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Corporate
Conglomerates Corporate conglomerates
have received an increasingly bad press both in the business world and
in academic research. They
are deemed to be wasteful and inefficient in allocating resources. In
the wake of a merger, conglomerates’ shares trade at an average
discount of 13–15%. However, merger and acquisition activity proceeds
relentlessly, with around 40% succeeding. This variation in performance
has attracted the attention of researchers, who are now trying to
understand its reasons. What are the factors that lead 40% of mergers to
succeed? Is the recent merger-mania an attempt to imitate the
‘winners’? What are the
consequences of this merger wave for internal and external capital
markets? These
were the questions discussed at a joint CEPR/CSEF Conference on ‘Core
Competencies, Diversification and the Role of Internal Capital
Markets’, which took place at the Istituto Italiano degli Studi
Filosofici in Naples on 28/30 January 1999. The existing literature
largely focuses on corporate governance (how external investors can
discipline both controlling shareholders and management), and on the
boundaries of the firm (what should be managed inside a firm and what
should be left to the markets). The papers presented in the conference
mark a shift in focus from external to internal capital markets. Instead
of posing the question of the external control mechanisms and boundaries
of the firm, the conference focused on the mechanisms of the capital
budgeting decision within organizations. The analysis concentrated
mainly on the case of conglomerate corporations, where the allocation of
capital across divisions is the main activity of headquarters. Other
cases were also discussed, such as leverage buy out associations and
venture capital. The conference revolved
around two main (related) themes: how the incentive problems that arise
in organizations affect the rules used to allocate capital internally,
and what are the cost and benefits of conglomerate corporations. An
immediate implication of the incentive constraints under which capital
must be allocated internally is that a simple rule, such as net present
value (NPV) maximization, may fail to be the efficient criterion to use
for corporate headquarters. The paper by Elazar Berkovitch (Tel Aviv University) and Ronen Israel (University of Michigan), entitled ‘Why the NPV
Criterion Does not Maximize the NPV’, shows how NPV criterion can
fail, if divisional managers have more information than headquarters
about the relative merits of alternative projects and their incentives
are not perfectly aligned with shareholders’ value maximization. In
these situations, alternatives, such as the Internal Rate of Return, the
Profitability Index or other statistics, may produce a better allocation
criterion than NPV maximization. The
tension between these conflicting objectives – eliciting information
from various units within the company and providing them with incentives
to exert effort – was also illustrated by the paper by Robert
Gertner (University of Chicago) on ‘Coordination, Dispute
Resolution, and the Scope of the Firm’. He studied how the conflict is
modified by changing the allocation of control rights within the
organization. In his model, two units need to coordinate on a decision
such as the design of a new product. Each unit has private information
about its own input. The question is, under which structure are the two
units willing to share information efficiently in order to implement the
value maximizing design? Gertner’s results suggest that organizations
where both units report to a manager entrusted with the allocation of
capital achieve more information sharing than those where there is a
direct contractual relationship between the units.
In
certain circumstances, however, contracts may turn out to be a
preferable arrangement. In
his paper on ‘Financing Mechanism and R&D Investment’,
co-authored by Haizhou Huang
(IMF), Chenggang Xu (London
School of Economics and HIID, Harvard University) suggested that the
efficiency of the venture capital mechanism in financing R&D
investments may lie in its contractual foundation for soft budget
constraints. A second group of papers
shed light on the costs and benefits of conglomerates and other
diversified organizations such as universal banks. Understanding these
costs and benefits is crucial to determining the motivations behind the
current wave of mergers. First
among the benefits stands the conglomerates’ superior ability in
taking advantage of deregulation and technological advances: being
well-diversified across markets, this mode of organization possesses the
option value of being in a market ‘before the others’. This option
may be more valuable at times of great technological progress, and this
can help explain the current merger-mania. This argument was offered by Arnoud
Boot (Universiteit van Amsterdam and CEPR) with special reference to
banking and financial conglomerates in his paper on ‘Expansion of
Banking Scale and Scope: Don’t Banks Know the Value of Focus?’
co-authored with Todd Milbourn
(London Business School) and Anjan Thakor. In the discussion it was
pointed out that the model might be more suited to non-financial
companies than to the financial sector, where technical innovation has
been comparatively limited. A
second benefit of merger activity is directly related to the efficiency
of internal capital markets. This theme, which connects directly with
the contributions of the first set of papers discussed above, was
highlighted by Zsuzsanna Fluck
(Stern School of Business, New York University) in her paper with
Anthony W. Lynch on ‘Why Do Firms Merge and Then Divest: A Theory
of Financial Synergy’. They develop a model where, in the presence of
agency costs, mergers can increase efficiency in the allocation of
capital across companies. In their view, a conglomerate merger is a
technology that allows the financing of marginally profitable projects
which, because of agency problems, would not otherwise be financed.
Interestingly, the model predicts that merger activity would not proceed
unchecked; external pressure by capital markets is predicted to lead
conglomerates to dispose of projects which have already been financed
and are able to proceed more profitably as standalone companies. It
is generally argued that a third benefit of mergers derives from the
fact that diversification creates value. Synergies that arise from the
merger of two or more firms can lead to cost reductions, to higher and
more stable demand, to the ability to organize activities more
efficiently, and to the exploitation of a greater range of
opportunities. The value of diversification is at the heart of the paper
by Arnoud W. Boot (Universiteit van Amsterdam and CEPR) and Anjolein
Schmeits (Washington University) on ‘Market Discipline and
Incentive Problems in Conglomerate Banks’. In their model, the cost of
capital reflects the company’s risk, implying that a conglomerate –
and in particular a conglomerate bank – benefits from a lower cost of
capital because of diversification, other things being equal. However,
Boot and Schmeits show that other things are not equal: because
diversification also allows cross-subsidies and free riding between
divisions in a conglomerate, the cost of capital ends up holding an
ambiguous relationship with risk-taking. The
unpleasant side-effects of synergies were central to the paper by Raghuram
Rajan (University of Chicago), Henri Servaes and Luigi Zingales on
‘The Cost of Diversity: The Diversification Discount and Inefficient
Investment’, where the attempt to exploit these synergies may actually
impose considerable costs. Rajan explained that it could be very
expensive to exploit synergies when the incentives of different
divisions are not aligned: the friction between divisions can lead them
to forfeit value-enhancing investments that would potentially make them
more dependent upon each other. To persuade the divisions to proceed
with investments that require them to integrate their operations,
corporate headquarters need to make transfers among divisions to align
their incentives. As a result, the benefit of the synergies can only be
reaped at the cost of distorting the allocation of resources in internal
capital markets, allocating a disproportionate amount of funds to less
profitable divisions in order to ‘bribe’ them into cooperating with
the others. Further
implications of the emergence of conglomerates are the extent of market
power they are able to exercise and their ability to span various
interrelated markets. This point is emphasized in the paper by
Oved Yosha (Berglas School of Economics, Tel Aviv University and
Bank of Israel), Hedva Ber and Yishay Yafeh on ‘Conflict of Interest
in Universal Banking: Bank Lending, Stock Underwriting and Fund
Management’. Based on the analysis of a panel data set on Israeli
banks, the authors find that the hypothesis that bank conglomerates use
their market power to overprice the stocks they sell to their own mutual
funds (thus inflicting a cost on investors in those funds) could not be
rejected. There are essentially two
questions that the conference left for further research: First,
because of time constraints in processing information a lot of capital
allocation is inevitably delegated to financial intermediaries and
corporate headquarters within organizations.
What we need to understand better is the extent to which the
market achieves an efficient level of decentralization and how incentive
problems and corporate politics disrupt the process of capital
allocation. More research is needed on the design of internal
organizations for the effective allocation of capital within
multidivisional firms. The
scope of investigation must be broadened beyond the allocation of
capital to include the allocation of human resources and other inputs.
The allocation of human resources is the least studied. This is partly
because little systematic research has been done to identify empirical
facts on human resource management. These issues clearly go beyond the
narrow boundaries of economic analysis. What emerged from the
discussions during the conference is that a theory that attempts to
explain capital budgeting also has to take into account issues related
to the sociology of organizations. Politics, power, authority and
leadership, which influence behaviour at the top of an organization, all
play an important role when trying to understand internal capital
markets. Second,
the relationship between internal and external capital markets needs to
be investigated further. The existing literature has shown how external
capital markets may impose some discipline on insiders, thus shaping
corporate governance. Contributions at this conference have instead
shown how organizations determine the allocation of capital across
alternative uses via internal capital markets, taking the external
constraints on chief executive officers (CEOs) as given. In fact,
external investors can influence the appointment and removal of CEOs,
therefore affecting how they allocate capital within a conglomerate
company. The power and authority of the CEO within the organization
ultimately rests upon these external factors. Hence the next step must
be to understand how the two decision mechanisms – internal and
external capital markets – interact with each other. |