Bank, the largest German bank, with 28 percent; Mercedes Automobil Holding, with 25 percent; and the Kuwait government, with 14 percent. The remaining 32 percent of the shares were widely held by about 300,000 individual and institutional investors.
But this was only the top layer. Mercedes Automobil Holding was half owned by two holding companies, “Stella” and “Stern” for short. The rest of its shares were widely held. Stella’s shares were in turn split four ways: between two banks; Robert Bosch, an industrial company; and another holding company, “Komet.” Stern’s ownership was split four ways too, but we ran out of space.41
The differences between German and U.S. ownership patterns leap out from Figure 34.3. Note the concentration of ownership of Daimler-Benz shares in large blocks and the several layers of owners. A similar figure for General Motors would just say, “General Motors, 100 percent widely held.”
In Germany these blocks are often held by other companies—a cross-holding of shares—or by holding companies for families. Franks and Mayer, who examined the ownership of 171 large German companies in 1990, found 47 with blocks of
39A surprising number of public U.S. corporations do have majority owners. A study by Clifford Holderness and Dennis Sheehan identified over 650. See “The Role of Majority Shareholders in Publicly Held Corporations: An Exploratory Analysis,” Journal of Financial Economics 20 (January/March 1988), pp. 317–346.
40You would predict that companies with concentrated ownership would show better financial performance simply because the blockholders face less of a free-rider problem when they represent shareholders’ interests. This prediction appears to be true. However, investors who accumulate very large stakes and gain effective control of the firm may act in their own interests and against the interests of the remaining minority shareholders. See R. Morck, A. Shleifer, and R. Vishny, “Management Ownership and Market Valuation: An Empirical Analysis,” Journal of Financial Economics 20 (January/March 1988), pp. 293–315.
41A five-layer ownership tree for Daimler-Benz is given in S. Prowse, “Corporate Governance in an International Perspective: A Survey of Corporate Control Mechanisms among Large Firms in the U.S., U.K., Japan and Germany,” Financial Markets, Institutions, and Instruments 4 (February 1995), Table 16.
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only, so the gains to ordinary stockholders from changes in control are small.43 In the United States, by contrast, the big winners in acquisitions are usually the selling firm’s ordinary stockholders.
Blockholders in Germany do not have unchecked power, however. Large German companies have two boards of directors: the supervisory board (Aufsichtsrat) and management board (Vorstand). Half of the supervisory board’s members are elected by employees, including management and staff as well as labor unions. The other half represents stockholders, often including bank executives. (There is also a chairman who can cast tie-breaking votes if necessary.) The supervisory board oversees strategy and elects and monitors the management board which operates the company. Thus control of shares does not mean control of the company—100 percent ownership controls only half of the supervisory board.
This two-tier governance structure reflects a belief, widespread in Europe, that the firm should act in the interests of all its stakeholders, including its employees and the public at large, and not just seek to maximize shareholder value. This structure does not mean poor financial performance or an easy life for management— poor performance leads to management turnover, just as in the United States,44 and the German economy has, in general, thrived over the last 50 years. One may ask, however, whether German companies which undertake extensive international operations, and seek financing in international capital markets, are best served by a financial architecture that skimps on protection for outside minority investors and discourages attempts to maximize the market value of the firm.
Daimler-Benz, now DaimlerChrysler, is an interesting case study. In the mid1990s it reversed an unsuccessful diversification strategy that had led it into several other industries, including aerospace and defense. In 1998 it took over Chrysler. It listed its shares on the New York Stock Exchange and issued financial statements conforming to U.S. accounting standards. It turned to international capital markets for financing, including a share issue in the U.S. At the same time Deutsche Bank was reducing its stake in the company. DaimlerChrysler has formally announced a commitment to increasing shareholder value.
. . . And in Japan
Japan’s system of corporate governance is in some ways in between the systems of Germany and the United States and in other ways different from both.
The most notable feature of Japanese corporate finance is the keiretsu. A keiretsu is a network of companies, usually organized around a major bank. There are long-standing business relationships between the group companies; a manufacturing company might buy a substantial part of its raw materials from group suppliers and in turn sell much of its output to other group companies.
The bank and other financial institutions at the keiretsu’s center own shares in most of the group companies (though a commercial bank in Japan is limited to 5 percent ownership of each company). Those companies may in turn hold the bank’s shares or each others’ shares. Here are the cross-holdings at the end of 1991 between Sumitomo Bank; the Sumitomo Corporation, a trading company; and Sumitomo Trust, which concentrates on investment management:
43Franks and Mayer, op. cit., Table 9, p. 969.
44See Franks and Mayer, op. cit.; and S. Kaplan, “Top Executives, Turnover and Firm Performance in Germany,” Journal of Law and Economics 10 (1994), pp. 142–159.
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operating cash flows can turn to the main bank or other keiretsu companies for financing. This avoids the cost or possible bad-news signal of a public sale of securities. Second, when a keiretsu firm falls into financial distress, with insufficient cash to pay bills or fund necessary capital investments, a “workout” can usually be arranged. New management can be brought in from elsewhere in the group, and financing can be obtained, again “internally.”
Hoshi, Kashyap, and Scharfstein tracked capital expenditure programs of a large sample of Japanese firms—many, but not all, members of keiretsus. The keiretsu companies’ investments were more stable and less exposed to the ups and downs of operating cash flows or to episodes of financial distress.45 It seems that the financial support of the keiretsus enabled their members to invest for the long run.
The Japanese system of corporate control has its disadvantages too, notably for outside investors, who have very little influence. Japanese managers’ compensation is rarely tied to shareholder returns. Takeovers are unthinkable. Japanese companies have been particularly stingy with cash dividends; this was hardly a concern when growth was rapid and stock prices were stratospheric but is a serious issue for the future.
Corporate Ownership around the World
The theory of modern finance is most readily applied to public corporations with shares traded in active and efficient capital markets. The theory assumes that stockholders’ interests are protected, so that ownership can be dispersed across thousands of minority stockholders. The protection comes from managers’ incentives, particularly compensation tied to stock price; from supervision by the board of directors; and by the threat of hostile takeover of poorly performing companies.
This is a reasonable description of the corporate sector in the U.S., UK, and other “Anglo-Saxon” countries such as Canada and Australia. But as Germany and Japan illustrate, it is not an accurate description elsewhere. Corporate ownership in Germany is typical of continental Europe. The ownership diagram for a large French company would resemble Figure 34.3.46
The financial architecture of public companies in “Anglo-Saxon” economies may be the exception, not the rule. La Porta, Lopez-de-Silanes, and Shleifer surveyed the ownership of the largest companies in 27 developed countries. They found that “except in economies with very good shareholder protection, relatively few of these firms are widely held. Rather these firms are typically controlled by families or the State,” or in some cases by financial institutions.47
This finding has various possible interpretations. The first is obvious: Protection for outside minority stockholders is a prerequisite for dispersed ownership and a broad and active stock market. Second, in countries that lack effective legal protection for minority stockholders, concentrated ownership may be the only feasible financial architecture.
45T. Hoshi, A. Kashyap, and D. Scharfstein, “Corporate Structure, Liquidity and Investment: Evidence from Japanese Industrial Groups,” Quarterly Journal of Economics 106 (February 1991), pp. 33–60, and “The Role of Banks in Reducing the Costs of Financial Distress in Japan,” Journal of Financial Economics 27 (September 1990), pp. 67–88.
46See J. Franks and C. Mayer, “Corporate Ownership and Control in the U. K., Germany and France,”
Journal of Applied Corporate Finance 9 (Winter 1997), pp. 30–45.
47R. La Porta, F. Lopez-de-Silanes, and A. Shleifer, “Corporate Ownership around the World,” Journal of Finance 59 (April 1999), pp. 471–517.
We started with LBOs. An LBO is a takeover or buyout financed mostly with debt. |
SUMMARY |
The LBO is owned privately, usually by an investment partnership. Debt financing |
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is not the objective of most LBOs; it is a means to an end. Most LBOs are diet deals. |
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The cash requirements for debt service force managers to shed unneeded assets, |
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improve operating efficiency, and forego wasteful capital expenditure. The man- |
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agers and key employees are given a significant equity stake in the business, so |
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they have strong incentives to make these improvements. |
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Leveraged restructurings are in many ways similar to LBOs. Large amounts of |
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debt are added and the proceeds are paid out. The company is forced to generate cash |
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to cover debt service, but there is no change in control and the company stays public. |
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Most investments in LBOs are made by private equity partnerships. We called |
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these temporary conglomerates. They are conglomerates because they assemble a |
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portfolio of companies in several unrelated industries. They are temporary because |
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the partnership has limited life, usually about 10 years. At the end of this period, |
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the partnership’s investments must be sold or taken public again in IPOs. Private |
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equity funds do not buy and hold; they buy, fix, and sell. Investors in the partner- |
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ship therefore do not have to worry about wasteful reinvestment of free cash flow. |
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LBO managers know that they will be able to cash out their equity stakes if their |
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company succeeds in improving efficiency and paying down debt. |
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The private equity partnership (or fund) is also common in venture capital and |
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other areas of private investment. The limited partners, who put up almost all of |
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the money, are mostly institutional investors such as pension funds, endowments, |
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and insurance companies. The limited partners are first in line when the partner- |
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ship’s investments are sold. The general partners, who organize and manage the |
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fund, get a carried interest in the fund’s profits. |
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The private equity market has been growing steadily. In contrast to these tempo- |
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rary conglomerates, public conglomerates have been declining in the United States. |
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In public companies, unrelated diversification seems to destroy value—the whole is |
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worth less than the sum of its parts. There are two possible reasons for this conglom- |
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erate discount. First, the value of the parts can’t be observed separately and it is diffi- |
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cult to set incentives for divisional managers. Second, conglomerates’ internal capital |
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markets are inefficient. It is difficult for management to appreciate investment op- |
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portunities in many different industries, and internal capital markets are prone to |
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overinvestment and cross-subsidies. The difficulties of running internal capital mar- |
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kets are not restricted to pure conglomerates, but they are most acute there. |
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Of course corporations shed assets as well as acquire them. Divisions are di- |
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vested by asset sales, carve-outs, or spin-offs. These divestitures are generally good |
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news to investors; it appears that the divisions are moving to better homes, where |
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they can be better managed and more profitable. The same improvements in effi- |
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ciency and profitability are observed in privatizations, which are spin-offs or |
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carve-outs of businesses owned by governments. |
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Although conglomerates are a declining species in the United States, they are |
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common elsewhere, particularly in emerging economies. An internal capital mar- |
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ket can make sense when a country’s financial markets are not well developed. Di- |
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versification also brings scale, which may make it easier to attract professional |
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management, to gain access to international financial markets, or to gain political |
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power in countries where the government tries to manage the economy or where |
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laws and regulations are erratically enforced. |
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We wonder, though, whether some of these emerging-market conglomerates |
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will be temporary rather than permanent. In a rapidly growing and modernizing |
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CHAPTER 34 Control, Governance, and Financial Architecture |
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A. Shleifer and R. Vishny: “A Survey of Corporate Governance,” Journal of Finance, 52:737–783 (June 1997).
Here are five useful articles on corporate finance in Germany and Japan:
S.Prowse: “Corporate Governance in an International Perspective: A Survey of Corporate Control Mechanisms among Large Firms in the U.S., U.K., Japan and Germany,” Financial Markets, Institutions, and Investments, 4:1–63 (1995).
J.Franks and C. Mayer: “Ownership and Control of German Corporations,” Review of Financial Studies, 14:943–977 (Winter 2001).
T.Jenkinson and A. Ljungqvist: “The Role of Hostile Stakes in German Corporate Performance,” Journal of Corporate Finance, 7:397–446 (December 2001).
D.E. Logue and J. K. Seward: “Anatomy of a Governance Transformation: The Case of Daimler-Benz,” Law and Contemporary Problems, 62:87–111 (Summer 1999).
E.Berglof and E. Perotti: “The Governance Structure of the Japanese Keiretsu,” Journal of Financial Economics, 36:259–284 (October 1994).
Here are some interesting case studies pertinent to this chapter.
J.Allen: “Reinventing the Corporation: The Satellite Structure of Thermo Electron,” Journal of Applied Corporate Finance, 11:38–47 (Summer 1998).
R. Parrino: “Spinoffs and Wealth Transfers: the Marriott Case,” Journal of Financial Economics, 43:241–274 (February 1997).
C. Eckel, D. Eckel, and V. Singal: “Privatization and Efficiency: Industry Effects of the Sale of British Airways,” Journal of Financial Economics, 43:275–298 (February 1997).
B.Burrough and J. Helyar: Barbarians at the Gate: The Fall of RJR Nabisco, Harper & Row, New York, 1990.
G. P. Baker: “Beatrice: A Study in the Creation and Destruction of Value,” Journal of Finance, 47:1081–1120 (July 1992).
D. J. Denis: “Organizational Form and the Consequences of Highly Leveraged Transactions,” Journal of Financial Economics, 36:193–224 (October 1994).
1. Define the following terms: (a) LBO, (b) MBO, (c) spin-off, (d) carve-out, (e) asset sale, QUIZ
(f) privatization, and (g) leveraged restructuring.
2.True or false?
a.One of the first tasks of an LBO’s financial manager is to pay down debt.
b.Once an LBO or MBO goes private it almost always stays private.
c.Privatizations are generally followed by massive layoffs.
d.On average, privatization seems to improve efficiency and add value.
e.Targets for LBOs in the 1980s tended to be profitable companies in mature industries.
f.“Carried interest” refers to the deferral of interest payments on LBO debt.
g.By the late 1990s, new LBO transactions were extremely rare.
3.What are the government’s motives in a privatization?
4.a. List the disadvantages of a traditional conglomerate in the United States.
b.What advantages might a conglomerate have in other countries, particularly lessdeveloped economies? List some examples.
5.What are the chief differences in the role of banks in corporate governance in the United States, Germany, and Japan?
6.What is meant by a “temporary conglomerate”? Give an example.
