The Market for Corporate Control and Recent Changes in Corporate Governance • 89
CEOs who undertake acquisitions appear to benefit. Chris Avery, Judy Chevalier, and Scott Schaefer, for example, found that CEOs who undertake acquisitions are more likely to be appointed to other firms’ boards of directors.21 If CEOs value such appointments, they may wish to pursue acquisitions in order to secure them.
Managers may pursue unrelated acquisitions in order to increase their compensation. Robert Reich wrote:
When professional managers plunge their companies deeply into debt in order to acquire totally unrelated businesses, they are apt to be motivated by the fact that their personal salaries and bonuses are tied to the volume of business their newly enlarged enterprise will generate.22
Evidence on this point is mixed. It is true that executives of larger firms earn higher compensation, but this does not imply that a given executive can increase compensation through diversification. Moreover, most executive compensation includes substantial stock and options; diversification that reduces firm value will automatically reduce compensation.
Although diversification is not a useful way to reduce investor risk, it may lessen managerial risk. Yakov Amihud and Baruch Lev observe that shareholders are unlikely to replace top management unless the firm performs poorly relative to the overall economy. 23 By diversifying their firm, managers limit the risk of extremely poor overall profitability, which helps protect their jobs. This is not necessarily a bad thing for the owners of the diversified company—managers may be willing to accept lower wages in exchange for job security.
Problems of Corporate Governance
Managerial motives for diversification rely on the existence of some failure of corporate governance—that is, the mechanisms through which corporations and their managers are controlled by shareholders. If shareholders could (1) determine which acquisitions will lead to increased profits and which ones will not and (2) direct management to undertake only those that will increase shareholder value, the possibility of managerially driven acquisitions would disappear.
In practice, however, neither condition (1) nor condition (2) is likely to hold. First, it is unlikely that shareholders can easily determine which acquisitions will increase profits and which ones will not. Typically, shareholders have neither the expertise nor the information to make such determinations. Second, even if shareholders do disagree with management’s decisions, they may find it difficult to change those decisions. Formally, boards of directors are charged with the responsibility of monitoring management to ensure that actions are taken to increase shareholder value. However, many authors, including Benjamin Hermalin and Michael Weisbach, have suggested that CEOs may exercise considerable control over the selection of new directors.24
THE MARKET FOR CORPORATE CONTROL AND RECENT CHANGES IN CORPORATE GOVERNANCE
If diversification is driven in part by managerial objectives, what forces work to keep managers focused on the goals of owners? Henry Manne suggests that the “market for corporate control” serves as an important constraint on the actions of managers.25
90 • Chapter 2 • The Horizontal Boundaries of the Firm
Manne’s argument is as follows. Managers who undertake acquisitions that do not serve the interests of shareholders will find that their firms’ share prices fall, for two reasons.
First, if a manager overpays for a diversifying acquisition, the value of his or her firm will fall by the amount of the overpayment. Second, if the stock market expects the firm to overpay for additional acquisitions in the future, the market price of the firm’s shares will fall today in expectation of these events. This disparity between the firm’s actual and potential share prices presents an opportunity for another entity (either an individual, another firm, or a specialist investment bank) to try a takeover. A potential acquirer can purchase control of the firm simply by buying its shares on the market. With a sufficiently large block of shares, the acquirer can vote in its own slate of directors and appoint managers who will work to enhance shareholder value. The acquirer profits by purchasing shares at their actual value and then imposing changes that return the shares to their potential value. Note that the market for corporate control can serve to discipline managers even without takeovers actually occurring. If an incumbent manager is concerned that he or she may lose his or her job if the firm is taken over, he or she may work to prevent a takeover by keeping the firm’s share price at or near its potential value.
Michael Jensen argues that the market for corporate control was in full swing during the wave of leveraged buyout (LBO) transactions observed in the 1980s. Jensen claims that firms in many U.S. industries had free cash flow—that is, cash flow in excess of profitable investment opportunities—during this period. Managers elected to invest this free cash flow to expand the size of the business empires they controlled, both by undertaking unprofitable acquisitions and by overexpanding core businesses. Given that these investments were unprofitable, Jensen reasons that shareholders would have been better served had the free cash flow been paid out to them in the form of dividends. In an LBO, a corporate raider borrows against the firm’s future free cash flow and uses these borrowings to purchase the firm’s equity. Such a transaction helps the firm realize its potential value in two ways. First, since the number of shares outstanding is greatly reduced, it is possible to give the firm’s management a large fraction of its equity. This improves incentives for management to take actions that increase shareholder value. Second, since the debt must be repaid using the firm’s future free cash flow, management no longer has discretion over how to invest these funds. Management must pay these funds out to bondholders or risk default. This limits managers’ ability to undertake future acquisitions and expand core businesses.
The LBO merger wave ended rather abruptly around 1990. Holmstrom and Kaplan attribute this development to changes in corporate governance practices since the mid-1980s.26 They point out that firms increased CEO ownership stakes (dramatically, in many cases) and introduced new performance measures that forced an accounting for the cost of capital (such as Economic Value Added). In addition, large shareholders such as pension funds began to take a more active role in monitoring managers. These recent changes in corporate governance practices may serve to constrain managers’ actions without relying on corporate takeovers.
PERFORMANCE OF DIVERSIFIED FIRMS
Although we have discussed why diversification may be profitable, many academics and practitioners remain skeptical of the ability of diversification strategies to add value. Michael Goold and Kathleen Luchs, in their review of 40 years of diversification, sum up the skeptics’ viewpoint:
Performance of Diversified Firms • 91
Ultimately, diversity can only be worthwhile if corporate management adds value (emphasis added) in some way and the test of a corporate strategy must be that the businesses in the portfolio are worth more than they would be under any other ownership.27
Studies of the performance of diversified firms, undertaken from a variety of disciplines and using different research methods, have consistently failed to find significant value added from diversification. And whereas the BCG model encourages diversified firms to use the profits from cash cows to fuel the growth of rising stars, in reality diversified firms end up underinvesting in their strongest divisions. This may be due to influence activities, a central issue in diversified firms that we postpone discussing until Chapter 3. Simply put, the overall performance of diversified firms lags behind more focused companies; that is, diversified firms usually fail the Goold/Luchs test of corporate strategy that we quoted above. This helps explain why it is often quite profitable for corporate “raiders” to purchase a conglomerate and sell off its unrelated business holdings.
Many well-known and respected firms have fallen victim to the inefficiencies of diversification. Consider Beatrice, which once owned Avis Rent-a-Car, Samsonite Luggage, and Dannon yogurt; the Daewoo Group, which once sold eponymous automobiles and consumer electronics, as well as oil tankers and textiles; and Nueva Rumasa, the Spanish business group whose business empire included yogurt and ice cream, hotels, wine and spirits, real estate management, and a soccer team. Beatrice, which ranked 35th on the 1980 Fortune 500, was split up after a hostile takeover by Kohlberg Kravis Roberts in 1986. Daewoo, once the second largest conglomerate in South Korea, went bankrupt in 1999. In 2011, Nueva Rumasa, one of Spain’s largest conglomerates, had to sell off several of its businesses to avoid bankruptcy.
Many successful firms have experienced trouble when diversifying from their core businesses. Microsoft has made unsuccessful forays into PDAs, music players, and television (with the MSNBC cable network). The road to bankruptcy for Circuit City, once the largest electronics retailer in the United States, began when it rapidly expanded its CarMax used car subsidiary and accelerated when it launched the DIVX video disc format as an alternative to DVD. Example 2.6 describes the problems that arose at Haier—China’s largest consumer electronics firm—when it diversified away from its core portfolio of businesses.
The early evidence on diversification offered by management scholars was fairly conclusive that diversified firms underperformed more focused firms in the 1980s. Other research consistently finds that the overall shareholder value is increased when conglomerates split up. But this does not automatically imply that diversification is unprofitable. From a theoretical perspective, there are genuine benefits of scope economies and the use of internal capital markets. As an empirical matter, we must remember the statistical adage that correlation does not imply causality. The firms that diversify may have been underperformers regardless of diversification. And more recent research finds that the stock market reacted positively to diversifying acquisitions in the 1990s.
It is too simplistic to conclude that “diversification sometimes works and sometimes doesn’t.” When firms believe they have found a money-making opportunity by diversifying, the market reacts positively. And the market also reacts positively when conglomerates stem losses by shedding business units that are better off as stand-alone firms. In other words, when it comes to the question of whether firms should diversify, the answer is “yes, but only when the economics make sense.”
92 • Chapter 2 • The Horizontal Boundaries of the Firm
EXAMPLE 2.6 HAIER: THE WORLD’S LARGEST CONSUMER APPLIANCE
AND ELECTRONICS FIRM
It may be surprising to learn that the world’s top-selling brand of consumer appliances and electronics is not Bosch or Sony or General Electric. That honor goes to the Haier Group, a Chinese firm with 70,000 employees and annual revenues of $20 billion. Those familiar with the Haier Group may be even more surprised that less than two decades ago the firm was in the midst of a disastrous diversification strategy with corporate tentacles reaching into pharmaceuticals, restaurants, and many other unrelated businesses. Haier’s success today is due to a corporate decision to narrow its reach, to retrench from diversification.
Haier is headquartered in Shandong where it started life in the 1920s as a refrigerator manufacture. Haier was turned into a stateowned enterprise after the establishment of the People’s Republic of China in 1949, and for a long time thereafter the firm suffered from inadequate capital investment, poor management, and a lack of quality control. The company’s fortunes changed in 1985 when the local government appointed Zhang Ruimin as the managing director.
Zhang’s first step was to implement strict quality control, a notion that seemed foreign to Chinese workers. According to one story, after a customer complained about a faulty refrigerator, Zhang went through the entire inventory and found that 76 out of 400 refrigerators were defective. Zhang lined up the 76 refrigerators, distributed sledgehammers to employees, and ordered them to join him in destroying them. What makes this truly remarkable is that at the time, one refrigerator cost about 2 years’ worth of wages for the average Chinese worker. Through this emphasis on quality, Haier became one of the first Chinese brands to establish a reputation for quality; within China, Haier was known for its “zero-defect” refrigerators.
Recognizing the benefits of quality control in related markets and eager to leverage its brand, Haier started diversifying by acquiring other home appliance companies. By the early
1990s, Haier was China’s largest seller of washing machines and air conditioners and was ranked third in freezers. By mid-decade, Haier was exporting into the international market. Flush with success, Zhang set his sights on turning Haier into the “GE” of China, and adopted a more aggressive diversification strategy. Beginning in 1995, Haier acquired or launched businesses in such far-flung industries as pharmaceuticals, televisions, personal computers, software, logistics, and financial services. But Haier’s magic touch with home appliances did not reach into these new industries. For example, in 1995 the nutritional supplement market of China was booming, and Haier decided to build a “Kingdom of Health Products.” Its first step was to introduce Cai Li Oral Solution. But Haier’s management knew very little about the health products market and lacked the expertise to do appropriate consumer research. So it chose to mimic the business model and marketing strategy of “San Zhu,” one of the most popular nutritional supplement products in the market. Cai Li never bested San Zhu in sales, and when the supplement market proved to be a fad, Haier pulled Cai Li from the market. Haier faced similar problems in the pharmaceutical sector, failing to produce a single blockbuster product. In 2007, Haier sold its pharmaceutical division to a company in Hong Kong.
Haier even ventured into fast food, launching the “Dasaozi” Noodle House in its headquarters city of Qingdao and then spreading nationwide. Haier positioned Dasaozi as a budget fast-food franchise, in stark contrast with its reputation for high quality in appliances. Dasaozi enjoyed limited success in Qingdao, but confusion about the brand kept customers in other cities away. Today, Dasaozi operates only in Qingdao. This story has repeated itself in other industries; today, Haier remains focused on consumer appliances and electronics, having learned some painful lessons about unrelated diversification.