A Culture of Paper Tigers

...The justifications for greenmail are equally suspect: executives and directors argue that predators don't understand the business and, once in control, would diminish its value...

...They speak of wondrous gains from "synergy," the dynamic effects of pooled management upon what were formerly independent firms, making the whole greater than the sum of the parts...

...Eventually he will win big...

...These loans are backed by the company's assets...

...The proferred justification is dubious: such insurance is thought essential to preserve the executive's impartial judgment about hostile takeover bids...

...Here again, the proferred justification is oddly inconsistent with our inherited notions about the function and purpose of the corporation...

...The argument is that once managers' wealth is tied up in the company, they will become more efficient and improve the firm's performance...

...All of these asset-rearranging techniques require the ubiquitous skills of accountants and lawyers...

...and he can always make another bet...

...Investors expropriate other investors' wealth by trading on inside information...

...Nothing so focuses the corporate mind as threat of bankruptcy...

...By the end of 1988 one-quarter of all new private-sector jobs in New York City and more than a third of all its new office space were devoted to paper professionals engaged in rearranging assets...

...Top executives are fired, or they are lured to other newly rearranged corporations...

...Within a year, revenues in Wall Street brokerage houses plunged $600 million...

...The Brookings Institution, not known for its alarmist rhetoric, undertook to examine the effects on corporate America of a recession WINTER • 1990 • 63 Culture In an Age of Money similar in severity to that which rocked the nation in 1974 and 1975...

...The Brookings computer simulation revealed that, with the levels of debt prevailing in the late 1980s, one in ten American firms would succumb to bankruptcy...

...By this view, proper entrepreneurialism is a form of antiseptic, washing away encrusted layers of managerial bureaucracy...

...No longer...

...It was exactly as if we had all crowded into Vegas for a long binge...

...America has become a second-rate power, Gekko tells the Teldar shareholders...

...Michael Milken, of Drexel Burnham, earned, we now know, $550 million in 1988, a sum that exceeded the total amount spent by the United States in the search for a cure for AIDS...

...Independence" to today's business graduate means working for McKinsey instead of for General Motors...

...Over the decade, the average incomes of paper entrepreneurs grew 21 percent, compared with a 7 percent rise in the incomes of everyone else...

...The dollar value of trading in stock index options and futures—bets on how bundles of stocks will move—was five times that of the trades in shares of stock...

...In 1978 mergers and acquisitions accounted for less than 5 percent of the profits of Wall Street brokerage houses...

...As those engaged in rearranging the slices of the pie become more numerous and far more wealthy than those dedicated to enlarging the pie, social tranquility is threatened...

...Securities analysts and brokers likewise hope to show profits by correctly guessing the short-term fluctuation of price-earning multiples instead of the long-term potential for growth...

...It was happily anticipated that the bonds of newly bankrupt companies could be purchased for a small fraction of their face values and new shares issued to the remaining creditors...

...During the entire year, some 12 percent of the listed shares were exchanged and, on average, held eight years before being resold...

...Truncated vision is due, in part, to the 62 • DISSENT Culture hi an Age of Money necessity of repaying huge loans used to finance such asset rearrangements...

...There are other, far less debilitating remedies, like competition for markets...

...Portfolio managers frantically bid against one another to take advantage of small upticks or downblips in this vast casino, betting pension funds or mutual funds in which Americans had placed their savings...

...Undoubtedly, American business needs a good housecleaning...

...The logic suggests that the only way stockholders can trust corporate executives not to feather their nests at the stockholders' expense is to provide them a prefeathered nest at the stockholders' expense...

...For at least fifty years it had been assumed that public ownership of stocks assured that America's major corporations were well managed and that public trading in such stocks guaranteed that investors received fair value...

...Deals thus have become more plentiful and larger...

...Whole departments of investment banks scan corporate America for WINTER • 1990 • 59 Calton in an Age of Mow businesses ripe for the plucking...

...Texaco and Pennzoil feuded over Getty Oil Company for almost three years...

...Obscene Profits, Obscure Activity Through all this, the historic relationship between product and paper has been turned upside down...

...Deal making has prdved particularly lucrative, because every time industrial assets are rearranged, paper professionals earn money...

...During an average day in 1988, by contrast, 200 million shares exchanged hands...

...Risk-taking and initiative are proving to be better stimuli to growth than are directives from the top...

...Paper entrepreneurialism not only reflects how we do business, it reflects how we think about business...

...But it also creates substantial danger should the economy sputter and interest payments be missed...

...The larger and more complex the escapade, the more money they earn...

...For several months there were poignant stories of $200,000-a-year investment bankers suddenly forced to sell their East-Side duplexes...

...The Art of the Deal And profitable it has been...

...On the management side, the motivation is similar...

...The prospective sales of the food and tobacco businesses would earn investment bankers an additional $100 million...

...The leading edge of American jurisprudence is found in such fields as securities and tax law, where piles of arcane pleadings and truckloads of depositions now inundate our courtrooms and preoccupy squadrons of lawyers, overworked clerks, and despairing judges...

...Average stock prices have barely risen...

...They thus regarded International Nickel's act as hostile, as it in fact was—the first in a long and not-sodistinguished line of unfriendly initiatives...

...The result is a "brain drain" from product to paper...

...But within a year, the forward thrust of the M&A business was restored...

...Divisiveness: An economy based on asset rearranging has a final disadvantage...

...Golden parachutes are nothing more than generous severance payments, often totaling large multiples of an executive's annual salary and bonus, which are awarded—the parachute opens automatically, as it were—when the takeover becomes successful...

...Were the antitrust laws enforced against mergers that reduce competition—such as General Foods' recent acquisition of Kraft—managers would have to stay on their toes in order to preserve their company's market share...

...Twenty-five years ago the titans of American industry were chief executive officers of major industrial corporations...

...Between 1977 and 58 • DISSENT Culture in an Ago of Money 1987 employment in the securities industry doubled—increasing by an average of 10 percent a year, compared to average yearly job growth of 1.9 percent in the rest of the economy...

...The Street had to forage for new sources of earnings, and hostile takeovers looked like just the place to start...

...Most of this is nonsense or worse...

...The International Nickel Company decided to buy up enough shares in the Electric Storage Battery Company to gain control over the board of directors of Electric Storage and thus allow International Nickel to effectively run the company...

...As trust declines, the pie may actually shrink...

...But this logic suggests that the same managers have been grossly deficient in the past, failing to act in the stockholders' best interests...

...Defenders of such escapades also claim that asset-rearranging is no mere speculative game but a means by which the financial market ensures that resources are available for new enterprise...

...Wasted talent: Asset rearranging also harms productivity by using up the energies of some of our most talented citizens...

...Investment banks are replacing the publicly held industrial corporations as the largest and most powerful economic institutions in America...

...Either way, the logic suggests that the current executives and directors are doing a superb job, and only they are fit to judge how superb...

...Greed, he says, is all we have left...

...More plentiful: In 1960 an average of three million shares of stock were traded daily on the New York Stock Exchange...

...Today, as in the late nineteenth century, they are investment bankers...

...The record of the 1970s and 1980s is dismally clear...

...Today 70 percent of corporate stock is bought and sold by professional portfolio managers of mutual funds, pension funds, and insurance companies...

...Forget the niceties...

...This is precisely what has occurred...

...Average real wages (controlled for inflation) have stagnated...

...Throughout the world we are witnessing the triumph of capitalism over centrally planned economies...

...But greed, he continues, is good...

...The ransom money comes ultimately from the same stockholders who are being courted by the predator...

...Out of a recent graduating class of 721 at the Harvard Business School, a grand total of seven reported that they had gone on to start ventures of their own...

...As recently as 1974, it was not this way...

...One wing of the Metropolitan Museum of Art is named after its benefactor, Henry Kravis...

...Thus, there has emerged a strong interest in doing deals...

...Apologists of such antics argue that they are justified by economic fundamentals...

...Worse still, especially for workers in dying industries like auto and steel, it is an economy in which the victors' pyrryhic sense of triumph is not very different from that of the T-shirt slogan that became so popular in the days following the stock market crash of 1987, "Whoever dies with the most toys wins...

...They thus make a bundle...

...Just three years later, the newly merged company became the object of a mammoth contest between armies of investment bankers pledging billions of dollars for the privilege of breaking it up once again...

...It would be a sad irony if the nation that became a model for the social benefits of capitalism succumbed to the zeal of a group of entrepreneurs more intent on rearranging paper than on creating real value...

...Ninetynine percent of Wall Street's exuberance pertained to shares of stock already in circulation, which became objects of titillating rumor...

...Investment banks had already amassed funds for "deleveraged buyouts," the purpose of which would be to do the reverse of what had been done during boom times—this time, reduce the debt load and increase the shares of stock...

...These managers must do more than invest for the future—they must also attract and keep clients...

...Besides, there was no reason for such shenanigans...

...Should the economy suddenly fall into recession or worse, no matter...

...As has been suggested, high leverage creates extraordinary opportunities for profit...

...The financial complexities were dazzling, but the underlying principle was straightforward...

...Corporate borrowers utilizing high-yield ("junk") bonds expropriate the wealth of other bondholders, and of employees, by suddenly subjecting the entire enterprise to greater risk...

...But what has happened over the last decade has been counterproductive rather than productive...

...White knights, poison pills, and further exotica also help incumbent management ward off unfriendly predators...

...In the 1970s, it was 33 cents...

...Gekko is depicted as a Wall Street villain, but his real-life counterparts, the Ivan Boeskys and Michael Milkens, have neither behaved nor sounded very differently from him...

...By the close of the 1980s, paper entrepreneurs were preparing to make money on the pending collapse...

...Research aimed at developing fundamentally new technologies is apt to go slowly, yielding little or no profit for many years...

...One didn't just take over a company...

...Problems with the Paper Economy I do not want to suggest that all efforts directed at rearranging corporate assets are necessarily wasteful...

...The development of the internal combustion engine, electronics, xerography, and semiconductors each depended on a quarter century or more of trial and error...

...This was, after all, the lesson we were supposed to have learned in the 1920s, when America last went on a speculative spree: there are few adventures more thrilling than gambling in the stock market with someone else's money and few more dangerous to the overall economy...

...Then Wall Street's other shoe fell...

...Never have so few exercised so much power over how the slices of the American pie are rearranged...

...By the end, Texaco had paid over $60 million to lawyers...

...And through it all, they exhibit faith—endless faith, indomitable faith—in the hidden, potential value of the assets being purchased, relative to the price they currently fetch on the stock market...

...Most of our top corporate executives are trained in law and finance—in contrast to three decades ago, when most were trained in marketing, engineering, and sales...

...Without the parachute, so the argument goes, the executive would be tempted to fight the takeover even if it were in the best interests of the stockholders...

...Trust declines...

...Merger and advisory fees" added another $150 million...

...In that year an economic turning point, of sorts, occurred...

...Today's corporate executives spend an increasing portion of their days fending off takeovers, finding companies to acquire, and responding to depositions in lawsuits...

...A new field of consultancy has grown up in recent years, euphemistically deemed "earnings management," which consists of the strategic use of accounting conventions— redistributing income from good years to bad, recognizing profits in advance of sales, and similar innovations...

...Executives expropriate the wealth of stockholders by paying greenmail to would-be acquirers or by undertaking a leveraged buyout and then reselling the company at a higher price...

...In effect, most Americans unknowingly were engaged in continuous bidding against one another (and, if their money was entrusted to more than one fund manager, as was often the case, against WINTER • 1990 • 61 Culture in an Age of Money themselves...

...In 1987 General Electric cut its research spending by 8 percent...

...Paper entrepreneurs now embody the nation's most original economic thinking and energetic wheeling and dealing...

...With high leverage, small improvements in operating 60 • DISSENT Culture In an Age of Money performance can dramatically increase the value of a tiny equity base...

...Since 1980, the average large corporation has been paying more than 50 cents of every dollar of pretax earnings in interest...

...Each of the partners of KKR earns about $70 million a year...

...But paper entrepreneurs typically require that investments pay off in the short term at the expense of greater yields later on...

...Pennzoil, $400 million...

...A recent study undertaken by the National Science Foundation concludes that takeovers and leveraged buyouts have accounted for a substantial slowing of America's research and development...

...Such fragility marks the triumph of private greed over social rationality...

...The ransom is paid by corporate executives and directors, who presumably would lose their jobs if the predator succeeded...

...It is what makes America a great place to live...

...The most sought-after jobs among business school graduates continue to be in finance and consulting, where the specialty is the shuffling of corporate assets...

...They feel no loyalty to their present companies, which, after all, are regarded by directors and stockholders as little more than collections of financial assets...

...Productivity gains come gradually...

...While graduate programs in law and accounting are booming, engineering and science programs are foundering—again in contrast to other industrialized nations...

...A half century later, Keynes's fear seems just as warranted as it was during the Great Depression...

...A company was its managers and employees, its trademark and reputation...

...The managers of Electric Storage Battery did not want International Nickel to run the company, because they didn't believe that International Nickel could do a very good job of it, and they didn't want to lose their own jobs...

...Faced with the alternatives of investing in new plants, equipment, or research (risky propositions whose payoffs are likely to be in the distant future) or of distributing the earnings to shareholders (who are immediately taxed on such largesse), corporate managers instead see considerable attraction is snapping up profitable, well-run companies with established market positions—even their own...

...Rarely have so few earned so much for doing so little...

...In 1987 Drexel Burnham Lambert, Wall Street's fastest growing company, posted earnings of over $1.5 billion, putting it right up there with Xerox and the Monsanto Company...

...A third justification is often heard of late: takeovers are necessary in order to wake incumbent managers from their stupor...

...Wall Street's dynamism has little to do with the financing of new commercial venture...

...Corporations now exist for the investment bankers, who openly put them into play, buy and sell stock in them, initiate takeovers and leveraged buyouts...

...The merger was then hailed as brilliant strategy, through which the tobacco company would diversify into foods...

...R. J. Reynolds, the giant tobacco company, merged with Nabisco, the giant food processor, in 1985...

...When you hear an argument based on "economic fundamentals," you would be wise to place a hand firmly over your wallet and keep it there until the perpetrator has moved on...

...If he loses, most of the loss is borne by those who lent him the money...

...This was no time for squeamishness...

...It may be in the self-interest of a lone paper entrepreneur to bet a giant American corporation against the odds...

...The stock market crash of October 19, 1987, slowed things down a bit...

...So they are under pressure to demonstrate the short-term earnings that potential clients demand...

...Before International Nickel did this dirty deed, Wall Street had viewed such aggression as unseemly, if not unethical...

...The result is an economy ruled by the cynical values of takeover artists like Asher B. Edelman, whose course at the Columbia School of Business—in which he offered a $100,000 reward to any student who found a company he could acquire—was called "Corporate Raiding—The Art of War...

...In one memorable scene of Oliver Stone's 1987 film, Wall Street, Gordon Gekko, a corporate raider played by Michael Douglas, takes the microphone at the annual meeting of Teldar Paper, a company he is trying to acquire...

...Commercialization often requires the development of large production facilities, distribution and sales networks, and quality control systems...

...In the end, their legacy cannot be separated from the following problems in America's economy: • Myopia: Improvements in productivity often depend on investment strategies geared to the long term...

...The language through which this economic transformation has been accomplished is colorful and childlike, featuring "golden parachutes," payments of "greenmail," "white knights," and poison pills of all hues...

...Twenty-five years ago, the average American corporation paid sixteen cents of every dollar of pretax earnings in interest on its debt...

...The subsequent rush to dismember suggests, in fact, the reverse...

...The platoon of lawyers and legal advisers reaped at least $50 million...

...Is This Necessary...

...It is as if doctors and auto mechanics went house to house instructing the occupants on what they must do to avoid death or breakdown and then ripped them and their cars apart to make the prescribed repairs...

...Henceforth, brokers' commissions were to be subject to the free market, to ungentlemanly competition...

...Not long ago, the majority of stock on our exchanges was owned by individuals, many of whom remained with their companies for years...

...Our best minds are increasingly drawn to the pie-dividing professions of law, finance, and accounting and away from pie-enlarging professions like engineering and science...

...If he wins, he earns a fortune...

...For the year as a whole, 95 percent of the listed shares were traded, and most remained with their owners for only a few hours...

...And only the public-relations office of the United States Chamber of Commerce would contend that American firms have stayed competitive with those of Japan, West Germany, South Korea, and other places around the globe where, incidentally, hostile takeovers and leveraged buyouts rarely, if ever, occur...

...Deal making also has created abundant work for lawyers, especially when deals turn sour...

...Corporate raiders expropriate the wealth of employees by forcing them to agree to lower wages and then passing the savings on to the new stockholders...

...The frenetic movement of corporate assets engenders a similar shifting of managerial talent...

...But if all paper entrepreneurs behave similarly, the entire economy is bet against the odds...

...The American economy, then run along more gentlemanly lines, had grown quite large, and at a rapid clip, without stooping to such behavior...

...There are signs that this vicious spiral has begun, as each corporate player seeks to preserve its standard of living by expropriating a portion of the declining wealth of another group...

...Despite all the claims for synergy, there is little evidence to suggest that mergers have on the average enhanced the basic profitability of merging enterprises...

...between 1981 and 1984 there were forty-five...

...After a fierce takeover battle in the 1980s, the firm gutted its research laboratory...

...There were twelve hostile takeovers of $1 billion or more in the remainder of the 1970s...

...Asset rearrangers also have changed the pattern of stock ownership in ways that emphasize immediate gain...

...To the extent that they allocate capital more efficiently to where it can be most productive or smooth out what would otherwise be sudden changes in supply and demand, they make our economy perform better...

...The newly reorganized company could then be sold for a fat profit...

...Alternatively they argue that the stockholders don't know how much their stock is really worth, and they are being duped by the low bids of predators...

...Like doctors and automobile mechanics, who occupy equally enviable positions both of advising about the need for their services and supplying the services, paper entrepreneurs have discovered that their is no necessary limit to the amount of service they can urge upon their customers and thereupon provide...

...q 64 • DISSENT...

...It tends to invite zero-sum games, in which one group's gain is another's loss...

...400 million for "junk-bond underwriting and bank commitment...

...With good reason...

...In 1975 the Securities and Exchange Commission decreed that commissions paid on stock transactions were no longer to be based on fixed rates but were to be negotiable...

...Opportunism: The money required to rearrange industrial assets—to mount hostile takeovers, to defend against hostile takeovers, to return a company to private ownership by repurchasing the publicly owned shares of stock—typically is borrowed...

...These attributes could not be purchased against its will, or so it was assumed...

...Then came the leveraged buyouts, culminating in the last days of the Reagan administration, appropriately enough, with the $25 billion buyout of RJR-Nabisco...

...A case in point...

...If they manage the financial niceties, they are paid a small percentage of the deal...

...Thus the average term of office for today's chief executive officers is only four years...

...If they handle the legal complexities, they are paid according to the amount of time they put in...

...Corporate debt in the 1980s has reached alarming proportions...

...The corporate managers borrow money, often at high interest rates, to buy up their company's stock...

...General Electric's costly acquisition of RCA, for example, resulted in less research for both...

...All this demands a willingness to invest now for greater returns in a distant future...

...that is, managers who own their company work harder and better...

...In the search for quick profits, they move in and out of large positions with little regard for the strengths of the underlying enterprise...

...Close examination belies this comforting view...

...By 1988 the "M&A business," as it was affectionately called on the Street, accounted for more than 50 percent of their profits...

...The supply of investment bankers, as it were, created its own demand...

...During most of the 1980s, new issues of common stock averaged only about 1 percent of the total stock outstanding...

...Larger: The RJR-Nabisco deal of 1988 generated close to $1 billion in paperentrepreneurial fees...

...It was not unusual for such an investor to take a mildly proprietary interest in how his or her company was doing and what it was planning to do...

...Acquiring companies rarely have done well for their stockholders...

...They wax with equal enthusiasm over the gains to be had from disassembling and selling off piecemeal such parts, thus making the sum of the parts greater than the whole...

...After purchasing RJR-Nabisco, the firm of Kohlberg, Kravis, and Roberts controlled companies with total revenues of $50 billion, transforming KKR into the fifth-largest industrial company in the United States...

...Yet this is not a complete explanation...

...The average corporate chief executive may have an even smaller stake in future growth than the average stockholder...

...That it does is a sign of how thoroughly the culture of the new American paper entrepreneur has come to dominate the American economy of the 1980s...

...Like the obscure services listed on hospital bills and automobile repair receipts, those that made up this sum were not self-evident: some $200 million for what was called a "buyout fee...

...The demand for paper entrepreneurs, in turn, generated more of a supply...

...It keeps the system going...

...But the question is whether hostile takeovers are the most efficient means...

...By the late 1980s, managers who sensed the possibility of a hostile takeover employed a technique known as the "leveraged buyout...

...Or consider Borg-Warner, another company specializing in high technology...

...Paper entrepreneurs not only do the deals, but also advise their clients (corporate directors, chief executives, pensionfund managers) about when and whether such deals should be done...

...The bright colors mask darker realities, calling into question the purpose of the American corporation in the latter decades of the twentieth century...

...Since the mid-1970s, when most of this began, productivity gains have slowed...

...Investment bankers no longer think of themselves as working for the corporations with which they do business...

...Even by the cynical standards of the 1980s, the new paper entrepreneurs of Wall Street have given greed a bad name...

...He cites the nation's trade imbalance and loss of industry...

...Product competition is a healthy antiseptic for cleaning away encrusted management...

...The American economy as a whole has not benefited demonstrably from these paper activities...

...Takeovers are more like defoliants...

...Under new management, RCA's famed David Sarnoff Research Center, for decades an incubator of television technology, slashed its staff by 25 percent...

...Greenmail is ransom, paid to those who are trying to take over the company, to get them to stop offering the company's stockholders high prices for their stock...

...The managers who now own the company thereupon make it more valuable, either by increasing its productivity or by selling off its divisions...